Our Outlook for the Market

·         The events in Europe over the last several months have raised the level of uncertainty over the market's short-term direction yet again. While we think the market looks somewhat undervalued these days, the news out of Europe could mean stocks get much cheaper before they start to appreciate. As of mid-June, the market-capitalization-weighted average price/fair-value of stocks under Morningstar coverage has fallen to 83%, down from 92% at the end of the first quarter, and in line with where it started the year.

·         We expect opportunities will arise where strong companies with little exposure to Europe will get thrown out with the bathwater, and we'll be jumping on those opportunities because we're still relatively optimistic about the outlook for the U.S. economy, particularly when compared with the outlook for the rest of the world. 

·         In times like these, we think it's particularly important to stick to high-quality, wide moat businesses, and use the volatile nature of the markets to your advantage by buying stocks when they are trading at a discount to fair value.

Global markets spent a good part of the second quarter giving up gains achieved during the first quarter, thanks to a bevy of bad news out of Europe and weaker economic data in the U.S. and China as well. We don't expect things to calm down in Europe for several years, as we commented last quarter, because even as shorter-term liquidity problems can be averted by European Central Bank actions, the underlying solvency problems are nowhere near fixed. What started out as a private-sector problem in Spain is quickly becoming a sovereign debt issue, and we expect the austerity measures that are being implemented throughout Europe to result in a very poor outlook for economic growth there.

As our director of economic analysis, Robert Johnson, has stated many times before, the good news is that the U.S. economy is not overly reliant on exports to Europe, with European exports constituting little more than 3% of U.S. GDP. In fact, changes in the price of gasoline are more likely to have a material impact on U.S. GDP than what happens with European or Chinese demand for U.S. exports.

Although the U.S. economy may be somewhat insulated, we have no doubt that the news out of Europe will continue to impact U.S. markets. Despite the small direct impact Europe may have on the U.S. economy, there are numerous indirect linkages, and many major U.S. companies generate a meaningful amount of revenue and profits from Europe. In this environment, we're focusing our ideas on stocks of wide-moat, U.S.-based companies with little exposure to Europe. After the second quarter's correction, valuations are pretty much back to where they started the year, with the market-capitalization-weighted average price/fair-value of stocks at 83% as of mid-June. Although we would hardly call the market a screaming buy at these valuation levels, we are seeing more value than we did a quarter ago. We now have about 160 stocks with 5-star ratings, up from just 60 at the start of the quarter, and the number of overvalued, 1-star stocks has fallen to 35 from 60 over that same period. Within our coverage universe, wide-moat stocks are slightly more expensive than stocks with a narrow or no moat rating, but we're still focusing on the universe of moaty stocks for ideas, given our weak outlook for global markets.

As we look across sectors, the economically sensitive areas of basic materials and energy continue to stand out as cheap relative to the overall market. Basic materials is trading at just 74% of fair value, and energy is trading at 77% of fair value. Although this leads us to conclude that these sectors will outperform over time, we think the issues holding these sectors back--namely lower commodity prices and weak global demand for commodities--are likely to continue for the coming quarter. That said, with valuations as low as they are, we expect that the risk-reward in these sectors is starting to turn more favorable, with the caveat that careful stock selection is critical. 

On the flip side, investors' insatiable appetite for high-yielding stocks has resulted in overvaluation of the real estate sector. This dynamic also affects utilities and communication services, but doesn't show up as directly in the top-line valuation statistics for those sectors due to the bifurcated nature of each sector. In utilities, a thirst for dividends has pushed up valuations of the stalwart regulated firms, while the independent power producers in that sector remain undervalued due to low prices for natural gas, for example. The same goes for communication services, where the bellwether U.S. telecom names such as AT&T (T) and Verizon (VZ) are trading at premiums, while the European and emerging-markets telecom names we cover have gotten quite cheap.

We expect market volatility to continue, and combined with low inflation and continued sovereign debt concerns in Europe, it portends continued strength in the market for bonds over the next quarter or two. However, as we said last quarter, we're still more interested in allocating cash to stocks than bonds in this environment, particularly if we're talking about Treasuries, with a negative real return at today's levels. Although the situation in the bond market may not reverse itself in the next quarter, over the next couple of years, we think investors will find better opportunities, on a risk/reward basis, among stocks.

In an environment like this, where the short-term outlook for the market is quite murky, we believe maintaining a long-term focus on solid businesses with wide or narrow moats and that generate strong cash flows is the way to go. We would keep some dry powder to add to positions as the market hands us opportunities in the short term to buy great businesses at a discount to fair value.

Heather Brilliant is the Vice President of Global Equity and Credit Research at Morningstar.