The stock market is looking fully valued, says Matthew Coffina, CFA, who edits Morningstar StockInvestor.
This means investors should get ready for “modest returns over the next five years,” he explains in an outlook piece on Monday.
“Market-timing has never been our game, but we can’t help but notice signs that this bull market may be getting long in the tooth: the Federal Reserve’s first interest-rate hike in a decade, a lack of market breadth, investors’ willingness to pay almost any price for fast-growing but unprofitable ‘story stocks,’ signs of trouble in the junk-bond market, and records or near-records in share repurchase activity and mergers and acquisitions,” he stated.
The Morningstar specialist sees earnings declining by 5% for the S&P 500 Index in 2015. Furthermore, it seems unlikely for dividends and earnings growth to support total returns above 6%-8% per year over the long run, Coffinna says. “Investors should set their expectations accordingly,” he cautioned.
“The market is increasingly driven by a handful of high-flying growth stocks such as Amazon.com (AMZN) and Netflix (NFLX), leaving more opportunities in out-of-favor cyclicals and value stocks,” he explained. “We believe investors are too pessimistic about certain apparel, energy and industrial companies, among others.”
Still, the S&P has been cheaper on a normalized price/earnings basis two-thirds to three-fourths of the time over the past 25 years, the CFA adds, meaning the prices are (too) high overall.
Poor Earnings, Value Plays
The S&P 500 may end the year near where it started, but earnings have been deteriorating, which pushes up valuation multiples, he says.
Some factors driving weak earnings include the strong U.S. dollar, weak commodity prices, slowing emerging-markets growth and recession-like conditions in several industrial areas of the U.S. economy.
Nonetheless, diverging returns between industries have created “a few areas of opportunity,” according to the Morningstar editor.
The consumer cyclical sector has posted strong year-to-date total returns, but apparel firms and lower-ticket discretionary retailers have fallen out of favor, he notes.
“Our analysts see value in firms such as VF Corp. (VFC), Nordstrom (JWN), and Gap (GPS),” Coffinna explained. As for the consumer defensive arena, Wal-Mart‘s (WMT) valuation “already incorporates the growth and margin pressures confronting the world’s largest retailer.”
While falling commodity prices are hurting the energy and basic materials sectors, Morningstar is says it is more likely that we will see an intermediate-term turnaround in energy before we see one in basic materials.
This is because “sooner or later natural decline curves will catch up to [energy] producers that are sharply cutting back on drilling activity. Our analysts favor energy firms with low costs and relatively strong balance sheets, including ExxonMobil (XOM), Continental Resources (CLR), and Cabot Oil & Gas (COG).
Morningstar specialists urge investors to avoid most industrial commodity miners. However, they are “relatively more bullish on commodities linked to Chinese consumer spending, such as gold and fertilizer.”
A number of factors have hit the industrials sector, such as low energy prices, the strong U.S. dollar and global macroeconomic worries. Morningstar analysts, though, are bullish on conglomerate Emerson Electric (EMR), mining equipment manufacturer Joy Global (JOY) and some railroads, like Canadian Pacific (CP), Kansas City Southern (KSU), and CSX (CSX).
Analysts with the research group also are seeing discounted valuations for in media, health-care REITs, biotech and Canadian banks.
Valuation ratios are worth a re-examination, according to Morningstar.
As of mid-December, the median stock followed by the research group trades with a price/fair value ratio of 0.95, which is generally unchanged since last quarter.
The S&P 500 is at 2,073, which implies a price/earnings ratio of 19.5 using trailing 12-month operating earnings, 26.2 using a 10-year average of inflation-adjusted earnings (the Shiller P/E), or 18.1 using trailing peak operating earnings.
“Those measures have been lower 67%, 67%, and 74% of the time since 1989, respectively,” according to Morningstar. In addition, valuation multiples have deteriorated since last quarter as stock prices have improved and earnings have dropped.