Stock market outlook: Stocks start to look more attractive

Some fears are overblown, leading to attractive valuations in financial services and consumer cyclical.

Elizabeth Collins 29 March, 2016 | 5:00PM

Although the S&P 500 had fallen some 10% from the start of 2016, a strong bounce from mid-February puts the U.S. stock market basically back to where it started the year. As of mid-March, the market-cap-weighted-average price/fair value ratio of our coverage universe is 0.92, down from 0.96 as of Dec. 15, 2015.

The financial services sector is by far the most undervalued based on our estimates of companies' intrinsic values, with a market-cap-weighted price/fair value ratio of 0.78. While investors are right to be somewhat concerned about energy-related credit losses, currently low interest rates, and possible interbank contagion, the magnitude of the coming losses priced into many bank stocks is overdone, and we find many to be sporting attractive valuations today. We believe most bank's exposure to the energy sector is ultimately manageable. And we believe fears regarding counterparty risk and notional derivative exposures are also overblown. Net exposures to individual asset classes, events or counterparties are relatively manageable -- especially in the case of interest rates, which make up a bulk of reported notional exposures.

That's not to say that it won't be a painful year for bank earnings. Net interest margins will likely remain depressed. Credit quality will likely deteriorate. And poor stock market returns would be bad news for capital markets and wealth management businesses. But to us, it seems like for many banks investors have priced in this pain, and much more. For example,  Citigroup (C) has been hit hard by fears over its emerging-markets exposures, but we think the long-term outlook for the bank is actually brightening. The company could take losses of 36% on its entire emerging-markets exposure (which would be at the high end of historical emerging-markets crisis ranges for loss rates) and maintain its current 12% Common Equity Tier 1 ratio.

The basic materials sector is currently the most overvalued, according to our estimates of companies' intrinsic values, with a market-cap-weighted price/fair value ratio of 1.13. Although the sector has already seemingly suffered more than its fair share of volatility and concerns about a slowdown in Chinese fixed-asset investment, we still think that there is more downside for all-important valuation drivers such as iron ore, metallurgical coal and copper prices. Our bearishness rests on the assumption that Chinese steel demand will fall to 648 million metric tons by 2025, down from a peak of 765 million in 2013, because of slowing urbanization and absorption of excess real estate supply. In addition, rising scrap supply availability decreases the demand for key steel inputs, iron ore and metallurgical coal. We also expect Chinese copper demand to disappoint, with 2015 levels representing a medium-term peak as demand from the construction sector weakens and demand from the power sector shifts toward aluminum. All told, we find miners such as  Teck Resources (TCK),  Anglo American (NGLOY),  Southern Copper (SCCO) and  Vale (VALE) to be quite overvalued, with these specific companies all sporting our 1-star rating currently.

In contrast, we think China-related fears are actually overblown in the consumer cyclical sector. Here, we have a market-cap-weighted price/fair value ratio of 0.89, making it the second-most attractively valued sector (after financial services). While we're bearish on China's fixed-asset investment and overall GDP growth rate, domestic consumption could still post high-single-digit growth over the next five years. In line with this, we're positive on China passenger vehicle sales, and we forecast annual light vehicle registrations climbing to 23.7 million in 2020 from an estimated 20.5 million in 2015.  Fiat Chrysler (FCAU) is one of the most attractively priced stocks in the consumer sector. Although the company was late to enter China, Jeep's re-entry into China should provide 5-star-rated Fiat with growth potential.  Wynn Resorts (WYNN), currently rated 4 stars, is well- positioned for the long-term growth we expect to see in the Macau region.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Anglo American PLC ADR12.43 USD1.30
Citigroup Inc69.74 USD0.20
Fiat Chrysler Automobiles NV13.22 USD0.61
Southern Copper Corp33.88 USD0.95
Teck Resources Ltd Class B16.49 USD0.73
Vale SA ADR11.15 USD-0.18
Wynn Resorts Ltd113.52 USD-0.46

About Author

Elizabeth Collins

Elizabeth Collins  Elizabeth Collins, CFA, is global head of equity research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. In this role, she leads the global equity research team, which focuses on providing in-depth, fundamental equity research based on sustainable competitive advantages and long-term valuation analysis. Before assuming her current role in 2018, Collins was director of North American equity research. She joined Morningstar in 2005. She holds an MBA from DePaul University and is coauthor of Why Moats Matter: The Morningstar Approach to Stock Investing, published by John Wiley & Sons in 2014.