Outlook for U.S. stock market: Pick your spots carefully

Interest-rate fears bring utility and real estate valuations in line, but the broader market still looks fully valued.

Matthew Coffina 6 July, 2015 | 5:00PM

To see investors' mood swings when it comes to interest rates in the United States, take a look at a three-year chart of  Utilities Select Sector SPDR (XLU) or  iShares US Real Estate (IYR). Both exchange-traded funds zoomed higher in the first half of 2013 as the yield on 10-year U.S. Treasury bonds fell as low as 1.66%. They collapsed in the second half of 2013 as the 10-year rate surpassed 3%. They climbed steadily throughout 2014 as the Treasury yield fell back to 2.17%. And they've been sliding thus far in 2015 as long-term rates creep higher and the Federal Reserve signals its first hike to short-term rates in almost a decade.

We take a long-term view of both cash flows and discount rates, so our fair value estimates haven't moved nearly as much as stock prices. Our discount rates incorporate a 4.5% normalized long-run risk-free rate, which is well above current interest rates. Last quarter, we thought utilities and real estate were overvalued, but with the recent stock price declines, we now see these areas as roughly fairly valued. The median stock in both sectors is trading at a 1% to 2% discount to our fair value estimate.

As investors continue to overreact to moves in interest rates, there are a few pockets of opportunity emerging. Within utilities,  Southern Company (SO),   Duke Energy (DUK) and  American Electric Power (AEP) offer generous dividend yields and 8% to 10% long-run total return potential. Wide-moat  ITC Holdings (ITC) trades at the steepest discount to fair value since we started covering the stock and offers earnings growth that is double the regulated-utility average. As for real estate, we like the economic defensiveness, long-term growth opportunities and above-average dividend yields of health-care real estate investment trusts, including  Ventas (VTR) and  HCP (HCP).

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
American Electric Power Co Inc90.33 USD0.01
Amgen Inc216.52 USD0.06
Banco De Chile ADR15.80 USD-1.19
Banco Santander Chile ADR14.39 USD-2.77
Bank of Nova Scotia55.12 CAD1.55
Baxter International Inc77.27 USD-1.13
Duke Energy Corp92.44 USD1.60
Healthpeak Properties Inc27.37 USD2.95
Royal Bank of Canada92.88 CAD1.85
Southern Co58.71 USD0.60
Svenska Handelsbanken A72.88 SEK-0.16
The Toronto-Dominion Bank58.61 CAD1.37
U.S. Bancorp831.99 MXN0.00
U.S. Bancorp37.45 USD0.40
Ventas Inc39.86 USD2.63
Wells Fargo & Co20.94 USD-1.16

About Author

Matthew Coffina

Matthew Coffina  Matt Coffina, CFA, is a portfolio manager for Morningstar’s Investment Management group and editor of Morningstar® StockInvestorSM.

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