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).
Wide-moat banks, overvalued health care
On the other end of the spectrum, the health-care sector has been on fire thus far in 2015, up by a double-digit percentage. That follows the pattern of the past three years, during which health care has delivered annual total returns approaching 30% -- 11 percentage points better than the S&P 500. Speculation about mergers and acquisitions and investors' unbridled enthusiasm for biotechnology deserve much of the credit. The downside is that we now view health care as modestly overvalued, though there are a handful of exceptions such as Amgen (AMGN) and Baxter (BAX). Technology and telecom stocks have also been engulfed in M&A rumours, and with both sectors overvalued, we encourage investors to be selective and focus on the fundamentals.
Elsewhere, we have eight new wide-moat banks following a comprehensive review of our moat methodology for the global banking industry. The highest-quality banks are able to establish sustainable competitive advantages through a combination of low costs (cheap deposit funding, superior underwriting and operational scale) and customer switching costs (most customers would rather avoid the hassle of changing banks). We analyzed 22 global banking systems and found that Australia, Canada, Sweden and, to a lesser extent, Chile have favourable macroeconomic, regulatory, political and competitive characteristics that are conducive to moats. As a result, we upgraded our moat ratings for Toronto-Dominion (TD), Bank of Nova Scotia (BNS), Royal Bank of Canada (RY), Banco Santander Chile (BSAC), Banco De Chile (BCH) and Svenska Handelsbanken (SHB.A) to wide from narrow.
Although the U.S. banking system is more challenging -- including intense competition and a fragmented regulatory landscape -- we found that Wells Fargo (WFC) and U.S. Bancorp (USB) also deserved wide moats. Several of these banks are trading at attractive discounts to our fair value estimates, including TD and U.S. Bancorp.
Flat market leaves stocks fully valued
The S&P 500 has barely budged since our last quarterly update, so the market as a whole still looks fairly valued to slightly overvalued. The median stock in Morningstar's coverage universe trades right around our fair value estimate. However, this measure has benefited from lower discount rates in our valuation models, as we now assume investors require a 9% long-run total return from stocks, down from 10% previously.
There can be little question that higher valuations today correspond to lower returns tomorrow. Elevated price/earnings ratios detract from future returns in at least two ways. First, they diminish the benefits of capital allocation: Higher stock prices mean lower dividend yields and less-effective share repurchases. Second, higher valuations increase the likelihood of future P/E multiple contraction, and make it less likely that P/E multiples will expand.
On a price/earnings basis, the S&P 500's valuation remains rich by historical standards. The index was around 2,120 in late June. That implies price/earnings ratios of 19.2 (using trailing-12-month operating earnings), 27.3 (using a 10-year average of inflation-adjusted earnings--the Shiller P/E) or 18.5 (using trailing peak operating earnings). Those measures have been lower 65%, 76% and 78% of the time since 1989, respectively. Such high valuation levels could be justified -- assuming interest rates stay low and profit margins stay high -- but we don't see much room for error in today's stock market.
More quarter-end insights:
- Economic outlook: Stuck in neutral as we cling to cash
- Financial services: A favourable outlook for insurance
- Consumer cyclical: Assessing disruptions in restaurant, retail and travel
- Consumer defensive: Top-shelf picks for a cautious spending environment
- Basic materials: China slowdown weighs on commodities (with one exception)
- Energy: No rapid rebound for oil prices
- Industrials: Stronger U.S. dollar, weaker energy activity weigh on sector
- Real estate: Rising interest rates wreak havoc on REITs
- Utilities: Starting to look attractive after a woeful 2015 start
- Health care: A few stocks still offer upside
- Tech and telecom: M&A heats up, and the cloud changes the landscape
