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The US market: under, over or fairly valued?

Jason Stipp  |  05 Dec 2011Text size  Decrease  Increase  |  

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Jason Stipp is the site editor for Morningstar US.

This week Morningstar kicks off global equities week. In the first of a series of articles, Jason Stipp examines the valuations on two US-based ETFs that offer exposure to the broad US market.

 

The S&P 500 has taken a beating over the past 10 years, up only 2.5 per cent on an annualised basis (as of 28 November). That anemic return came with incredible ups and downs, while safer bonds offered a 5.7 per cent return with less volatility over the same period.

But at this point, the outlook for US stocks has improved. Now, in late November, the S&P 500 is trading at the same level it hit in late 1998. Yet the underlying companies have grown considerably over the trailing decade. Profits in 2011 are expected to reach levels not achieved since before the crisis. And the dividend yield on the S&P 500 is higher than the yield on 10-year US Treasury bonds, a rare occurrence that bodes well for stocks.

Why have US stocks struggled lately? US economic growth hit a soft patch in the first half of 2011, stirring fears that the economy might dip back into a recession. However, from a fundamental standpoint, US firms are in a better position to handle an economic slowdown than they were three years ago. Since that time, corporations have reduced debt and raised cash.

But just how attractive does the market look at current levels? One way to get a handle on market valuation is by digging into Morningstar's ETF research and data. Most equity ETFs track indexes that are designed to capture the performance of certain regional markets, stock sectors, or other attributes. ETF portfolios are also transparent and reported daily by the ETF providers, so investors have much more certainty about ETFs' current holdings.

Given this timely portfolio data, Morningstar analysts are able to calculate a fair value estimate for an ETF's portfolio by rolling up Morningstar's individual fair value estimates for the underlying stocks. (Our stock analysts have such estimates for about 1350 companies.)*

We took a look at the valuation data on a couple of broad-market US-focused ETFs to glean some insight into overall market valuations. Excerpts based on Morningstar ETF analyst Mike Rawson's research reports on these funds are below.

 

Dow Jones Industrial Average: high quality on sale

As of 29 November, the SPDR Dow Jones Industrial Average (DJIA) ETF had a fair value estimate of US$136 per share versus a current trading price of US$116, making the market proxy about 15 per cent undervalued. Morningstar analysts cover all 30 stocks in the DJIA, meaning we have a fair value estimate on each of the names.

The Dow contains only the largest mega-cap stocks, and over 71 per cent of the asset weighting of the index is in stocks with a wide economic moat. (The moat rating - wide, narrow, and none - is how Morningstar analysts measure of the quality and defensibility of a firm's competitive economic advantage.) This indicates that DJIA has a very high-quality portfolio of companies.