U.S. Markets

The best-performing sectors thus far in 2016--utilities, consumer staples, energy and basic materials--all look overvalued to our analysts.
By Matthew Coffina | 04/07/16

After a rough start to the year -- the S&P 500 fell more than 11% in the first six weeks of 2016 -- the U.S. market abruptly reversed course. Although the "Brexit" vote caused volatility in recent days, we're now back within a few percent of the all-time high, and our analysts find the average stock in our coverage universe to be trading close to fair value.

About the Author
Matt Coffina, CFA, is a portfolio manager for Morningstar’s Investment Management group and edits Morningstar® StockInvestorSM, Morningstar’s flagship stocks newsletter. As part of his role as editor, Coffina manages the publication’s two real-money, market-beating model portfolios: the Tortoise and the Hare. Previously, Coffina was a senior equity analyst, covering managed care and pharmaceutical services companies. In 2012, he ranked third in the Food and Drug Retailers category in The Wall Street Journal’s annual “Best on the Street” analysts survey. Coffina also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe. He joined Morningstar in 2007. Coffina holds a bachelor’s degree in economics from Oberlin College. He also holds the Chartered Financial Analyst® designation.

The fears that had gripped investors early in the year haven't exactly gone away: Economic growth is still sluggish to nonexistent around the world, corporate earnings are moving in the wrong direction, and valuations remain well above historic norms. However, investors appear to be coalescing around a worldview that's even gained its own endearing acronym: TINA, as in "there is no alternative" to stocks.

Defying previous expectations for multiple Federal Reserve interest-rate increases this year, long-term Treasury bond yields have drifted lower since the beginning of 2016. At first, this was seen as reason for concern. If the Fed isn't in a position to raise rates now--seven years into the recovery and with unemployment at just 4.7%--then there must be something seriously wrong with the U.S. economy.

But TINA thinking is overtaking economic jitters. Sure, corporate earnings have been terrible. And sure, the S&P 500 was recently trading for 21 times trailing 12-month operating earnings--a level not seen since the cyclically depressed earnings of 2009. But investors have to put their money somewhere. Even overvalued stocks are better than a 10-year Treasury bond yielding 1.5%, right?

Commodity price rebound: Real or illusory?

The drop in interest rates explains half of the year's best-performing sectors: Defensive stocks like utilities, REITs and consumer staples--widely viewed as the most bond-like stocks--have been on a tear. The other half of the story can largely be attributed to a rebound in commodity prices ranging from oil to iron ore. Commodity prices are still well below their levels of a couple years ago, but they're well above the recent lows, giving investors hope that the worst may be behind us. As a result, energy and basic materials have joined the most defensive sectors in leading the market higher in 2016--one of the stranger correlations you'll see.

Unfortunately, our analysts believe investors have already overreacted to the run-up in commodity prices. This is especially true for industrial commodities, where our bearish view on China's infrastructure spending causes us to believe that current commodity prices are unsustainable. As of May 31, energy and basic materials were both trading more than 25% above our market-cap-weighted average fair value estimates, making them the most expensive sectors by far. Long-suffering commodity investors may want to take this relief rally as a chance to run for the exits.

Defensive, interest-rate-sensitive sectors also look overvalued to our analysts, though not to the same extent as energy and basic materials. We recently pegged utilities' market-cap-weighted average price/fair value ratio at 1.07 and consumer defensive's price/fair value at 1.04. These companies may be insulated from economic ups and downs, but many of them struggle to deliver attractive revenue and earnings growth.

Financial services, consumer cyclical and healthcare offer better values

No sector looks obviously cheap in this fully valued market, but we're finding better values among beaten-down financial-services, consumer cyclical and healthcare stocks. These sectors carried average price/fair value ratios of 0.88, 0.93 and 0.95, respectively, as of May 31.

Diminishing expectations for interest rates have been a significant headwind for financial services. Banks have seen steady erosion in their net interest margins, and were counting on Federal Reserve rate hikes to reverse this situation. For valuation purposes, our analysts still assume a long-term, normalized 10-year Treasury yield around 4% to 4.5%. In a discounted cash flow framework, this long-term assumption matters more than the path taken to get there.

Within the consumer cyclical sector, we believe investors have overreacted to the challenges facing apparel retailers. E-commerce poses a serious long-term threat, but there are also cyclical elements to recent weak apparel results, including excess inventory and a lack of new fashion trends. We think off-price retailers and branded apparel manufacturers, especially those selling basic replenishment goods like undergarments, are best positioned for the long run. Traditional retailers and department stores look most at risk.

As for healthcare, we see improved pipeline productivity driving growth at pharmaceutical and biotechnology firms. Despite political rhetoric around drug pricing, we expect pricing power to remain strong as companies deliver innovative new therapies in areas of unmet medical need, such as oncology and immunology. New immuno-oncology drugs are reaching the market in half the time of drugs developed a decade ago thanks to both scientific advancements and a more accommodative regulatory environment.

More quarter-end insights

Basic materials: Recent commodity rallies leave few opportunities

Consumer cyclical: Market underestimating apparel and e-commerce (Tuesday)

Consumer defensive: Not a lot to feast on (Tuesday)

Energy: Supply glut continues, but some respite on pricing (Wednesday)

Financial services: Accounting for Brexit and the fiduciary rule (Wednesday)

Industrials: Valuations stretched, but opportunities still exist (Thursday)

Healthcare: Stock selection increasingly important (Thursday)

Real estate: 'Safety' becomes more expensive (Friday)

Tech & telecom: We see opportunities in Apple and Microsoft (Friday)

Utilities: Is a sector-shaking pile-up coming? (Friday)

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