Morningstar Research published a remarkably useful U.S. market forecast that, while highlighting portfolio risks, also provided a number of well-considered equity options for investors.
Morningstar is not bullish on the S&P 500 as a whole for 2016. The analysts note that slowing profit growth has left many stocks with high price-to-earnings ratios, which are likely to limit price appreciation for the year. They are also concerned about market breadth – the fact that very few stocks are contributing to positive performance for the benchmark.
Expensive valuation levels and poor breadth are typical of a "late-cycle" market environment and current conditions suggest the post-crisis equity rally is drawing to a close.
"We can't help but notice signs that this bull market may be getting long in the tooth: the Federal Reserve's first interest-rate hike in a decade, a lack of market breadth, investors' willingness to pay almost any price for fast-growing but unprofitable 'story stocks,' signs of trouble in the junk-bond market, and records or near-records in share repurchase activity and mergers and acquisitions," the report said. "It seems unlikely that dividends and earnings growth can support total returns above 6-8 per cent per year over the long run."
More positively, Morningstar has found a silver lining amidst the market's narrow focus, noting that the investor concentration in FANG stocks (Facebook Inc., Amazon.com Inc., Netflix Inc. and Google Inc. – now Alphabet Inc.) has left "more opportunities in out-of-favour cyclicals and value stocks. We believe investors are too pessimistic about certain apparel, energy and industrial companies, among others."
The report is particularly optimistic about U.S. retail stocks, a sector that outperformed in 2015 yet fell out of favour. Specifically, the analysts cite VF Corp., Nordstrom Inc., Gap Inc. and, more defensively, Wal-Mart Stores Inc. as undervalued.
In my opinion, Morningstar's argument for automotive stocks is the most compelling. Attractive financing has boosted North American auto sales and yet stocks in the sector have yet to benefit. The report includes General Motors Co.and Ford Motor Co. Ltd. as undervalued.
The chart shows valuation data for all major stocks mentioned as investment opportunities by Morningstar. The columns show the current trailing price-to-earnings ratios and the five-year average price-to-earnings ratios for each company. They are ranked, bottom to top, by companies trading at the largest discount to historical PE ratios. Cabot Oil and Gas stock, for example, currently trades at 30 times earnings, which is a 43-per-cent discount to the five-year average annual PE of 69 times.
Beyond Cabot, the notable stocks trading at the largest valuation discounts to recent history are Gap, Canadian Pacific Railway Ltd., and General Motors.