Jason Stipp: I'm Jason Stipp from Morningstar. Of course part of your portfolio check-in is reviewing past performance, but you should also set the right expectations for your portfolio looking ahead. Here to help us do that is Morningstar Markets Editor Jeremy Glaser. Jeremy, thanks for being here.
Jeremy Glaser: You are welcome Jason.
Stipp: 2014 turned out to be a better year in the stock market than a lot of folks expected. But what about 2015? When we look at market valuations today, what kind of expectations should we be setting for the future?
Glaser: Well, let's start by looking at those valuations. And one of the ways that we look at here at Morningstar is our price to fair value ratio for the entire market. And we arrive at this by our team of equity analysts figuring out the intrinsic value of a number of mainly large and mid-cap U.S. equities comparing those intrinsic values, there is fair value estimates to where the market price is and just seeing how they compare. And the median stock that we cover right now is trading at a 4% premium to its intrinsic value.
So overvalued, but only just, not a dramatic overvaluation. This has actually been the case kind of this range of being about fairly valued has been the case for quite some time. Now one of the big changes that has happened over the last couple of months is some very big divergence in the valuations of different sectors. The energy sector has become quite undervalued, its trading at 80% of its intrinsic value, obviously with lower oil prices that’s been a big weight on those firms.
So even though some of our fair value estimates have come down we still think that they are dramatically undervalued in some cases. And other sectors, notably utilities and real estate look almost 20% over valued as investors seeking yields have really bid up price of their shares too much. So generally valuations look about fair. But there are definitely some differences among sectors.
Stipp: You said we've seen the market looking overvalued about 4% or so for a little while and I looked a year ago. We thought the market was about 2% overvalued this time last year. So how can the market which was up about 13% last year the S&P 500 come up so much, but the fair value – price to fair value ratio doesn’t really change so much?
Glaser: The simple answer there is that our fair value estimates have increased and we've seen that for a couple of reasons. The first being that analysts sometimes just change their opinions on companies, because of new news, because of new information. They think that the earnings power of the company and the cash flows that they are going to produce over time have actually increased and that’s going to boost their fair value estimates. So that one I think makes a lot of sense to most investors.
But also even if you didn’t expect big changes in the business, you still would want the fair values, we would see the fair value estimate increase every year due to the time value of money that the money that you have now is worth more than money in the future.
So as you bring those earnings forward a year discounting by one less year that’s going to increase your fair value estimate; think about those retained earnings, the intrinsic value of the company is getting bigger so you'd expect the fair value and intrinsic value to increase there too.
So between the upgrades that we saw just from fundamental reasons due to the upgrades that you see from the time value of money you do see fair value estimates start to come up a little bit I think that explains why the price to fair value ratios have looked pretty similar.
Stipp: So where we are sitting right now, stocks do look about the median stock does look about 4% overvalued. So what does that mean for the expectations I should set for my stock portfolio.
Glaser: Well this is obviously the important question. I think it's important to note that this median price to fair value number saying, okay, we think stocks are 4% overvalued is not a short term market call. In the short run even the medium term almost anything is possible. Stocks could become much more overvalued and stay there they could be become very undervalued and stay there for some time. We really are trying to think about what's a reasonable expectation for given current valuations where we are now that investors can earn over say a 20 or 30 year time horizon. The kind of time horizon that people actually should hold stocks for, or that would make sense as part of that broader portfolio.
Matt Coffina who is our Editor of Morningstar StockInvestor and equity strategist at Morningstar thinks that somewhere in the 4.5% to 6% range is reasonable for that long term stock returns given where we are now and that takes into account what earnings growth is going to look like, dividend yields, because that total return number includes what you are going to get paid in dividends.
And I think that, that strikes me to as very reasonable number for what investors can expect over that long run. But you actually need to be invested over that 20 and 30 years to recognise and to really realise the potential of those gains over time trying to time the market by saying, it's a little bit overvalued now, it’s a little bit undervalued now and coming in and out you could really miss some of the big upswings that really could contribute a lot of that return over time and be stuck in the market in periods when maybe stocks aren’t doing so well.
It's just very difficult to make those short term timing decisions. So I think most investors are really sticking with their plan, sticking with that asset allocation is really going to help them achieve those goals even if that rate's a little bit lower than they are used to over the short term. It's still probably the best strategy versus trying to get the timing exactly right.
Stipp: So you mean the long term average return means you have to hold for the long term. Let's just turn finally and talk a little bit about the fixed income markets we thought and lot of people have thought that rates would be coming up for a while that was not the case in 2014. So sitting here where we are now at the beginning of 2015 given what we think rates might be doing. How should I set expectations for fixed income?
Glaser: Well, if you are going to have more modest expectations on equities, you should probably also have more modest expectations in fixed income maybe even prepare yourself with the possibility that bonds could lose ground in a situation where interest rates are rising and that really is the key question.
Going into last year basically everyone thought that interest rates were going nowhere but up and that just wasn’t the case. They actually came in as investors really were looking for safe havens even in a situation where the Fed was very clearly laying the ground to raise rates some time in 2015. And rates will eventually come up, they are not sustainable at these relatively low levels.
Bob Johnson our Director of Economic Analysis thinks that it will be somewhere into 3% to 3.5% range at the end of 2015. So when you have those rising rates that’s going to provide a headwind and prove to be a headwind for bonds and for bond funds. So I think investors should be prepared for that.
But they should also think closely about why they are holding bonds. It is probably not for absolute return. It's probably because they are using it in a portfolio context as part of an asset allocation – to provide that diversification those are the real reasons that they hold it not just for kind of the big returns that they may have seen when we were in environment where rates just kept getting lower and lower. So I think that even if bond returns aren’t going to look spectacular, aren’t going to replicate the returns we've seen in the past that’s not to say that you shouldn’t hold bonds or that bonds aren’t still an important part of your portfolio.
Stipp: Setting the right expectation certainly helps us be better investors. Jeremy thanks for joining me today.
Glaser: You are welcome Jason.
Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.
