Summary:
- We think the market looks pretty close to fairly valued at this point, with stocks under Morningstar coverage trading at 91% of fair value, using a market-capitalisation-weighted average. Due to the third-quarter rally, this represents an improvement from 83% of fair value at the end of the second quarter. High-quality names have done particularly well during this period, with wide-moat stocks trading at 96% of fair value.
- Europe did not end up dragging down global markets in the third quarter as we had feared. European Central Bank president Mario Draghi's promise to do "whatever it takes" to save the euro freed the market to go on holiday, and the market's rally in August was driven by pretty low volumes. Although we're pleased to see Europe attacking its financial crisis head-on, we still have concerns about the region longer term.
- Headline news in the fourth quarter will include the US presidential election. This quadrennial event always has the potential to put the market on edge, but we don't think it will materially affect company fundamentals. As we mentioned last quarter, we're still relatively optimistic about the outlook for the US economy, particularly when considered in the context of a weaker global economic picture.
In Depth:
August was a particularly quiet month this year, with top-tier markets marching slowly upwards on very low volumes as many traders and equity investors opted to take a summer break. In fact, this August was downright tranquil compared with the heightened volatility we saw in August of the last two years, and it was a welcome respite. Mario Draghi, president of the European Central Bank, calmed markets in late July with his comment that the ECB would do "whatever it takes" to save the euro, setting markets up for a nice rally throughout August.
Investors shouldn't get too comfortable, however, as we expect market volatility will resume this autumn. Now that the world is returning from holiday and paying attention, the ECB will need to successfully implement its plan for saving the euro, which we expect will prove a lot harder than its initial pledge implies. We think the risk of sovereign default is no longer imminent. However, the economic outlook for the region is weak and long-term solvency issues remain.
Clearly we are not the only ones with this concern, as the valuations of European firms under Morningstar coverage are significantly less demanding than we see for our North American companies, on average. Our European coverage is trading at 91% of fair value, while our North American coverage universe is currently priced at 97% of fair value. In fact, we find valuations of higher-quality, lower-risk companies exceed those of higher-risk businesses across the board. For example, wide-moat businesses are trading at 96% of fair value on average, compared with stocks without a moat trading at 92% of fair value. Similarly, companies with low fair value uncertainty ratings trade at just a 2% discount to our fair value estimates for those firms, in contrast to firms with high and very high uncertainty ratings that are trading at 87%-91% of fair value. Looked at another way, our defensive super sector is trading at 97% of fair value, while companies in the cyclical super sector are priced at 88% of fair value.
An environment like this can lend itself well to focusing on stock-specific investments, rather than following along with the overall market or macroeconomic picture. As my colleague Dave Sekera comments on the bond market, "Currently, the market as a whole appears to be driven more by monetary policy as opposed to individual company fundamental analysis. In this environment we advise investors to be cautious in selecting which bond offerings they participate, lest they be plagued with buyer's remorse if/when the market takes a turn for the worse." We think similar rationale applies to the stock market here, as well. Indiscriminate buying is not likely to serve investors well, but focusing on specific stocks trading at a meaningful discount to fair value is a sound strategy. Compelling valuations are hard to come by at the moment, however. A quarter ago, we had about 160 companies that carried Morningstar Ratings for stocks of 5 stars; now we are down to just 69. At the same time, the number of overvalued, 1-star stocks has remained steady at right around 35.
Along those lines, we continue to see the greatest areas of opportunity among the more cyclically oriented sectors. At the moment, the basic materials and financial-services sectors offer the greatest discounts, with basic materials trading at 82% of fair value and financial services at 87% of fair value. European steel firm 
ArcelorMittal (MT) has garnered a narrow economic moat rating as a result of its cost advantage, and while the market is concerned about the 40% of ArcelorMittal's sales that come from Europe, we think the firm benefits from product, end-market and geographic diversification that help offset this concern. An investment in a firm like ArcelorMittal is not for the faint of heart, as we expect 2012 to continue to be challenging for the firm, but we think the risk/reward is positively skewed at a discount to fair value that exceeds 60%.
When it comes to highly valued stocks, as we commented last quarter, investors' insatiable appetite for high-yielding stocks has resulted in overvaluation of the real estate sector, which is trading at more than a 10% premium to our fair value estimates for that sector. Consumer defensive names have also had a good run in recent years and now trade at a 6% premium to fair value. Investors have been loath to sell high-yielding names in this environment even if valuations look stretched, given the lack of undervalued alternatives. We see this in the bond market, too, with bond investors indiscriminately picking up any new paper that comes to market, with little regard for the underlying fundamentals. We think investors will be well-served in the long run to hold out for undervalued names, both in the equity and corporate credit markets, particularly of companies with wide or narrow economic moats.
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