Question: I moved part of my portfolio out of the market in late 2008 when I was concerned that the economy and the stock market were in a downward spiral. But now that stocks have rallied, how can I get back in without getting burned?
Answer: It's small consolation, but you're far from alone in this conundrum.
I'd recommend that you start by establishing your target position in stocks. Then plan to slowly build your position during the next six to 12 months, adding a set amount each month until you hit your target.
As to your broader concern that it might be too late to invest in stocks, Morningstar's various valuation tools can help shed some light on that topic. They can also help you focus on parts of the stock market that still have upside potential left while avoiding overheated areas.
As of early this week, the universe of 1,683 companies that our stock analysts cover was, in aggregate fairly valued to slightly overvalued, with a fair value rating of 1.04 on this Market Fair Value graph. To arrive at a fair value estimate for the market as a whole, our equity analysts first assign a fair value estimate to each of the companies that they cover. So if one of our analysts thinks a company is worth $100 but it's currently trading at $75, that company would have a price/fair value ratio of 0.75. We then arrive at a price/fair value ratio for the whole stock universe by looking at the median price/fair value ratio for companies under coverage.
The current price/fair value ratio for our entire coverage universe is very close to its 52-week high, and is a far cry from where it was a year ago, when stocks under coverage, in aggregate, traded at a 24% discount to our analysts' fair value estimates.
High Quality, Reasonable Price
But the fact that our stock universe is trading right around its fair value shouldn't deter you from investing in stocks. On the left-hand side of the Market Fair Value page, you can drill into various segments of the coverage universe to identify market segments with upside potential remaining. For example, while our stock universe is, on the whole, fairly valued, the wide-moat companies in our coverage universe are currently trading at a small discount to fair value estimate. (A wide moat means that a company has a sustainable competitive advantage versus its peers, in our analysts' view.) Narrow-moat companies are fairly valued, on average, whereas no-moat companies are now substantially overvalued following a tremendous runup in 2009. Under normal circumstances, wide-moat firms should command higher prices than narrow- and no-moat firms, not lower. So it looks like a good time to pick up quality on the (relative) cheap.
So how does that translate into investment ideas? If you're an individual-stock investor and a Premium user, you can screen our stock universe for wide-moat companies that are trading well below our analysts' fair value estimates. As of March 29, 18 wide-moat companies sported price/fair value ratios of 0.75 or less, including Eli Lilly (NYSE:LLY - News), General Electric (NYSE:GE - News), Paychex (NasdaqGS:PAYX - News), and Weight Watchers International (NYSE:WTW - News).
Mutual fund investors might also concentrate their energies on funds with a big share of wide-moat firms. Although moats aren't yet a screenable data point, Jensen Portfolio (NASDAQ:JENSX - News), Bridgeway Blue Chip 35 Index (NASDAQ:BRLIX - News), Dreyfus Appreciation (NASDAQ:DGAGX - News), Vanguard Dividend Growth (NASDAQ:VDIGX - News), and Vanguard Dividend Appreciation. (That last fund comes in the form of a mutual fund (NASDAQ:VDAIX - News) and an exchange-traded fund (NYSEArca:VIG - News).)
Advantage Large Cap Value
Morningstar's ETF Valuation Quickrank offers yet another tool for identifying potential investment ideas and avoiding land mines. Like the aforementioned tools, the Valuation Quickrank provides a price/fair value ratio for an entire exchange-traded fund based on the price/fair value ratings for all of that ETF's constituent holdings.
The Valuation Quickrank shows that broad-market ETFs, such as Vanguard Total Stock Market ETF (NYSEArca:VTI - News), are currently trading at a slight discount to fair value, with a price/fair value ratio of 0.94 as of March 29. (In case you're wondering, that's a more attractive price/fair value ratio than our entire stock coverage universe because the ETF is cap-weighted and skews toward very large companies, which appear to be more cheap than smaller firms do right now.)
Generally speaking, the large-cap ETF categories offer a far larger share of ETFs trading below their fair values than do the mid-cap ETF groupings. (We don't currently have enough small-cap stocks under coverage to formulate price/fair value ratios for entire small-cap ETFs.) Ditto for value stocks versus growth. Every large-cap value ETF in the Quickrank is trading below our analysts' fair value estimates, whereas most large-cap growth ETFs are trading right around or above fair value.
You can also use the ETF Valuation Quickrank to help identify whether sectors are looking cheap or dear based on the ETFs' constituent holdings. (Just recognize that some ETFs skew heavily toward a handful of stocks, so the price/fair value ratio that you see may not be particularly representative of the valuation of an entire sector but rather just a few holdings.) Right now, for example, most real estate and technology ETFs are trading substantially above the fair values of their constituent holdings, indicating that many stocks in those sectors are fully priced or overvalued. The health-care sector, meanwhile, still sports a number of ETFs whose holdings are trading well below our analysts' fair value estimates.
If you find yourself, as this reader did, with a portfolio that's dramatically light on a given asset class, plan to dribble the money in slowly during a period of several months until your allocation reaches your target. As you do so, you can use Morningstar's various valuation lenses to help guide you toward those parts of the market that offer the greatest upside potential. Right now, high-quality large-cap stocks and funds appear to be reasonably priced relative to lower-quality (that is, no-moat) firms in the small- and mid-cap space. So although there may not be as many screaming buys as there were a year ago, it does appear to be a good time to upgrade the quality of your portfolio without breaking the bank.