Trust Quality, Not the Trashy Rally

05/04/2009 12:01 am EST

Focus: GLOBAL

Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

The recent outsized gains by lower-quality stocks have turned top-shelf names into relative bargains, writes Morningstar InternationalInvestor editor Allan Nichols.  

As Charles Dickens said, "It was the best of times, it was the worst of times." For the past month, it was one of the best of times in the stock market, but it was still one of the worst of times for the economy.

The upsurge in stock markets around the world implies that the global recession will end by fall. While I hope that is true, I'm not a believer. The economic numbers that I report in my weekly e-mail updates continue to show severe contractions in industrial output and trade.

While employment is a lagging indicator, layoffs seem to be moving from blue collar and finance-related to white collar positions with no direct connections to finance. As redundancies increase amongst highly paid professionals and companies scale back on operations, with the resulting lost spending, I have a hard time seeing a snapback in the economy.

Who is going to spend in order to move the economy forward? As severe and widespread as this recession has been, I think it will be a slow recovery. While the worst may be over, the market has acted like we will be back to normal by the fourth quarter.

While I think the stock market is on average still undervalued, I think some stocks have run too far too fast and will likely roll back over. The median stock is still undervalued, according to Morningstar, but nothing like it was last month. The median international stock has run from trading at 0.67x its fair value estimate to 0.86x, with the biggest move in emerging markets, where the median stock has moved from 0.7x to 0.9x.

We [also] can see a big change in star ratings: significantly more three-star-rated stocks and fewer four-and five-star rated stocks. The biggest move has been those with high and very high fair-value uncertainty ratings. There are no longer any 5-star rated stocks in the very-high-uncertainty category.

The higher percentage of stocks receiving fewer stars as you move down the uncertainty scale is a further indication that investors are moving back out on the risk spectrum, which is why lower-quality stocks have moved more in general than higher-quality stocks. This also leaves the best values in the high-quality stocks we like.

I am not convinced the stock market has started a new bull phase, but I expect it to continue to be volatile. I think the high-quality companies with their nice yields will reward us well and we will generate solid long-term results. I expect to remain focused on companies with sustainable moats and solid balance sheets, and if they pay juicy dividends, all the better.

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