A Blue-Chip Bargain Hunter’s Bonanza

08/19/2011 8:30 am EST

Focus: MARKETS

Paul Larson

Editor, Morningstar StockInvestor

Valuations for the large caps are reaching the most attractive levels in decades, writes Paul Larson of Morningstar StockInvestor.

Last week, I enjoyed a long weekend with extended family. For better or worse, I experienced Monday’s 6.7% crash in the S&P 500 with one eye on my young children at a waterpark, and the other eye on my iPhone. In some ways, it was a blessing.

However, I was disappointed I was not able to spend more time sniffing around for bargains amidst the indiscriminate selling. I’m glad I was able to take advantage of at least one opportunity this past week, adding to our ExxonMobil (XOM) stake at a very attractive price.

Anyway, this week’s market action did remind me a bit of a rollercoaster, with severe ups and downs and an abundance of alternating fear and exhilaration. Volatility was at its highest point since the May 2010 flash crash; we had four straight trading days (and five out of seven) where the Dow Jones Industrial Average moved 400 points or more.

But when the ride was over for the week, much like a real rollercoaster, we basically ended up right back where we began, with the major indexes down a little more than 1% for the week.

Two unprecedented events have transpired:

  • the S&P downgrade of the United States Treasury debt
  • the Federal Reserve explicitly announcing its anticipated interest-rate policy for the coming two years.

The S&P downgrade is a historic event, but it really has not changed much of anything. Rather, it is an arbitrary milepost in a long journey, similar to hitting an age that ends in zero.

Uncle Sam’s financial state is only marginally worse than it was last week or last month. The situation of high deficits and debt has been long in the making and continues apace, just as we are only one day older on our birthdays rather than a full year.

And it’s not as if the downgrade by one notch from AAA has triggered a liquidity event for Uncle Sam. If anything, it triggered a flood of "risk-off" trades that ironically raised the demand for Treasuries!

There has also not been any evidence of meaningful "forced selling" caused by the downgrade. This is certainly good news, because it means the feared "unforeseen consequences" and contagion of the downgrade have not materialized.

Of course, we may have avoided this one particular acute negative outcome, but there remains no shortage of long-term issues to fret about. Namely, the ongoing European sovereign debt and banking crisis, our own debt and deficit situation here in the US, and an economy that is sputtering along at a very anemic rate.

NEXT: Recession?

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My phone has been ringing off the hook with media requests, and I was asked on both live television and radio if I thought there was going to be another imminent recession. (No pressure!)

The answer I gave with nanoseconds to think about it is basically the same answer I will give now with more time to contemplate my answer. I personally think the odds are basically 50/50 at this point, which is up significantly from something closer to the 10% to 20% chance I would have said just three months ago.

Unfortunately, the debt-ceiling debate and political rancor, as well as the high volatility in the markets, have contributed to significantly weaker consumer confidence.

Just how poor is the mood of consumers? It was revealed recently that consumer confidence is now at its lowest level since 1980! Thankfully, the retail sales data disclosed this week showed that this low confidence has not translated to a significant drop in consumer spending, at least not yet. (July sales were up 0.5% from last month, and an impressive 8.5% above last year’s levels.)

But the longer the markets stay in a highly volatile state, the greater the spending headwind we will experience, and the greater the odds that we tip back into recession.

If there is any silver lining, many of our stocks are now sporting valuations that appear to assume another recession is essentially a foregone conclusion. While I am increasingly concerned about the macroeconomic outlook, I don’t think the odds of an impending recession are anything close to 100%.

This risk of recession is more than baked into the cake when we can buy solid companies like ExxonMobil, Abbott Labs (ABT), Microsoft (MSFT), Pfizer (PFE), and Novartis (NVS) at single-digit multiples of estimated forward earnings (and these estimates should—for these particular companies—be relatively durable, even if a recession comes).

We may be in for a tough slog as the economy continues to suffer from the effects of the housing bubble bursting and Western governments approaching the end of their debt-fueled spending frenzy. But from a valuation standpoint, prices on blue-chip stocks are very close to being the most attractive that they’ve been in at least three decades.

Of course, there remains a great deal of uncertainty—especially out of Europe—and volatility in the markets tends to breed volatility. So don’t unbuckle your seatbelt; the rollercoaster ride is not over just yet.

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