Q4 2014 U.S. Stock Market Outlook: Keep Your Expectations in Check

The outlook for the first two sources of return doesn't look promising. The S&P 500's dividend yield is right around 2%--typical for the past decade but well below longer-term historical norms. The median stock in our coverage universe is trading at a 3% premium to our fair value estimate, indicating that investors are already fully valuing most stocks. As of this writing, only 10 companies carry Morningstar's 5-star rating, none of which has a wide moat and only four of which have a narrow moat. Compare that to the worst of the financial crisis in late 2008 and early 2009, when more than 850 stocks earned our 5-star rating.

Our view that the market is fully valued is supported by the Shiller price/earnings ratio, which uses a 10-year average of real （inflation-adjusted) earnings in the denominator. The Shiller P/E stands around 26.5; it has been lower 70% of the time in the past 25 years and 92% of the time in the past 100 years. The Shiller P/E has been this high only three times in history: during the lead-ups to the 1929 market crash, the 2000-02 dot-com crash, and the 2008-09 financial crisis. Historically, Shiller P/E ratios above about 25 have been associated with poor subsequent five-year total returns and an elevated risk of a material drawdown, as can be seen in Exhibit 1.

However, that doesn't mean the market is necessarily headed for a crash, or even that stocks are unattractive as an asset class. First, a moderately overvalued market can still deliver strong total returns for years. For example, the Shiller P/E was at a comparable level in 1996 and 2003. As it turned out, those years were toward the beginning of major speculative bubbles, but the bubbles would inflate for several more years before finally popping.

Second, normal valuation levels can fluctuate significantly over time, and there's no guarantee that the past will be an accurate gauge of the future. For example, in the 100 years through 1988, the median Shiller P/E was 14.1. In the roughly 25 years since, the median has shifted to 23.5--two-thirds higher than in the preceding century. Anyone waiting for the Shiller P/E to revert to its very-long-run historical average would have been kept out of stocks for almost the entirety of the past 25 years! Long-run interest rates remain well below historical norms, which if sustained could justify substantially higher valuation levels than in the past.

Lastly, and perhaps most importantly, we can't forget the third source of returns from stocks: growth in intrinsic value. Fair value is a moving target--as companies grow their earnings, raise their dividends, and realize cash flows, their intrinsic values tend to increase. A reasonable total return is already incorporated in our analysts' fair value estimates when we discount future cash flows. The Shiller P/E should also gradually decline as S&P 500 earnings rise. In other words, it's just a matter of time before intrinsic value catches up to--and soon exceeds--current stock prices. Over a long enough investment time horizon, common stocks are almost certain to outperform bonds and cash, especially considering current interest rates.

Even so, stock investors would be wise to moderate their return expectations. The phenomenal returns of the past five years were driven by the recovery in earnings and P/E multiples from the depths of the financial crisis. Such high returns are not sustainable when starting from current valuation levels; mid- to high-single-digit average annual total returns are more realistic over the long run, with plenty of bumps along the way.

Opportunities Are Few and Far Between
Digging deeper into our global coverage, a handful of opportunities can still be found, though investors need to be especially discerning in this environment. In general, we would discourage investors from sacrificing quality in search of an outlier bargain.

Interest rates have been one of the biggest surprises of the year. Going into 2014, most pundits expected a steady rise in interest rates as the Federal Reserve winds down its purchases of long-term bonds and moves closer to raising short-term rates. Instead, the yield on the 10-year Treasury fell from 3% at the start of the year to a low of 2.34% in mid-August. The 10-year Treasury yield has since recovered to around 2.6%, but it remains below where many market observers had expected.

Industries such as consumer staples, regulated utilities, and real estate investment trusts are especially sensitive to long-term interest rates because of their above-average dividend yields, slow growth, and lack of economic sensitivity. We see relatively few opportunities in this area, though there are a handful of exceptions based on company-specific circumstances. We also like wide-moat consumer staples firms with scale, leading brands, and exposure to faster-growing emerging markets, such as Coca-Cola, Diageo, Unilever, and Philip Morris International.

Momentum stocks have staged a comeback in recent months, and we would advise investors to approach these names with caution. High-profile momentum stocks such as Netflix, Twitter, Tesla, and even wide-moat Facebook are trading far above our fair value estimates. We think their current stock prices incorporate too much hope and optimism, and not nearly enough fear and conservatism. On the other hand, there are still a few faster-growing companies trading at reasonable valuations, such as Priceline,  Cognizant,  American Tower, and  MasterCard. Here, too, company-specific considerations dominate.

Lastly, energy is arguably the sector that is most out of favor right now because of recent weakness in oil prices and concerns about the global economic outlook, especially outside the U.S. The median energy stock is trading at the steepest discount to our fair value estimate （7%) of any sector. We see opportunities in wide-moat oil-services firms Schlumberger and Core Laboratories, as well as a broad group of oil and gas producers such as Tullow Oil, Ultra Petroleum, BP, Tourmaline Oil, and Range Resources, among others. Of course, all of these companies are sensitive to commodity prices, and our investment theses will depend to a significant extent on correctly predicting oil and gas prices.