Morningstar Advisor - Summer 2007 - 10

Gray Matters Abroad Foreign Independence Correlation between U.S. and international equities has declined sharply in recent years, Morningstar research analyst Preethi Parmar finds. This conclusion flies in the face of the popular perception that globalization will unite the world’s equities markets and they will eventually move as one. True, until recently, correlation between the S&P 500 and MSCI EAFE indexes had steadily increased since the early 1990s. The twoyear period between April 2003 and March 2005 saw a correlation as high as 0.93. (Total correlation is 1.) But since then, we have seen a sharp drop. From June 2005 through May 2007, correlation is 0.60. But Kelly found a stark contrast between the valuations of a small group of mega-cap stocks—which have a disproportionate effect on the S&P 500 and Dow indexes—and the rest of the market. Mega-caps are cheap, he says. Names such as Bank of America BAC, Wal-Mart WMT, Procter & Gamble PG, and Johnson & Johnson JNJ all are 5-star stocks, meaning they are trading at large discounts to Morningstar’s fair value estimates. Valuations get dicier further down the size spectrum. All told, there are only 104 names currently on Morningstar’s 5-star list, out of a coverage universe of close to 2,000 stocks. The median stock in our coverage universe is about 3% overvalued, Kelly says. That’s in contrast to a year ago, when our view was that the median stock was about 4% undervalued. “With most indexes up 20% or more over the past 12 months, prices appear to have overshot fair value in many cases,” Kelly says As the table below shows, only two of Morningstar’s 12 sectors—consumer services and utilities—are undervalued when looking at simple medians and averages with no market-cap weighting. (Star range: 1 and 2 stars, overvalued; 3 stars, fairly valued; 4 and 5 stars, undervalued.) Sector Valuations Median Price/ Fair Value Avg Star Rating Happy Returns Patterns to Success For the newsletter Morningstar FundInvestor, senior analyst Michael Breen wanted to see what factors lead to good and poor investor returns. (For more on Morningstar’s new dollar-weighted return figure, see page 18 in the spring issue of Morningstar Advisor.) Breen studied a decade’s worth of unweighted and asset-weighted data— including market returns, volatility, investment style, fund family affiliation, sales-load structure, share-class type, and redemption fees—and found some interesting patterns. 1 Investors who paid for the advice of a full-service broker and bought load funds ended up with no advantage over those who bought no-load funds either on their own or through a financial planner. Although there wasn’t much of a pattern in fund share classes, there was a strong pattern by category. Breen found that the Morningstar categories with the biggest gaps between their 10-year total returns and investor returns were those that have shown the greatest volatility in their performance. Investing with discipline in the right funds can deliver solid investor returns in even the toughest categories. When Breen asset-weighted the data, he found that large funds with solid investor returns boosted the asset-weighted returns for entire categories. For example, the investor returns for the health category benefited greatly from the strong investor returns of Vanguard Health Care VGHCX and Fidelity Select Health Care FSPHX, which have accounted for nearly half the category’s assets. Assetweighting had an even greater impact in the world-stock category. There, four funds—American Funds Capital World Growth and Income GWGIX, Vanguard Global Equity VHGEX, Templeton Growth TEPLX, and American Funds New Perspective ANWPX—cranked out solid 1 .8 2 .2 1980 1990 2000 In addition, the decline in the U.S. dollar against major international currencies has increased the value of foreign investments for a U.S. investor. With burgeoning foreign equity markets, a declining U.S. dollar, and correlations taking a dive, international securities are looking up. 3 Business Services Consumer Goods 1.04 1.01 0.98 1.11 1.03 1.05 1.05 1.08 1.05 1.03 1.12 0.97 2.60 2.86 3.03 2.37 2.80 2.66 2.73 2.45 2.72 2.64 2.32 3.09 Outlooks Think Big Haywood Kelly, Morningstar’s chief of securties analysis, looked at Morningstar’s fair value estimates for all of the underlying stocks in the S&P 500 Index. He summed them to find what the index is really worth. By his estimates, the S&P 500 is trading 4% below its fair value heading into the third quarter. The Dow Jones Industrials is trading at a 6% discount, he says. Consumer Services Energy Financial Services Hardware Health Care Industrial Materials Media Software Telecommunications Utilities Data as of 06-15-07 10 Morningstar Advisor Summer 2007

Morningstar Advisor - Summer 2007

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