Stocks have tumbled in recent months, with the S&P 500 dropping 20%.
As Morningstar’s chief U.S. market strategist, Dave Sekera, pointed out in a commentary, that fall has stemmed from slowing economic growth, tightening monetary policy, rising interest rates, and high inflation.
The economy contracted 1.6% annualized in the first quarter. And the Federal Reserve has raised interest rates 150 basis points (1.5 percentage points) since March.
The 10-year bond yield has soared 131 basis points this year, even after the decline of the past three weeks. And consumer prices surged 8.6% in the 12 months through May.
But the decline of stocks caused by those factors has “pushed markets down deep into undervalued territory,” Sekera said.
Stocks Trading at 83% of Fair Value
“Based on a composite of the intrinsic valuation of all the stocks we cover that trade on U.S. exchanges, we calculate that the broad U.S. stock market is trading at a price-to-fair value [ratio] of 0.83.”
To give that number historical context, “the current level of undervaluation is the greatest discount to our intrinsic valuations since the emergence of the pandemic in March 2020 and the growth scare that sent stocks lower in December 2018,” Sekera said.
“Growth stocks are the most undervalued, trading at a price-to-fair-value [ratio] of 0.78, followed by the value category trading at 0.83,” he said. Core stocks, which don’t trend predominantly to growth or value, are trading closer to fair value at 0.91.
“Across capitalization levels, large- and mid-cap stocks are trading near the broad market valuation, whereas small-cap stocks are trading at the greatest discount to fair value at 0.68,” Sekera said. So perhaps now is a good time to buy small-cap stocks.
Communications Is Most Undervalued Sector
As for industry sectors, communications is the most undervalued, with a price-to-fair-value ratio of 0.63, Sekera said. “The valuation of the communications sector is skewed by the sheer size of the market capitalization of Alphabet (GOOGL) and Meta Platforms (META),” he noted.
“Yet, even after accounting for this, communications remains the most undervalued sector, both from the perspective of the greatest number of undervalued stocks as well as the greatest discounts to our fair values.”
Consumer cyclicals represent the second most undervalued sector, with a price-to-fair-value ratio of 0.75, Sekera said. “Concerns of a possible near-term recession sent consumer cyclical stocks plunging during the second quarter,” he said.
“Yet, we think the market is overreacting, as we do not project a recession occurring in the near term.”
And even if there is a recession, “we think that the sector already factors in enough of a margin of safety, as it currently trades at a 25% discount to our fair value,” Sekera said.
“Many of the services-oriented companies in this sector should benefit, as the pandemic continues to recede, and consumer spending returns to normal and shifts back to services and away from goods.”
