Stocks soared in January, with the S&P 500 index gaining 6%. But that doesn’t mean equities are overvalued, says Dave Sekera, senior U.S. market strategist for Morningstar.
“The U.S. equity market remains undervalued, albeit much less undervalued than at the beginning of the year,” he wrote in a commentary. The S&P 500 dropped 20% in 2022.
As of Jan. 31, a composite of the 700-plus stocks listed on U.S. exchanges and covered by Morningstar indicated the market was 10% undervalued. That’s based on Morningstar’s estimates of fair value for the stocks.
“However, while we view the broad markets as undervalued for long-term investors, in the short term, we think the easy returns are behind us,” Sekera said.
Morningstar Sees Tale of Two Halves for Stocks
Stocks are “entering a stage where economic and monetary headwinds will slow additional gains to a grind over the first half of the year,” he said.
“We continue to think that 2023 will be a year of two halves. For the first half of the year, the market will continue to contend with two main headwinds: tightening monetary policy and a weakening economy.” That will limit earnings, Sekera said.
Also, “while we don’t expect negotiations over the debt ceiling will result in the U.S. defaulting on its debt, dire headlines in the media could damp investor risk sentiment,” Sekera said.
But then the picture brightens. “This near-term turbulence should lead to clearer skies in the second half of the year,” he said.
Morningstar Cites Positives for Stocks
“The Fed will likely halt any further monetary tightening following its March meeting. Then, by early summer, we expect leading economic indicators to turn upward as the economy re-accelerates.”
Morningstar also predicts that inflation will continue to slide over the course of the year. By year-end the firm sees the combination of low inflation and weak economic growth from the first six months leading the Fed to reverse policy and cut interest rates.
Keep in mind, though, that on Feb. 1, Fed Chairman Jerome Powell said, “given our outlook, I don’t see us cutting rates this year.” That obviously conflicts with Morningstar’s view.
In any case, based on valuations, long-term investors would do well to overweight value and growth stocks, which are both 15% undervalued, Morningstar says. And it recommends underweighting “core” stocks, which it sees trading at fair value.
“The core of a portfolio is where the biggest chunk of your money is invested,” Morningstar says. “The core may occupy 60% to 80% of assets. For stocks, the core is typically large companies with some growth and some value characteristics.”
When it comes to market capitalization, small-cap stocks remain the most undervalued, trading at a 23% discount to Morningstar’s fair value estimates, Sekera said.
Among industries, as of Jan. 31, the communications sector was the most undervalued, trading at a 34% discount. That number was heavily influenced by Alphabet (GOOGL), which traded with 38% discount, and Meta Platforms (META), which traded at a 43% discount.
Other communications stocks that Morningstar sees as significantly undervalued compared to its fair value estimates are Warner Brothers Discovery (WBD) with a 51% discount and Verizon Communications (VZ) with a 27% discount.
Consumer cyclicals are the second most undervalued sector. “We expect … consumer behavior to revert to pre-pandemic norms, and to [continue the] shift into services from goods,” Sekera said. Stocks leveraged to this theme include:
- Anheuser-Busch InBev (BUD), which traded with a 33% discount from Morningstar’s fair value estimate,
- Caesars Entertainment (CZR): 35% discount,
- Carnival (CCL): 51% discount,
- Delta Air Lines (DAL): 35% discount,
- Macerich (MAC): 50% discount,
- Park Hotels & Resorts (PK): 44% discount,
- Sabre Corporation (SABR): 43% discount,
- Uber Technologies (UBER) 58% discount.
The author of this story owns shares of Alphabet, Meta and Verizon.
