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Downside overcorrection: US stock markets…

Stock markets attempted to bottom in June and rebounded in July and August as inflationary and economic headwinds appeared to ease.

However, this respite was short-lived as higher-than-expected inflation and weaker economic measures in September sent markets back to new lows.

As we approach 2022, we noted that the US stock market is overvalued and is expected to face four main headwinds this year:

  • Slower economic growth rate;
  • tightening of Federal Reserve monetary policy;
  • Hot inflation, and;
  • Our expectation of a rise in long-term interest rates;

What we have seen most recently is:

  • Economic growth even weaker than expected;
  • The Federal Reserve has become even more hawkish;
  • Inflation is still hot, and;
  • Long-term rates started to rise again, 10-year US Treasuries rose 80 basis points in September to almost 4%.

In addition to these headwinds, additional pressures have emerged, including:

  • Strong appreciation of the US dollar, which will reduce the earnings of US companies with high foreign exposure;
  • Europe appears to be heading into recession, the only question being how long and how deep, and;
  • China’s economic outlook is particularly bleak.

The equity market is trading deep in undervalued territory

Yet, with stocks selling 24% year-to-date, we believe the market has overcorrected lower. According to a composite of the stocks we cover that trade on US exchanges, the stock market is significantly undervalued and trading at more than 20% discount to its fair value.

Growth stocks are the most undervalued, trading at a price/fair value of 0.75, followed by the value category trading at 0.77. Basic shares are trading closer to fair value at 0.86. Investors appear to be best positioned with a dumbbell-shaped strategy, overweighting both the value and growth categories and underweighting the core.

Across all cap levels, large and mid-cap stocks trade near the overall market valuation, while small-cap stocks trade at the largest discount to fair value at 0.62.

Morningstar Equity Research Coverage Price/Fair Value, US Equity Style Box

Source: Morningstar Equity Research. Data as of September 26, 2022.

Shares have rarely traded at such a deep discount

The current level of undervaluation is the biggest discount to our long-term intrinsic valuations since the emergence of the pandemic. Intramonth of March 2020, the price/fair value bottomed at 0.77 on March 23, 2020.

Over a longer historical period, there have only been a few other instances where our price/fair value measure has fallen to similar levels.

Stocks fell precipitously in December 2018 as the Fed had already tightened monetary policy for a year and markets were pricing in global growth scares. In autumn 2011, fears that the possible contagion of the Greek debt crisis would spread to other countries (Portugal, Italy and Spain) and that the systemic risk of the European sovereign debt crisis would spread to the system European banking.

While near-term conditions may put pressure on near-term earnings, at current valuations we believe the market has fallen more than enough to price in these headwinds. In our view, we think the market is too pessimistic about the long-term outlook for equity valuations.

US Morningstar Cover Price/Fair Value Month-End

Source: Morningstar Equity Research. Data as of September 26, 2022

Expect more volatility until conditions improve

Over the next six to twelve months, we expect markets to remain under pressure and volatility to remain elevated. To bottom, markets will need clarity on when economic activity will make a significant and sustained rebound and evidence that inflation will start to decline and return to the Fed’s 2% target.

Over this period, we expect:

  • GDP will remain sluggish and will only start to reaccelerate in the second half of 2023;
  • The Federal Reserve will conclude its tightening policy by the end of 2022;
  • The momentum may push interest rates slightly higher in the short term, but the preponderance of the rise in long-term rates has already happened, and;
  • Inflation will begin to moderate over the next few months and decline in 2023.

We believe the combination of these factors will give the Fed the breathing room it needs to begin easing monetary policy by the end of 2023. Our forecast is for the fed funds rate to fall to 2.00% at the end of 2023 and the yield on the 10-year US Treasury will average 2.75% in 2023.

Communications and cyclical sectors were the hardest hit

Meta Platforms and Alphabet both underperformed the market over the past quarter and helped push the communications sector even deeper into undervalued territory.

Yet even excluding these two stocks, we see significant value among traditional media and communications companies. Many of these companies are building their own streaming services, and the market has been particularly pessimistic about their long-term prospects.

The price/fair value of the Consumer Discretionary sector remained stable at 0.75. We believe the market is overreacting to fears of a possible near-term recession. In the event of a recession, we believe it would be short and shallow and that the sector already builds in a sufficient margin of safety at its current valuation.

Many service-oriented businesses in this sector stand to benefit as the pandemic continues to recede and consumer spending behavior normalizes and shifts back to services and away from goods.

The biggest decline in the price-to-fair value ratio this quarter occurred in the real estate sector, as the impact of rising interest rates wreaked havoc on net asset values. The second largest drop in the price/fair value ratio was recorded in the energy sector. Oil prices peaked in early June and generally trended lower. Energy stocks followed suit and fell precipitously in September. Following this decline, the price/fair value fell to 0.91 from 0.99 last quarter.

In general, defensive sectors have held up relatively well this year and are trading closer to fair value, with utilities leaning slightly towards the overvalued side. We expect inflation to start to moderate, but if inflation remains more persistent, utilities would be the most negatively affected sector.

Morningstar Equity Research Price/Fair Value Coverage by Sector

Source: Morningstar Equity Research. Data as of September 26, 2022.

What to do now?

In these types of market environments, it is especially important for investors to have a plan that balances their long-term investment goals with their tolerance for risk.

This plan should also allow for periodic rebalancing to increase equity allocations when valuations decline, but also reduce exposure when valuations become excessive. Based on our view that the US stock market is undervalued, we believe now is not the time to reduce equity exposures, but to add wisely, especially in companies with large moats. economical, depending on your investment plan and objectives.

Note: This article was originally written for an American audience.


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