Equity markets tried to bottom out in June and bounced higher in July and August as inflation and economic headwinds appeared to ease. However, this recovery was short-lived as higher-than-expected inflation and weaker economic metrics in September sent markets back to new lows.

Coming into 2022, we noted that the US equity market was overvalued and would have to contend with four main waves this year:

  1. Slow rate of economic growth,
  2. The Federal Reserve is tightening monetary policy,
  3. Inflation is running hot, and
  4. Long-term interest rates were expected to rise.

The latest we’ve seen is:

  1. Economic growth weaker than expected,
  2. The Federal Reserve is now more hawkish,
  3. Inflation is still running hot, and
  4. Long-term rates started to rise again, with 10-year US Treasuries rising 80 basis points in September to nearly 4%.

Consolidating these headwinds, additional pressures emerged, including:

  1. A strong appreciation of the US dollar, which will reduce earnings for US companies with significant foreign exposure,
  2. Europe appears to be heading for recession, and the only question is how far and how deep, and
  3. The economic outlook for China is particularly murky

Equity Market Trades Deeply Undervalued

But, with equities selling 24% year to date, we see the market as overcorrected to the downside. According to a composite of the stocks we cover that trade on US exchanges, the equity market is severely undervalued and is trading at a discount of more than 20% to 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. Core stocks are trading closer to fair value at 0.86. Investors seem to be in the best position with a barbell-shaped strategy, overweighting both value and growth categories and overweighting core.

Across capitalization levels, large-cap and mid-cap stocks are trading close to broad market valuations, but small-cap stocks are trading at the biggest discount to fair value at 0.62.

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

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

Rarely do Equities Trade at such a deep Discount to Intrinsic Valuation

The current level of undervaluation is the largest discount to our long-term intrinsic valuations since the onset of the pandemic. Between March 2020, the price/fair value on the basis reached 0.77 on 23 March 2020.

Over a longer historical time frame, there have been only a few other instances where our price/fair value metric has fallen to similar levels. Stocks fell precipitously in December 2018 as the Fed was already tightening monetary policy for a year and markets were pricing in a global growth scare. In the fall of 2011, there was concern that the possible contagion from the Greek debt crisis was spreading to other countries (Portugal, Italy and Spain) and that systemic risk from the European sovereign debt crisis was spreading to the system European banking.

While near-term conditions may pressure earnings in the short term, at current valuations we think the market has more than enough downside to incorporate those headwinds. In our view, the market is over-optimistic about the long-term prospects for equity valuations.

Morningstar US Cover Price/Fair Value at Month End

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

Looking Ahead, Expect More Volatility Until Conditions Improve

Over the next six to 12 months, we expect markets to remain under pressure and volatility to remain high. To establish a baseline, markets will need clarity on when economic activity will make a meaningful and sustained recovery and evidence that inflation will begin to trend downward and return to the Fed’s 2% target.

Over this period, we expect:

  • GDP will remain sluggish and will not begin to accelerate again until the second half of 2023,
  • The Federal Reserve will complete an inflationary policy by the end of 2022, ie
  • Momentum may push interest rates slightly higher in the short term, but long-term rates have already risen, and
  • Inflation will begin to moderate over the coming months and will decline in 2023.

We think the combination of these factors will provide the Fed with the room it needs to begin easing monetary policy by the end of 2023. Our forecast is for the federal funds rate to fall to 2.00% at the end of 2023 and the result on. 10-year US Treasuries will average 2.75% in 2023.

Communications and Cyclical Sectors Worst Ended and Best Undervalued Now

Meta Platforms and Alphabet underperformed the market this past quarter and helped push the communications sector deeper into undervalued territory. But, even excluding these two stocks, we see significant value among traditional media and communications companies. Many of these companies are in the midst of developing their own streaming services, and the market is particularly pessimistic about their long-term prospects.

The consumer cyclical sector’s price/fair value was steady at 0.75. We think the market is overreacting to concerns about a potential short-term recession. In the event of a recession, we think it would be short and shallow and the sector already has plenty of margin of safety at its current valuation. Many of the service-oriented companies in this sector should benefit as the pandemic continues to worsen and consumer spending behavior normalizes and shifts back to services and away from goods.

The largest decline in price/fair value this quarter occurred in the real estate sector, as the impact of rising interest rates took its toll on net asset values. The next drop in price/fair value was in the energy sector. Oil prices peaked in early June and have generally been declining. Energy stocks followed suit and fell sharply in September. After this pullback, the price/fair value fell to 0.91 from 0.99 last quarter.

In general, the defensive sectors have fared well this year and are trading closer to fair value, with utilities trending towards a bit of value. We expect inflation to start moderate, but if inflation remains more persistent, utilities would be the sector most adversely affected.

Morningstar Equity Research Cover Price/Fair Value by Sector

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

What to Do Now?

In these types of market environments, it is extremely important for investors to have a plan that balances their long-term investment goals with their risk tolerances. This plan should also allow for periodic rebalancing to increase equity allocations when valuations decline but should also reduce exposure when valuations are overextended. Based on our view that the US equity market is undervalued, we think now is not the time to reduce equity exposures but to invest wisely – especially in companies with broad economic horizons – based on your investment plan and your goals.

Note: This article was originally written for a US Audience

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