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After experiencing a bit of downward pressure in April, markets have managed to regain some of their upward momentum. David Sekera, Chief U.S. Market Strategist at Morningstar Research, looks at potential undervalued pockets of the market.
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Well, markets have had a better start to the month of May after facing some downward pressure in April. Joining us now to discuss how valuations are looking and some of the big takeaways from earnings season so far is David Sekera, Chief US Market Strategist with Morningstar Research. David, thanks very much for joining us today.
Of course. Good afternoon.
So after a rough April for stocks, how are valuations looking right now generally?
It's interesting. At the end of March in our second quarter outlook, we published a note that the market was actually trading at a premium to a composite of our fair values. In fact, at that point in time, we noted less than 14% of the time since 2010 had the market traded at that much of a premium or more.
But now, following the April pullback and then adjusting some of the fair values in a couple of our different stocks following earnings, we do think the market is trading pretty close to fair value right now. So what that means for long-term investors, we do think that going forward over the next couple of years, if you were to put money to work today, we would expect to get that historical average cost of equity over time.
OK. Now, you also highlight two areas of the market that are looking interesting on a valuation basis. Tell us what you're seeing with value stocks and small caps.
Yeah. So by style, we still see the value category as the most undervalued category. It trades at about a 10% discount to fair value, whereas both the growth and the core categories after the pullbacks are now pretty much on top of our fair value estimates. And then by capitalization, we still think small cap stocks are significantly undervalued.
As a composite, they trade at about a 20% discount to our fair value. Midcap stocks still somewhat attractive in our view-- a few percent below fair value. But then large caps are just at or maybe even slightly above fair value at this point in time. So I think one of the questions I probably get most often is, regarding value and small caps, when could we expect these to start to perform?
And of course, no one can really predict when that market sentiment is going to shift. But I'd just note that I would expect that value stocks should outperform as the US economy slows. We would look for earnings from the growth stocks to slow, so that could shift people out of growth and into value. And then I'd also just note that, historically, small cap stocks usually tend to start to outperform once the Fed begins to start cutting the federal funds rate, which our economics team currently projects to be this September.
OK, so I want to pivot now to some of the sectors, particularly I want to look at valuation. Which sectors right now are looking undervalued or overvalued right now for you?
Well, right now, still, the most hated asset class on Wall Street has got to be real estate. But I think that's what also is providing investors some opportunities today. So as a composite, the real estate sector is trading at about a 17% discount to our fair values.
So we see a lot of areas there that, with the right margin of safety, some good places to put money to work. We also like the communications sector. That trades at about a 8% discount to fair value. And then basic materials would be the other one that I'd highlight trading at a 6% discount to fair value.
And then lastly, energy. Now, energy is only trading at a 3% discount-- so not that much of a margin of safety. But I still think that that provides a good natural hedge in your portfolio to the ongoing and potentially even more heightened geopolitical risk, as well as if inflation does stay higher for longer.
Now, one risky highlight is the potential for a weaker economy, but also sticky inflation. What's the potential headwind here according to your view?
Well, there's really two headwinds here right now. And unfortunately, in the first quarter, I do think what we've seen is kind of been the worst of both worlds. So inflation has been running higher than what our US economics team had originally projected coming into the year. And then the US real GDP was only 1.6% on an annualized basis in the first quarter. And that was even slower than what our economics team had projected.
And I think we are even on the low side or below consensus coming into the year. So looking forward, our base case is that real annualized GDP in the US is probably only going to run between 1% to 1 and 1/4% through the first quarter of 2025. Now, having said that, they do still expect the inflation will moderate.
Our US economics team is looking at a number of different real time indicators, like rent costs, some of those things that have kept inflation higher for longer. And they do note that as those are slowing in real time, that should be reflected in the economic metrics over the next couple of months. Now, originally, we were looking for the Fed to actually have started cutting the federal funds rate by now.
But with inflation lasting longer than what we originally had thought, we did push that forecast back to September. But once the Fed does begin to cut, our view is that they'll probably actually cut the Fed funds rate even faster than what the consensus is expecting because of our view for that slow economy. So I think there's really two risks here.
In the short-term over the next couple of months, I do think that slow economic growth will weigh on earnings. That could drive maybe some negative sentiment and maybe a pullback in the market this summer. And then over the medium-term, if inflation remains too high and the Fed is stuck and can't begin to cut the Fed funds rate later this year, that could be something that maybe with that tight monetary policy, the economy could slip into recession late this year or maybe even into beginning of next year.
OK. That's a great overview. I want to get back to earnings. And we're well into earnings season right now. Looking at that, what are the big takeaways so far? And how have the banks and financials performed?
Yeah, so the banks and the financials, in my view, earnings were just fine. There was really no major differences there. I'd note in the US regional banks, we do still see some opportunities for investors there. But a lot of those stocks have recovered well off the bottoms that they had after the bankruptcy last year.
But I would say, really, the biggest takeaway for the banks would be we didn't see a meaningful uptick in loan loss reserves. So what that tells me is that the banks are relatively comfortable with their outlook for the economy for the next couple of quarters. And there were some increases in loan loss reserves for commercial real estate, but, again, not to the degree that that started to concern our bank analyst team.
OK. And how about big tech? Any trends you're seeing there?
A couple of different trends. The big tech that's leveraged to artificial intelligence, those obvious names like Microsoft, Alphabet, Amazon, still doing very well. Meta was actually interesting this quarter. They did beat, and they beat by quite a bit. "And I thought they gave a pretty good solid guidance, but that stock actually sold off pretty dramatically. Now, one, we just thought it was overvalued in and of itself. But I think the big thing that the market didn't like is just how much they're spending on capex and how much they're increasing that on artificial intelligence.
If you remember, when they changed their name to Meta and they spent a lot of money on the metaverse, a lot of that spending really came to naught at the end of the day. So I think there's a lot of negative sentiment there. And then I'd just note the technology that's not tied to artificial intelligence, a lot of people are starting to consider these names legacy technology-- names like IBM and Intel-- definitely struggling here in the short-term as they're really starting to lose relevance in the technology space and in their specific subsectors.
OK. Finally, talk to us about some of those real economy stocks. Do you think that they're feeling the pinch of slowing consumer demand due to inflation?
Yeah. So the industrial sector is overvalued, in our view. We do think that the slowing economy will put some pressure there. But, really, it's the US consumer. And the question we're getting there is, is the US consumer really finally starting to get tapped out? And when I take a look at results like Starbucks, McDonald's, and even Tyson Foods, in my opinion, I think that these results might be the canary in the coal mine that, yeah, the impact of inflation-- and not just the recent inflation but really that compound impact of inflation over the past two years now-- is really starting to pinch the consumer.
Originally, it started off with the low-income consumer feeling it the most. But it's definitely moving now into the middle-income consumer as well. Originally, consumers were able to offset the higher prices with excess savings from early on in the pandemic. We think that's been used up for a while now.
Then consumers started to eat into their savings rate. We've seen saving rates decline as well. And at this point, that appears to be nearing kind of the end of that trend as well. So we're definitely seeing decreases in volume. For example, Starbucks had a 7% decrease in store traffic.
That's really a meaningful decrease for a company like Starbucks. So we're really seeing consumers pull back, but especially in those areas that I think consumers consider to be a little bit more indulgent.
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Well, markets have had a better start to the month of May after facing some downward pressure in April. Joining us now to discuss how valuations are looking and some of the big takeaways from earnings season so far is David Sekera, Chief US Market Strategist with Morningstar Research. David, thanks very much for joining us today.
Of course. Good afternoon.
So after a rough April for stocks, how are valuations looking right now generally?
It's interesting. At the end of March in our second quarter outlook, we published a note that the market was actually trading at a premium to a composite of our fair values. In fact, at that point in time, we noted less than 14% of the time since 2010 had the market traded at that much of a premium or more.
But now, following the April pullback and then adjusting some of the fair values in a couple of our different stocks following earnings, we do think the market is trading pretty close to fair value right now. So what that means for long-term investors, we do think that going forward over the next couple of years, if you were to put money to work today, we would expect to get that historical average cost of equity over time.
OK. Now, you also highlight two areas of the market that are looking interesting on a valuation basis. Tell us what you're seeing with value stocks and small caps.
Yeah. So by style, we still see the value category as the most undervalued category. It trades at about a 10% discount to fair value, whereas both the growth and the core categories after the pullbacks are now pretty much on top of our fair value estimates. And then by capitalization, we still think small cap stocks are significantly undervalued.
As a composite, they trade at about a 20% discount to our fair value. Midcap stocks still somewhat attractive in our view-- a few percent below fair value. But then large caps are just at or maybe even slightly above fair value at this point in time. So I think one of the questions I probably get most often is, regarding value and small caps, when could we expect these to start to perform?
And of course, no one can really predict when that market sentiment is going to shift. But I'd just note that I would expect that value stocks should outperform as the US economy slows. We would look for earnings from the growth stocks to slow, so that could shift people out of growth and into value. And then I'd also just note that, historically, small cap stocks usually tend to start to outperform once the Fed begins to start cutting the federal funds rate, which our economics team currently projects to be this September.
OK, so I want to pivot now to some of the sectors, particularly I want to look at valuation. Which sectors right now are looking undervalued or overvalued right now for you?
Well, right now, still, the most hated asset class on Wall Street has got to be real estate. But I think that's what also is providing investors some opportunities today. So as a composite, the real estate sector is trading at about a 17% discount to our fair values.
So we see a lot of areas there that, with the right margin of safety, some good places to put money to work. We also like the communications sector. That trades at about a 8% discount to fair value. And then basic materials would be the other one that I'd highlight trading at a 6% discount to fair value.
And then lastly, energy. Now, energy is only trading at a 3% discount-- so not that much of a margin of safety. But I still think that that provides a good natural hedge in your portfolio to the ongoing and potentially even more heightened geopolitical risk, as well as if inflation does stay higher for longer.
Now, one risky highlight is the potential for a weaker economy, but also sticky inflation. What's the potential headwind here according to your view?
Well, there's really two headwinds here right now. And unfortunately, in the first quarter, I do think what we've seen is kind of been the worst of both worlds. So inflation has been running higher than what our US economics team had originally projected coming into the year. And then the US real GDP was only 1.6% on an annualized basis in the first quarter. And that was even slower than what our economics team had projected.
And I think we are even on the low side or below consensus coming into the year. So looking forward, our base case is that real annualized GDP in the US is probably only going to run between 1% to 1 and 1/4% through the first quarter of 2025. Now, having said that, they do still expect the inflation will moderate.
Our US economics team is looking at a number of different real time indicators, like rent costs, some of those things that have kept inflation higher for longer. And they do note that as those are slowing in real time, that should be reflected in the economic metrics over the next couple of months. Now, originally, we were looking for the Fed to actually have started cutting the federal funds rate by now.
But with inflation lasting longer than what we originally had thought, we did push that forecast back to September. But once the Fed does begin to cut, our view is that they'll probably actually cut the Fed funds rate even faster than what the consensus is expecting because of our view for that slow economy. So I think there's really two risks here.
In the short-term over the next couple of months, I do think that slow economic growth will weigh on earnings. That could drive maybe some negative sentiment and maybe a pullback in the market this summer. And then over the medium-term, if inflation remains too high and the Fed is stuck and can't begin to cut the Fed funds rate later this year, that could be something that maybe with that tight monetary policy, the economy could slip into recession late this year or maybe even into beginning of next year.
OK. That's a great overview. I want to get back to earnings. And we're well into earnings season right now. Looking at that, what are the big takeaways so far? And how have the banks and financials performed?
Yeah, so the banks and the financials, in my view, earnings were just fine. There was really no major differences there. I'd note in the US regional banks, we do still see some opportunities for investors there. But a lot of those stocks have recovered well off the bottoms that they had after the bankruptcy last year.
But I would say, really, the biggest takeaway for the banks would be we didn't see a meaningful uptick in loan loss reserves. So what that tells me is that the banks are relatively comfortable with their outlook for the economy for the next couple of quarters. And there were some increases in loan loss reserves for commercial real estate, but, again, not to the degree that that started to concern our bank analyst team.
OK. And how about big tech? Any trends you're seeing there?
A couple of different trends. The big tech that's leveraged to artificial intelligence, those obvious names like Microsoft, Alphabet, Amazon, still doing very well. Meta was actually interesting this quarter. They did beat, and they beat by quite a bit. "And I thought they gave a pretty good solid guidance, but that stock actually sold off pretty dramatically. Now, one, we just thought it was overvalued in and of itself. But I think the big thing that the market didn't like is just how much they're spending on capex and how much they're increasing that on artificial intelligence.
If you remember, when they changed their name to Meta and they spent a lot of money on the metaverse, a lot of that spending really came to naught at the end of the day. So I think there's a lot of negative sentiment there. And then I'd just note the technology that's not tied to artificial intelligence, a lot of people are starting to consider these names legacy technology-- names like IBM and Intel-- definitely struggling here in the short-term as they're really starting to lose relevance in the technology space and in their specific subsectors.
OK. Finally, talk to us about some of those real economy stocks. Do you think that they're feeling the pinch of slowing consumer demand due to inflation?
Yeah. So the industrial sector is overvalued, in our view. We do think that the slowing economy will put some pressure there. But, really, it's the US consumer. And the question we're getting there is, is the US consumer really finally starting to get tapped out? And when I take a look at results like Starbucks, McDonald's, and even Tyson Foods, in my opinion, I think that these results might be the canary in the coal mine that, yeah, the impact of inflation-- and not just the recent inflation but really that compound impact of inflation over the past two years now-- is really starting to pinch the consumer.
Originally, it started off with the low-income consumer feeling it the most. But it's definitely moving now into the middle-income consumer as well. Originally, consumers were able to offset the higher prices with excess savings from early on in the pandemic. We think that's been used up for a while now.
Then consumers started to eat into their savings rate. We've seen saving rates decline as well. And at this point, that appears to be nearing kind of the end of that trend as well. So we're definitely seeing decreases in volume. For example, Starbucks had a 7% decrease in store traffic.
That's really a meaningful decrease for a company like Starbucks. So we're really seeing consumers pull back, but especially in those areas that I think consumers consider to be a little bit more indulgent.
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