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The equity market’s rally has been fueled in large part by the so-called Magnificent Seven. David Sekera, Chief U.S. Market Strategist with Morningstar Research, explains why it may be time to look beyond big tech for potential opportunities in value stocks.
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With big tech leading the way to new highs for equity markets, some investors may be looking for opportunities beyond the Magnificent Seven. Joining us now to discuss the potential opportunity in value stocks is Dave Sekera, Chief US Market Strategist with Morningstar Research. Great to have you back on the program with us.
Hey, Greg. Good to see you again.
Let's talk about this, right? Obviously, we have seen these markets make some impressive gains over the past year, through the beginning of this year. People want to talk about market breadth, but we take a look at those big tech names. Is there a potential opportunity outside of that space?
Yeah, we think so. So right now the market overall is trading a few percent above our fair value. Not yet in what we consider to be overvalued territory, but it is starting to feel a little stretched to us at this point. So when we break our valuations down into the Morningstar style box, we do note that value is the one area that does still remain undervalued for investors today.
Now, when I think about what's happened with the market over the past 16 months, a year ago, growth was undervalued. In fact, tech was kind of one of the more undervalued sectors, according to our valuations. But at this point, these have all run up so much, so far, so fast. A lot of them are now trading at well into overvalued territory. And, of course, you know, value stocks have lagged.
So, looking forward, in order to outperform, I think investors are going to have to start bucking that trend of what's worked for the past year. You know, start scaling out of some of these that are now overvalued, overextended. You know, lock in some profits here. And I think you really need to start looking for some more contrarian plays. So the areas that we've really been digging into most recently are those that have underperformed the market over the past year, those that are unloved, the ones that have the worst market sentiment. And, of course, and more importantly, are those that we still see as being undervalued today.
All right, I think we can break those down according to the work that you've been doing, David. And the three buckets, let's start with the utility space.
Yeah, and, of course, you know, utilities are highly correlated with interest rates. A lot of investors have been using utilities, really, as a fixed-income substitute when rates were so low a couple of years ago. Now, the utility space did sell off last fall when we saw the 10-year start skyrocketing and first go above 4%. Now it has recovered a bit. The utility space that is, has recovered a bit. But fundamentally, we still think utilities, the outlook is really as strong as it's ever been. Our utility equity analyst team has noted they just see a long runway of growth here. The transition to renewable energy, certainly a long runway of growth. A lot of government spending and investment in infrastructure and upgrading the grid.
So fundamentally, we still think things are looking very positive here. And then when I talk to our US economics team, they do expect interest rates are going to decline and decline across the entire curve in the second half of this year. So I think between good positive fundamentals and the tailwind from declining interest rates, you know, that should portend well for that sector looking forward.
All right, that's the bullish case. What could get in the way of the utilities thesis?
Well, of course, interest rates. If we do see interest rates continue to keep moving up from here, that really is going to pressure the utility space a lot more than what we expect. And, of course, it is budget season in Washington, DC. So if we were to see the budget get changed, such that they start pulling some money out of the investment that they plan on spending in the utility space, specifically in the grid and infrastructure, that also would pressure our thesis there, as well.
OK. Another area that I know you've been taking a look into in terms of value is the energy space. What's happening here?
So the energy space, overall, is still trading at a pretty good discount from our fair value. And I like energy for a couple of different reasons today. So first, fundamentally, when I look at our valuations, I would note we use the two-year forward-strip price, so the market implied price for the next two years for oil in our model. And then we project oil prices will actually start declining towards our $55-a-barrel mid cycle-price. So again, once you get past year two, we start looking for lower prices. But even based on those lower prices, our models are still telling us that these stocks are undervalued today. Plus it also, I think, just gives your portfolio a good natural hedge. So if we're wrong and inflation stays hotter for longer, that certainly would help out in that case.
And, of course, I think it's also just a good natural portfolio hedge for geopolitical risk. And I think the downside here is, if demand falls off faster than what we expect-- we do expect demand will continue to climb for the next couple of years, level off towards the end of this decade before it starts to decline-- or if we do see a lot more drilling in the US or we start seeing a lot more supply coming on market, that could push oil prices down faster than what we currently expect.
Yeah, does that make it challenging when you're trying to build a thesis around energy and the teams? You can think of geopolitical conflict. You can think about the strength of China's economy, what their appetite is going to be for crude oil. There's just so many pieces that move, I feel, in this bucket.
Yeah, and that's why our energy team actually works hand in hand with our US economics team in order to put together that supply-demand curve, where we expect oil prices to be, not just necessarily coming up here in the short term but really throughout the entire economic cycle. So that's how we get to that $55-a-barrel mid-economic cycle price forecast for WTI and $60 a barrel for Brent.
OK, let's move to another area now. We said there was three. Here's number three-- real estate. Clearly very sensitive to interest rates.
Well, not only that. I think real estate has just got to be the most hated asset class in the market today. And personally, I'd still steer clear of urban office space. I'm still concerned there could be more downside pressure there for valuations. But the good news for investors is that I think that the urban office-space valuations have really just brought valuations down across the entire real-estate landscape. So there's a number of different areas that we do find to be attractive for investors today. Probably the two areas I'd really look the most are going to be in those defensive areas.
So again, think healthcare, medical offices, life-science buildings, and so forth. I think those are going to be good over the longer term, and even things like class A retail malls, the high-end malls. We've seen foot traffic rebound. They've changed those malls so they're more experiential, less reliant on retail traffic.
For people looking for growth here, real estate, I'd highlight data centers. I think there's going to be a long tailwind there from artificial intelligence. And as we talked about with utilities, we do expect interest rates to decline, and that should be a positive tailwind for the real-estate sector as well. Of course, if interest rates stay here or actually even increase from here, that certainly would pressure all of the real-estate valuations and could bring them down further.
All right, so you mentioned artificial intelligence in terms of a real-estate thesis. Let's talk AI. Let's talk about the stock that has clearly benefited from all this excitement in the past year, NVIDIA. How does it look right now at these levels, fully valued?
Actually, I think it's gone too high to the upside at this point. When I look at NVIDIA and I look at our base case, I think the market is expecting too much growth for too long. And when I look at our model, not only has the revenue for that company doubled over the course of this year, we're already projecting it to double again over the course of next year and, I think, increase, you know, 40% or 50% in 2025. We're looking for a top line of 30% compound annual growth rate over the next five years. Looking for margins that are stronger than they've ever been over the course of that five-year period, as well, but yet the market price is still much higher than what we see today. So unless we're completely misreading just the amount of growth in AI over time, that stock, in our view, is just gone too much too high to the upside. [AUDIO LOGO]
[MUSIC PLAYING]
With big tech leading the way to new highs for equity markets, some investors may be looking for opportunities beyond the Magnificent Seven. Joining us now to discuss the potential opportunity in value stocks is Dave Sekera, Chief US Market Strategist with Morningstar Research. Great to have you back on the program with us.
Hey, Greg. Good to see you again.
Let's talk about this, right? Obviously, we have seen these markets make some impressive gains over the past year, through the beginning of this year. People want to talk about market breadth, but we take a look at those big tech names. Is there a potential opportunity outside of that space?
Yeah, we think so. So right now the market overall is trading a few percent above our fair value. Not yet in what we consider to be overvalued territory, but it is starting to feel a little stretched to us at this point. So when we break our valuations down into the Morningstar style box, we do note that value is the one area that does still remain undervalued for investors today.
Now, when I think about what's happened with the market over the past 16 months, a year ago, growth was undervalued. In fact, tech was kind of one of the more undervalued sectors, according to our valuations. But at this point, these have all run up so much, so far, so fast. A lot of them are now trading at well into overvalued territory. And, of course, you know, value stocks have lagged.
So, looking forward, in order to outperform, I think investors are going to have to start bucking that trend of what's worked for the past year. You know, start scaling out of some of these that are now overvalued, overextended. You know, lock in some profits here. And I think you really need to start looking for some more contrarian plays. So the areas that we've really been digging into most recently are those that have underperformed the market over the past year, those that are unloved, the ones that have the worst market sentiment. And, of course, and more importantly, are those that we still see as being undervalued today.
All right, I think we can break those down according to the work that you've been doing, David. And the three buckets, let's start with the utility space.
Yeah, and, of course, you know, utilities are highly correlated with interest rates. A lot of investors have been using utilities, really, as a fixed-income substitute when rates were so low a couple of years ago. Now, the utility space did sell off last fall when we saw the 10-year start skyrocketing and first go above 4%. Now it has recovered a bit. The utility space that is, has recovered a bit. But fundamentally, we still think utilities, the outlook is really as strong as it's ever been. Our utility equity analyst team has noted they just see a long runway of growth here. The transition to renewable energy, certainly a long runway of growth. A lot of government spending and investment in infrastructure and upgrading the grid.
So fundamentally, we still think things are looking very positive here. And then when I talk to our US economics team, they do expect interest rates are going to decline and decline across the entire curve in the second half of this year. So I think between good positive fundamentals and the tailwind from declining interest rates, you know, that should portend well for that sector looking forward.
All right, that's the bullish case. What could get in the way of the utilities thesis?
Well, of course, interest rates. If we do see interest rates continue to keep moving up from here, that really is going to pressure the utility space a lot more than what we expect. And, of course, it is budget season in Washington, DC. So if we were to see the budget get changed, such that they start pulling some money out of the investment that they plan on spending in the utility space, specifically in the grid and infrastructure, that also would pressure our thesis there, as well.
OK. Another area that I know you've been taking a look into in terms of value is the energy space. What's happening here?
So the energy space, overall, is still trading at a pretty good discount from our fair value. And I like energy for a couple of different reasons today. So first, fundamentally, when I look at our valuations, I would note we use the two-year forward-strip price, so the market implied price for the next two years for oil in our model. And then we project oil prices will actually start declining towards our $55-a-barrel mid cycle-price. So again, once you get past year two, we start looking for lower prices. But even based on those lower prices, our models are still telling us that these stocks are undervalued today. Plus it also, I think, just gives your portfolio a good natural hedge. So if we're wrong and inflation stays hotter for longer, that certainly would help out in that case.
And, of course, I think it's also just a good natural portfolio hedge for geopolitical risk. And I think the downside here is, if demand falls off faster than what we expect-- we do expect demand will continue to climb for the next couple of years, level off towards the end of this decade before it starts to decline-- or if we do see a lot more drilling in the US or we start seeing a lot more supply coming on market, that could push oil prices down faster than what we currently expect.
Yeah, does that make it challenging when you're trying to build a thesis around energy and the teams? You can think of geopolitical conflict. You can think about the strength of China's economy, what their appetite is going to be for crude oil. There's just so many pieces that move, I feel, in this bucket.
Yeah, and that's why our energy team actually works hand in hand with our US economics team in order to put together that supply-demand curve, where we expect oil prices to be, not just necessarily coming up here in the short term but really throughout the entire economic cycle. So that's how we get to that $55-a-barrel mid-economic cycle price forecast for WTI and $60 a barrel for Brent.
OK, let's move to another area now. We said there was three. Here's number three-- real estate. Clearly very sensitive to interest rates.
Well, not only that. I think real estate has just got to be the most hated asset class in the market today. And personally, I'd still steer clear of urban office space. I'm still concerned there could be more downside pressure there for valuations. But the good news for investors is that I think that the urban office-space valuations have really just brought valuations down across the entire real-estate landscape. So there's a number of different areas that we do find to be attractive for investors today. Probably the two areas I'd really look the most are going to be in those defensive areas.
So again, think healthcare, medical offices, life-science buildings, and so forth. I think those are going to be good over the longer term, and even things like class A retail malls, the high-end malls. We've seen foot traffic rebound. They've changed those malls so they're more experiential, less reliant on retail traffic.
For people looking for growth here, real estate, I'd highlight data centers. I think there's going to be a long tailwind there from artificial intelligence. And as we talked about with utilities, we do expect interest rates to decline, and that should be a positive tailwind for the real-estate sector as well. Of course, if interest rates stay here or actually even increase from here, that certainly would pressure all of the real-estate valuations and could bring them down further.
All right, so you mentioned artificial intelligence in terms of a real-estate thesis. Let's talk AI. Let's talk about the stock that has clearly benefited from all this excitement in the past year, NVIDIA. How does it look right now at these levels, fully valued?
Actually, I think it's gone too high to the upside at this point. When I look at NVIDIA and I look at our base case, I think the market is expecting too much growth for too long. And when I look at our model, not only has the revenue for that company doubled over the course of this year, we're already projecting it to double again over the course of next year and, I think, increase, you know, 40% or 50% in 2025. We're looking for a top line of 30% compound annual growth rate over the next five years. Looking for margins that are stronger than they've ever been over the course of that five-year period, as well, but yet the market price is still much higher than what we see today. So unless we're completely misreading just the amount of growth in AI over time, that stock, in our view, is just gone too much too high to the upside. [AUDIO LOGO]
[MUSIC PLAYING]
