Did you know that the US equity market is trading at a 3% premium to fair value? The value segment and small cap stocks, meanwhile, display all the hallmarks of bargain pricing.
If you're a US equity investor, then, it's unlikely that what has worked over the past year-and-a-half will continue to work now. As such, contrarian investments might offer the best margin of safety at a time when companies are no longer cheap.
US Stock Market: Overvalued?
Although the above premium doesn't necessarily mean the US market is overvalued, it has been valued at these prices or higher only 14% of the time since the end of 2010.
Going forward, Morningstar analysts now expect further rises to be driven by higher yields across the market, and particularly in the value category, which remains the most undervalued by our assessments – and in the small cap segment, specifically.
In October 2022, the three most undervalued sectors were telecommunications, cyclical consumer goods, and technology. A year and a half later, technology stocks are overvalued and telecommunications and consumer cyclicals are trading at roughly fair value. As a result, it may be a good time for investors to investigate contrarian picks, and especially in sectors that have underperformed and, more importantly, are undervalued.
Fed Up, Fed Down: The Case For Value and Small Caps
In the first quarter of this year, the US equity market continued its rally. As of 8 April, the Morningstar US Market Index was up 8.73% in US dollars (USD). Although the rally was underpinned by better-than-expected earnings growth, it was the surge in artificial intelligence (AI)-related stocks that provided the biggest impetus for performance.
For this reason, most of the gains were concentrated in a handful of stocks, and especially those with strong exposure to AI as a theme. Nvidia (NVDA), for example, is up 90% and alone accounts for almost 25% of the market's performance to date. By contrast, 62% of this year's gain is concentrated in just 10 stocks (including Nvidia).
At a 6% discount to our fair value, however, the value segment remains the most attractive, while the growth segment, at an 8% premium, remains overvalued. Blend stocks, on the other hand, are trading just above fair value, at a 3% premium. Small cap stocks are the most attractively valued, at an 18% discount, followed by mid caps, discounted by 3%, and, finally, large caps, which are trading at a 5% premium.
Based on these valuations, we suggest overweighting value and blend stocks in portfolios and underweighting growth stocks. In terms of market capitalisation segments, we prefer to underweight large caps and overweight mid and small caps.
Morningstar's economics team also expects a soft landing for the US economy, with a slowdown in the rate of growth in the coming quarters, but not enough to lead to a recession. This trend will likely weigh on growth stocks, to the benefit of the small cap segment, which traders have avoided lest they suffer more from a recession.
Morningstar analysts also predict that interest rates will fall along the yield curve as soon as the Fed starts to cut its benchmark rate. Lower interest rates are positive for all stocks, but especially for sectors that are overweight in the value index. Cheaper money could also lead to a recovery in demand for dividend-paying stocks, which tend to be overweight in the value category. Historically, small caps tend to do well when the Fed starts to cut interest rates. Finally, a decline in the yield curve will eliminate the risk that future earnings of small cap companies will be squeezed when they go to refinance maturing cheap debt.
Contrarian Investment Ideas in US Equities
As of early 2023, the three most undervalued sectors were telecommunications, consumer cyclical, and technology. More than a year later, technology stocks are now overvalued, while telecommunications and consumer cyclical stocks are trading in line with fair value.
Based on an analysis of the performance of the Morningstar US Market index, as of March 22, the returns of 10 stocks represented approximately 62% of the overall gain achieved by the market. While these 10 stocks have led the index higher, we doubt they will continue to do so for the rest of the year. Right now, half of the US stocks covered by the Morningstar analysts are rated 3-Stars – the other half get a 2-Star rating. At the beginning of 2024, however, two stocks were rated 4 Stars, three companies were rated 2 Stars. Everything else was rated 3 Stars.
Spotlight on: Real Estate
Where can investors find contrarian ideas? Morningstar analysts are looking for those sectors that have lagged the overall market, for which the market has a negative sentiment, and which are trading at a significant discount to fair value. And there are three: real estate, utilities and energy.
Real estate is the least loved sector on Wall Street, as negative sentiment resulting from declining urban office valuations has infected the entire asset class.
In our view, this provides investors with an opportunity to take a position on some stocks that have been unfairly dragged down. Likewise, some of the most interesting opportunities are those that have defensive characteristics, including healthcare providers and triple-net leases (a commercial property lease agreement in which the tenant agrees to pay all expenses, including property taxes, as well as rent and utilities). In the healthcare sector, examples include Ventas (VTR) (rated 5 Stars) and Healthpeak (DOC). In the triple-net-lease segment, Realty Income (O) (rated 5 Stars) is one of the most undervalued stocks Morningstar analysts cover.
Spotlight on: Utilities
After reaching something of an overvaluation in late 2021, the utilities sector not only significantly lagged the market but has since posted a loss of 5%. Rising interest rates have played a role, as the current value of utility stocks is negatively correlated with rising yields.
However, we believe the market has overcorrected to the downside. From a fundamentals perspective, we believe the utility sector's outlook is as strong as it has ever been. Companies in the sector will benefit from the secular shift to renewable energy and increased investment in electricity grid infrastructure. Examples include NiSource (NI) and Entergy (ETR) (both rated 5 stars). We also believe falling interest rates will boost utilities.
The price/fair value ratio of the energy sector has increased in recent weeks. However, we still see a significant number of undervalued stocks. Furthermore, we believe the sector offers investors a natural hedge against further geopolitical risks – or the risk inflation remains elevated for longer. Among the global oil majors, our choice goes to 4-Star-Rated Exxon (XOM). US regional provider Devon (DVN) gets a 4-Star rating.
Which Sectors Are Overvalued?
Compared to fair value, the industrial goods sector is the most overvalued. Areas like transportation and airlines include some of the most overvalued stocks covered by our research. With a 1-Star rating, XPO (XPO) trades at a 64% premium to fair value, while 2-Star-rated Southwest Airlines (LUV) is overvalued by 50%.
Within the technology sector, shares in 1-Star-Rated ARM Holdings (ARM) are among the most overvalued, and are trading at prices more than double their Fair Value Estimate.
While ARM will benefit from the growth of AI, we believe the market is significantly overestimating its growth potential as a company. For the same reason, Morningstar analysts say Dell Technologies (DELL) is trading at prices much higher than our valuation.
In the defensive consumer goods sector, retailers such as Walmart (WMT), Target (TGT) and Costco (COST) are overvalued, while shares in companies that produce packaged foods, such as Campbell Soup (CPB), Kellanova (K) and General Mills (GIS) are trading at a discount. In the finance sector, on the one hand we see a notable overvaluation of insurance companies, such as Allstate (ALL) and Progressive (PGR), while US banks such as US Bank (USB) and Truist (TFC) continue to show attractive pricing.
When Will The Fed Cut US Interest Rates?
Through March 22, the Morningstar US Core Bond Index, the benchmark representative of the broader bond market, fell 0.90%. Interest rates rose at the longer end of the yield curve and the 10-year US Treasury yield rose 34 basis points to 4.22%.
Morningstar analysts still expect the Federal Reserve to begin easing monetary policy at its June meeting, lowering its key rate by 25 basis points, and then cutting further at each subsequent meeting to 2024's end. This projection is is based on the forecast that inflation will continue to cool throughout the year, and the rate of economic growth is slowing.
We now expect the policy rate to fall to a range of 4% to 4.25% by the end of the year and then settle between 2.50% and 2.75% by the end of 2025.
At the longer end of the yield curve, we expect the 10-year US Treasury yield to average 4.00% in 2024 and 3.00% in 2025. Based on our interest rate forecasts, We believe investors will be able to make the most of longer-dated bonds and lock in currently-high interest rates.
Corporate bond spreads tightened during the quarter. The average spread of the Morningstar US Corporate Bond Index narrowed by 10 basis points to +86. In the high-yield corporate bond market, the average spread fell 31 basis points to +302.
In their mid-2023 report on the bond market, Morningstar fixed income analysts wrote that corporate bond spreads offered "an adequate margin of safety for investors to compensate for future downgrades and default risks". At this moment, however, and given that corporate bond spreads have continued to narrow, we believe they have become too low to justify exposure to this asset class. Instead, on this, investors should be underweight.
Over the past 24 years, the Morningstar US Corporate Bond Index spread has only been lower than the current spread of 86 basis points for 2% of the time. Over the same period, the Morningstar US High-Yield Bond Index spread has been lower than the current spread of 302 basis points for 3% of the time. Spreads on investment-grade and high-yield securities reached their historic lows in 2007, at +80 and +241 basis points respectively.
