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Portfolio > Economy & Markets

U.S. Stock Market 'Deep Into Undervalued Territory:' Morningstar

By Dinah Wisenberg Brin

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What You Need to Know

  • Now is not the time to reduce equity exposures but to add judiciously, cautions Morningstar's Dave Sekera.
  • Morningstar predicts the Fed will stop tightening by year-end 2022 and will have room to ease by year-end 2023.
  • In this market environment, investors should have a plan that balances their long-term investment goals with their risk tolerances.

The U.S. stock market is trading “deep into undervalued territory,” at more than a 20% discount to fair value, according to Morningstar.

“With equities selling off 24% year to date, it appears to us that the market has overcorrected to the downside,” Dave Sekera, chief U.S. market strategist for Morningstar Research Services LLC, said in a Morningstar.com post on Monday, adding that the market appears “overly pessimistic” about long-term equity valuations.

A composite of the U.S. stocks that the research firm covers indicates “the equity market is significantly undervalued and is trading at over a 20% discount to fair value,” Sekera wrote. Equities have rarely traded at such a deep discount to their intrinsic valuation, he added.

A graphic accompanying Sekera’s commentary indicated the entire market composite was trading at 0.79 price/fair value as of Sept. 26.

“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 appear to be best positioned with a barbell-shaped strategy, overweighting both value and growth categories and underweighting core,” Sekera suggested.

Large- and mid-cap stocks trade near the broad market valuation, while at 0.62, small-cap stocks are trading at the greatest discount to fair value, according to the strategist, who wrote that communications and cyclical sectors are the most undervalued after experiencing the worst selloff.

The market’s oversold state comes in an environment with weaker-than-expected economic growth, a hawkish Federal Reserve, high inflation and other pressures, he noted. The undervaluation “is the greatest discount to our long-term, intrinsic valuations since the emergence of the pandemic,” Sekera said, adding that in March 2020, the price/fair value bottomed out at 0.77.

“On a longer historical time frame, there have only been a few other instances when our price/fair value metric had dropped to similar levels,” Sekera wrote.

“While near-term conditions may pressure earnings in the short term, at current valuations we think the market has fallen more than enough to incorporate those headwinds. In our view, we think the market is overly pessimistic regarding the long-term prospects for equity valuations,” he said.

Citing a 0.75 price/fair value for the consumer cyclical sector, Sekera suggested that “the market is overreacting to concerns of a possible near-term recession. In the event of a recession, we think it would be short and shallow and that the sector already factors in enough of a margin of safety at its current valuation.

“Many of the services-oriented companies in this sector should benefit as the pandemic continues to recede and consumer spending behavior normalizes and shifts back to services and away from goods.”

Defensive sectors, including consumer defensive, health care and utilities, generally have performed relatively well this year and are trading closer to fair value, with utilities slightly overvalued,  according to Sekera.

Morningstar expects more volatility in the next six to 12 months. Before finding the bottom, the markets need a better picture of when inflation will tame and trend toward the Federal Reserve’s 2% target and when economic activity will meaningfully rebound.

While Morningstar expects gross domestic product to remain sluggish — reaccelerating in next year’s second half — the firm predicted the Fed will end its tightening policy by year-end 2022 as inflation moderates in the next few months and subsides in 2023.

The Fed should have the room it needs to start easing monetary policy by late 2023, Sekera wrote. Morningstar predicted the Fed’s benchmark interest rate will drop to 2% at year-end 2023.

In this market environment, investors should have a plan that balances their long-term investment goals with their risk tolerances, Sekera recommended.

“This plan should also allow for periodic rebalancing to increase equity allocations when valuations decline but also reduce exposure when valuations become overextended,” he wrote.

Given Morningstar’s view that the U.S. equity market is undervalued, he added, “now is not the time to be reducing equity exposures but to be adding judiciously,” especially in companies with “wide economic moats,” (which Morningstar defines as companies with sustainable competitive advantages trading at attractive valuations) based on their investment plan and goals.

Dinah Wisenberg Brin

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