What Investors Can Expect in 2021's Second Half

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Through the first half of 2021, the stock market notched double-digit gains, earnings growth was robust, and inflation heated up. What can investors expect for the second half of the year? Joining me today to share some insights is Dave Sekera. Dave is Morningstar's chief U.S. market strategist. Dave, let's dive right in. How do stocks look heading into the third quarter?

Dave Sekera: We've taken a look at the intrinsic valuations of all the stocks that we cover, and we put together a composite and then compare that to the overall market. So, right now, we think the market is trading at about a 4% premium over those valuations, which in my view, puts us probably at the top end of what we consider to be the fairly valued range.

Dziubinski: Are there any sectors that are, say, most overvalued today?

Sekera: Yeah, probably the three that we think are the most overvalued right now would be basic materials, industrials, and real estate. In the basic material sector, I think investors generally have kind of over extrapolated the amount of gains that they expect those companies make over the long term. As you mentioned earlier, inflation certainly had been heating up, and a lot of those companies in the raw materials areas are certainly the beneficiaries of that. But again, we think those have just run too far, too fast here in the short term. Industrials, again, the economy is doing very well, we expect the economy to do well in the second half of this year. And, in fact, in our outlook, we expect the economy to generate over 4% and probably about 3% GDP next year and the year thereafter.

Again, those companies have a good pathway in front of them. But, in our view, we think that over the course of an entire business cycle, that's not being factored in, and those prices have gone up too high in the short term. Real estate is another one. Certainly people look at that as being an inflationary hedge as well. And it's interesting, it's a little bit of a barbell in that space that we think a lot of the REITs in that sector again are overvalued. But some of the REITs, especially those in the retail sector, investors really I think are overlooking, and we do see value in there. And we rate some of those companies 4 stars right now.

Dziubinski: And let's look at the flip side, what are some sectors that are maybe flying under the radar and undervalued today?

Sekera: Well, I don't know if it's under the radar. In our view, we've long been very constructive on the energy sector. And again, we think the energy sector is still undervalued today, even though it's had a really good performance this year, we still do see upside within that area. Probably the next most undervalued would be the communication sector. Now that one, I would say that investors need to be pretty choosy about which stocks they're going to be looking at, potentially investing in there. Two of the socks in there, you have Alphabet (also Google) as well as Facebook, two very large companies that we think are pretty significantly undervalued. And because they're so large, they do skew the overall valuation of that category. Having said that, there are still certainly some mid-cap and small-cap stocks that we think are undervalued there as well.

And finally, while it's not undervalued, I'd also recommend investors to take a look at the utilities sector. That's one that we think is fairly valued today, but it's actually been underperforming the market for the first half of this year. Utilities certainly will have a headwind as we see interest rates going up. And we would expect longer-term interest rates going up probably in the second half of this year, going into earlier next year, once the Federal Reserve starts to taper the asset purchase program and then thereafter starts thinking about raising interest rates. Having said that, we've already incorporated that into our view of utilities, and looking at the spread of the dividend payments, that utilities currently pay compared to Treasury rates, looking at the growth expectations, we think utilities will be able to hold their own.

Dziubinski: Now let's slice the market by market capitalization and growth and value styles. What looks the most overvalued through those lenses, and then the most undervalued.

Sekera: When we break it down into the nine Morningstar style boxes, we think the value category is pretty fairly valued, maybe a couple percent undervalued at this point. And again, in the value category, we think large cap, mid-cap, and small cap are all pretty fairly valued. I think anywhere in that category, within any of those market capitalizations, investors will be fine over the long term. On the growth side, we think growth is really kind of slightly overvalued, not hugely overvalued. There I would recommend investors focus on the large-cap growth space. That would be the area that we think is a little bit on the high side of the fairly valued range, but I would much prefer focusing in that area than in small cap and mid-cap. Now, there's also core stocks. Core stocks are a little bit of a blend--they have some characteristics of value, some characteristics of growth. That's actually the area that we probably see being the most overvalued in the marketplace today.

Dziubinski: Let's pivot and talk about higher-quality stocks, which we would think of as having wide economic moats. Are they outperforming, underperforming, are they undervalued, overvalued? What do they look like today?

Sekera: They've actually performed pretty well this year. Looking at the Morningstar Moat Index. I think it's outperformed the market. Last I checked, I think it was up about 20% compared to the market, maybe just shy of 15%. But we do still see value for investors in those companies that do have wide economic moats. When we break that down, we do look at companies, whether or not they have no moat, narrow moat, wide moat. Those wide-moat stocks that we're looking at today probably have the best opportunities, that's the most fairly valued of the sectors. Both the narrow-moat and the no-moat stocks, in our view, are overvalued at this point.

Dziubinski: If investors would want to be making some tweaks to their portfolios right now, what, in general, would you say are places to consider given what we've talked about so far?

Sekera: Well of course, that's always going to depend on individual investors, their risk tolerance and what their portfolio looks like today. But again, I think a good balanced portfolio between the value category and the growth category would be a good place for investors to be looking at balancing their portfolio today. However, on that growth side, I certainly would recommend that investors really focus on the large-cap growth part of the Morningstar Style Box.

Dziubinski: Well, Dave, thank you so much for your time today. And we'll talk to you at year-end to look forward to 2022.

Sekera: Sounds great.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.