Dave Sekera: Taking the Market’s Temperature

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Our guest this week is Dave Sekera. Dave is chief U.S. market strategist for Morningstar Research Services. In his role, Dave publishes research and commentary on the state of the markets and is a leading voice on Morningstar.com and other platforms. Before assuming his current role, Dave was a managing director for DBRS Morningstar. Prior to joining Morningstar in 2010, Dave worked in the alternative asset management field. Dave earned his bachelor’s degree in finance and decision sciences from Miami University and holds the Chartered Financial Analyst designation. You can follow him on Twitter at @MstarMarkets.

Background

Bio

Twitter handle: @MstarMarkets

Stock Market and Market Concentration

“The U.S. Stock Market Is Undervalued, but It Looks Like a Rough Road Ahead,” by Dave Sekera, Morningstar.com, March 3, 2023.

“What to Expect From Stocks in 2023,” by Susan Dziubinski and Dave Sekera, Morningstar.com, Jan. 23, 2023.

“How to Invest in 2023′s Uncertain Market,” by David Sekera, Morningstar.com, March 27, 2023.

“Q3 Stock Market Update: Time to Batten Down the Hatches or Raise the Sail,” by Dave Sekera, Morningstar.com, June 30, 2023.

“3 Cheap Stocks to Buy and Hold This Summer,” by Dave Sekera and Susan Dziubinski, Morningstar.com, July 10, 2023.

“Markets Brief: The ‘Magnificent 7′ Stock Have Driven the Rally, but Are They Too Expensive Now?” by Caryl Anne Francia, Morningstar.com, June 23, 2023.

“Despite Rally, Stock Market Remains Undervalued,” by Dave Sekera, Morningstar.com, May 8, 2023.

Sector View

“4 Stocks to Buy in Q3 2023,” by Dave Sekera and Susan Dziubinski, Morningstar.com, July 5, 2023.

“33 Undervalued Stocks,” by Susan Dziubinski, Morningstar.com, July 3, 2023.

“10 Top Small-Cap Stocks to Buy for the Long Term,” by Susan Dziubinski, Morningstar.com, June 20, 2023.

“2 Big Tech Stocks to Buy,” by David Sekera, Ali Mogharabi, and Susan Dziubinski, Morningstar.com, May 8, 2023.

Value and Quality

“Markets Brief: Fading Recession Fears, Cheap Valuations Have Small-Cap Stocks Looking Attractive,” by Sandy Ward and Jakir Hossain, Morningstar.com, June 2, 2023.

“4 Undervalued Wide-Moat Stocks With Defensive Traits,” by Susan Dziubinski and Dave Sekera, Morningstar.com, June 26, 2023.

Macroeconomic Environment

Preston Caldwell

“U.S. Leading Indicators,” The Conference Board, conference-board.org, June 22, 2023.

Bonds and Credit and Risk

“Markets Brief: There’s Good News for Investors in Rates Staying Higher for Longer,” by Tom Lauricella and Caryl Anne Francia, Morningstar.com, July 7, 2023.

“5 Undervalued Stocks for a Sideways Market,” by David Sekera and Susan Dziubinski, Morningstar.com, May 22, 2023.

“Where to Invest in Bonds in 2023,” by David Sekera, Morningstar.com, Dec. 14, 2022.

Real Estate

“5 Cheap Real Estate Stocks to Buy,” by David Sekera and Susan Dziubinski, Morningstar.com, March 6, 2023.

“Markets Brief: 10th Straight Fed Rate Hike Rate on Tap,” by Sandy Ward and Jakir Hossain, Morningstar.com, April 28, 2023.

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: Our guest this week is Dave Sekera. Dave is chief U.S. market strategist for Morningstar Research Services. In his role, Dave publishes research and commentary on the state of the markets and is a leading voice on Morningstar.com and other platforms. Before assuming his current role, Dave was a managing director for DBRS Morningstar. Prior to joining Morningstar in 2010, Dave worked in the alternative asset management field. Dave earned his bachelor’s degree in finance and decision sciences from Miami University and holds the Chartered Financial Analyst designation. You can follow him on Twitter at @MstarMarkets.

Dave, welcome to The Long View.

David Sekera: Hey, Jeff. How are you doing?

Ptak: We’re doing well. Thanks so much for being here. Why don’t we start in a logical place, given your role, which is, looking at the stock market. Maybe you could talk about, through the lens by which you assess market valuations, does the market look cheap, dear, or reasonably priced right now, and what leads you to that conclusion?

Sekera: Following the rally that we’ve already had in the first half of this year, the market is still at a slight discount, trading at about a 5% discount to a composite of our fair values, whereas at the beginning of the year, it was actually pretty significantly undervalued, trading at about a 16% discount to our fair value. And I think it’s important for listeners to understand how we think about value and look at the markets overall, because I really think we have a different take in how we do our market valuations as compared with a lot of other market strategists.

So, we really take a bottom-up approach. In our equity research group here at Morningstar, we cover over 1,500 stocks globally. Of that, there’s over 700 that we cover that trade on U.S. exchanges. And what I do is I will take a composite of the intrinsic valuation as assigned by all of our equity analysts and compare that to where those stocks are actually trading in the marketplace in order to come up with that price/fair value. So really that bottom-up approach. Whereas what I see a lot of other strategists do is they always have this top-down approach. And they have some sort of model or algorithm, and they’ll come up with their estimate for what they think S&P 500 earnings are going to be at the end of the year, and then they come up with some sort of forward multiple that they apply to that in order to get to their target price, which maybe I’m just being cynical here, but it always seems that their target price ends up being anywhere 8% to 10% higher than where the market is currently. So, I think that’s part of the difference in why we find that oftentimes our view for market valuation could be very different than what the consensus is.

Ptak: Just to follow up, can you explain real briefly for the benefit of listeners who might be less familiar, how a Morningstar stock analyst would evaluate a stock? There are different approaches, even within bottom-up security selection. How do they do it?

Sekera: We start with really a fundamental bottom-up approach. So, each analyst will take a look at not only the individual company but take a look at the entire sector that they cover and how that company fits within that sector and how they compete. And as part of that analysis, we look to determine whether or not we think a company has an economic moat. So, essentially, very Graham and Dodd or Warren Buffett-esque type approach—does this company have long-term durable competitive advantages, which will help that company be able to generate excess returns over invested capital over the long term? And I think that’s really one of the big differentiators we have compared with how a lot of other people look at valuations. Once we’ve done that, we will build a full discounted cash flow model. And then, within that, we will incorporate how long we think a company can generate those excess returns.

For example, I always assume a company, even if they’re generating excess returns today, competitors will see those excess returns, they’ll enter that space and be able to quickly compete those returns away. A company that we deem to have a narrow economic moat, we expect that that is going to be able to allow that company to generate those excess returns for the next 10 years. And a company with a wide economic moat can generate those excess returns for the next 20 years or more. And so, when I think about how that impacts our valuations, those companies that do have those economic moats—all else being equal—will be worth more than companies that don’t have an economic moat because they will be able to generate those excess returns for that longer time period.

Benz: Dave, just to follow up, maybe you can talk about how a measure like the Shiller CAPE ratio, the cyclically adjusted P/E ratio, is different and is a top-down measure versus the one that our analysts use. Because if you’re looking at the Shiller CAPE ratio today, you see a flashing red, whereas you just indicated that we aren’t that worried that valuations look reasonable to us. So, maybe you can contrast those two ways of looking at the market.

Sekera: And I’m always very cautious whenever people are talking about historical metrics and how they’ve been applied in the past and what that might tell investors thinking about returns going forward. So, when I started in finance back in 1990, the largest stocks by market cap were companies like Exxon, IBM, Merck, Coke, companies that had very different business models, very different sectors, growth rates, margins, things that were very different than what we see the largest stocks are in the marketplace today. So, while I do think that some of those ratios can be helpful, I don’t think that what the market looks like today is always necessarily comparable to what it might have looked like in the past. And then, the other part too is with our valuation—I’ll look at P/E ratios and forward P/E ratios, but those really aren’t used in our valuation process. That’s really more an end product than it is necessarily a determinant for valuation. And in fact, I often find that P/Es have a pretty poor track record for really helping investors time their investments. When I think about a P/E ratio and even the CAPE ratio, it’s really going to be based on a snapshot in time for earnings. And I don’t think that necessarily appropriately measures long-term earnings growth and cash flow.

So, again, when I think about the intrinsic value of a company, it’s not just a metric as far as what they’re going to earn next year and some sort of estimate on top of that. It is truly the present value of all the future free cash flow that a firm will generate over its lifetime, and then using an appropriate discounted cash flow model to come up with those long-term projections for revenue, changes in margin, capital allocation and so forth and in order to determine that intrinsic value.

Ptak: When we had the washout last year, it seemed like people were saying this would mark the start of a new era in which value beats growth. How has that played out?

Sekera: I always am cautious when people are talking about a new era of anything in the financial market. And at this point, I think it’s really going to be too early to tell whether or not value beating growth will last over the next several years. But I always think things in finance come back to valuation. And irrespective of if a stock is considered to be a value stock or a core stock or a growth stock, it’s going to be based on where is that stock trading in the marketplace today compared with what you think that stock is worth based on that intrinsic valuation. For example, at the beginning of 2022, according to our composite, we noted that the market was overvalued and that growth stocks, especially the technology sector, were overvalued.

The value category was trading only slightly under our fair value estimates, but on a relative value basis was the most undervalued part of the market, especially the defensive sectors. So, to the downside in 2022, value stocks substantially outperformed growth stocks. But having said that, we do think the markets then overshot to the downside in 2022. So, then coming into 2023, when we looked at our valuations, we actually thought the market was pretty substantially undervalued with both value and growth categories trading at substantial discounts to fair value, whereas the core sector was much closer to being fairly valued. So, at that point, we really advocated for what we call a barbell-shaped portfolio, where we thought investors should be overweight both value and growth and underweight core based on those valuations.

As the market has moved and we’ve seen growth stocks really be the predominant part of the market that’s really made the strong returns in the first half of this year, those stocks as a category are really starting to approach fair value. And so, we’ve recently been updating our recommendation, telling investors that now it’s actually probably a pretty good time to be taking some profits from the growth category and begin to move to more of an underweight position in growth stocks generally, but then reallocate those profits into the value category, which has lagged, and in our view, remains significantly undervalued and much better positioned for returns going forward.

Benz: To follow up on that, U.S. stocks in aggregate have had a good year so far. Can you break down the source of those returns between earnings-per-share growth, multiple expansion, and yield?

Sekera: The way that we look at the market, those aren’t necessarily the terms and how I think about how to measure returns. And so, when we’re looking at our valuations and thinking about what some of the best positioning for investors would be going forward, we really want to find those areas that either, one, are undervalued and have lagged that we do think will provide better returns going forward, whereas we’re looking for those other areas that have become overvalued and overextended to take profits and make those reallocations based on those current valuations.

Ptak: Have share buybacks remained an important source of earnings growth for firms and what is the overall trend in share repurchases been?

Sekera: Share buybacks have certainly gotten some negative press earlier this year. But in our view, they do remain a valuable tax-efficient tool for companies to support shareholder returns and support earnings growth. But I do think long-term investors need to look past that short-term impact of share buybacks and think more in terms of how those buybacks may or may not impact the value of a company. For example, where management is able to buy back stock at a discount to intrinsic valuation, we do think that that will end up bolstering future shareholder returns. However, when management teams are buying back stock above intrinsic value, that ends up actually being more of a detriment to future returns. But I think it also really brings up a much larger question, and that’s for investors to think about how management is using the free cash flow that the company generates and whether or not that management team are good stewards of that capital and using that cash flow to build additional long-term value for the investors over time.

And when I think about how management teams use cash flow, first, I think most management teams will look to see if there’s ways that they can invest in organic growth opportunities. To me, that’s always my preferred use of cash flow, where they’re able to take cash and reinvest directly into their own business. Second, I think management teams will then look to see whether or not there’s potential acquisitions that they think may be synergistic for the company. I always want to make sure I cast a very cautious eye on that. There’s certainly instances where acquisitions will build long-term value, but also lots of other examples out there where it has destroyed capital. So, I think as an investor, you need to take a very careful look when they do make acquisitions.

Third, they can use that cash to repay debt, which for a company that’s overleveraged, that’s probably a good use of cash. Or they can let that cash build on the balance sheet, which then provides future optionality. So, then lastly, the management team, when you have the cash left over from those activities, determine whether or not to make dividend payments and/or share buybacks. And so, there’s going to be several different considerations. Some companies in specific sectors may want to not do dividend payments because, again, once you start paying dividends, more people think of that as being more of a value stock as opposed to a growth stock. And management teams are also going to be very apprehensive of raising their dividends too much that they won’t be able to support that dividend in the future. Management teams never want to cut dividends over time. And so, when all of that is put together, that really ends up determining when they take those capital allocations, is that going to be something that builds that long-term value or not?

Benz: Dave, you previously referenced the fact that U.S. growth stocks, especially technology stocks, have been so dominant this year. And you’ve written about how concentrated the U.S. market is in its top holdings, especially some of those names. Do the data suggest that that’s cause for concern?

Sekera: I’ve seen some reports out there trying to make that. But for me, the concentration in and of itself doesn’t necessarily concern me. I think it’s more a matter of how investors should think about how they may want to position their portfolios based on the current valuations and then how that may impact their future returns. So, as you mentioned, it’s very concentrated right now. And in fact, the magnificent seven, as they’re being called, do account for two thirds to three quarters of the market return this year. It’s interesting in that when you look at those seven specific mega-cap stocks, of those, six of those seven were rated either 4 stars or 5 stars at the beginning of this year, indicating that we thought that they were significantly undervalued. Following this rally, only one is actually still undervalued and rated 4 stars. Four of those stocks are fairly valued, rated 3 stars, and two of them are now actually in overvalued territory and rated 2 stars.

So, at this point, when I think about what we expect from the market going forward, for this market rally to continue, I think it really needs to spread out into the value category and out of the growth and actually start going down in capitalization, down into the mid-cap and the small-cap area and away from the large-cap.

Ptak: Maybe to follow up on that and stick with what you just mentioned, which gets at what investors might want to be thinking about, given the level of concentration of what it sounds like is full valuation of some of those top index constituents. Are you suggesting that they should be thinking about leaning a little bit more toward value where they’d find some of those more reasonably priced names? Or should they just sit tight in confidence that the index normally turns, this is not an uncommon state of affairs, and it will work itself out over time?

Sekera: I think a lot of that is going to depend on personal investor preferences and what their own risk appetite might be. At this point, what the valuations are telling me today is that the growth stocks are pretty close to fairly valued. So, we would expect that they will make over time the cost of equity on average for the group of stocks, which is typically around 8% to 9%. But what we do see is a better margin of safety in the value area with those stocks trading at about a 15% discount to those fair values. So, we would expect that over time, not only will those stocks earn their cost of equity, but that as those value stocks trade up closer to fair value that you’ll be able to get some extra return over time.

Having said that, there’s always different sentiment in the marketplace, lots of different reasons why some stocks may perform better than others in the short term. So, based on that, I think it is going to be dependent on the investor as far as whether or not they’re willing to take on some of that extra risk. But with that extra margin of safety, I do think that that helps provide some downside cushion.

Benz: Sticking with the S&P 500, does that suggest that the methodology is flawed in the way that it allows that degree of concentration? Or do you think people get too hung up on how the largest constituents of the index fare because their own underperformance is more than offset by something that comes along to replace them?

Sekera: I don’t think it’s necessarily that the index in and of itself is flawed, but I do think that it’s just something that I think investors need to be aware of in their own individual portfolio positioning and how to think about as they make reallocations within their portfolio, where they may want to make those reallocations based on current valuations.

Ptak: Let’s switch over and talk about sectors. Maybe we can start with the most overvalued parts of the market. What’s looking frothy and what has to go right for these stocks to justify the price that’s being asked?

Sekera: I’m following this huge rally that we’ve had thus far this year and the technology sector that’s now the sector that is most overvalued in our view, trading about a 7% to 10% premium to our fair valuations. And it’s interesting, this is the first time that tech actually has now been in overvalued territory since the beginning of 2022. And to some degree, I think a lot of the valuation right now, certainly what we’ve seen over the past couple of months, it’s a lot of excitement from investors regarding artificial intelligence and how that may end up playing through the technology sector over the years ahead. When I think about artificial intelligence, I think it’s still very early innings as far as how that’s necessarily going to impact stock valuations. I know talking to our equity analyst team that we do think that artificial intelligence will certainly be a positive factor for companies like Microsoft and Alphabet and Amazon. But I also know that our equity analyst team hasn’t changed their fair values based on artificial intelligence just yet. I think what we’re looking at is that artificial intelligence will be additive to those company business models as opposed to necessarily being transformative. So, I think a lot of investors maybe are starting to price in a lot of excitement into those stocks without necessarily really having the fundamental change in the valuations that the market is currently pricing in.

Benz: Can you think of an instance like this in the past, say, within the past five years or so, where investors were extrapolating good recent performance and positive news flow well into the future beyond what was really reasonable for them to do?

Sekera: There’s a couple of different examples out there. Maybe none of them are really the exact same. But it is interesting that as I look through our valuations on a historical basis here, back at the beginning of 2018, the basic materials sector was the most overvalued sector, trading I believe at like a 25% to 30% premium over our fair values, something that you really don’t see happen very often. And then, when I started digging into that a little bit further, there were even companies that were trading at 2 times or 3 times over what we thought the company was worth. And in that case, what we found is that there were companies like steel companies and building material suppliers that for the past decade had just been making money hand over fist as they were supplying the build out of China, which of course at that point had been going on for at least the past decade. And I do think that’s an instance where investors were extrapolating those growth rates for too long going into the future and paying too much for those individual stocks.

Ptak: We’ve asked you about parts of the market that are looking particularly rich, and you cited a current example as well as one in the not-too-distant past. How about the flip side? What’s looking invitingly cheap right now when you scan across sectors and industries?

Sekera: Well, the sector that’s still most undervalued right now is the communications sector. And there’s still a lot of negative sentiment within communications in and of itself. It was the most undervalued sector coming into the year. And the thing you have to remember with communications is that both Alphabet and Meta are in the communications sector weightings. And of course, based on the size of both of those companies, the two of them together, I think about 55% of the market cap. So, anything that those two companies do certainly skew that overall sector return. Meta, I think, has more than doubled thus far this year. It’s gone from being a 5-star stock now to a 3-star stock. Alphabet is up pretty substantially as well. That’s one where we do still see some upside. It’s a 4-star-rated stock. But again, it’s certainly run a lot of the course thus far this year.

But within communications, we still find a lot of the traditional media companies, a lot of the traditional telecommunication companies are still very undervalued. Specifically, companies like AT&T and Verizon—companies where our analytical team is rating those 4 stars or 5 stars because we think that the market really is being very negative in the sentiment on those companies and not thinking through how the changes within that sector will play through. So, for example, I know that there’s been consolidation in the wireless telecommunications area. At this point, there’s really an oligopoly. It’s three main competitors between AT&T, Verizon, and T-Mobile. And so, I know our analytical team is expecting a much more rational competition in the future as far as pricing than what we’ve seen in the past, which should then reflect well in the margins for those companies going forward.

Benz: What’s your take on this idea of stocks needing a catalyst to outperform? Do you think there’s something to that notion or is it outmoded given the market’s ability to price in new information before investors can actually act on it?

Sekera: Well, when I think about catalysts, I usually think of that more in terms of trading than I do in investing. And I consider trading and investing to be two very different activities. And when we think about investing and intrinsic valuation, we do suspect that there are times where it can take up to three years for a stock to converge toward its intrinsic value. So, a catalyst can accelerate that process. But in our view, it’s that over time, the market will always end up converging toward what that true underlying value of a company will be.

Ptak: Small caps look cheaper than large caps, which I guess is not surprising considering the way stocks of larger firms have spanked those of smaller companies. Why have small caps slumped to this extent and what do you think will reverse that trend?

Sekera: To a large degree, I think small caps have been under pressure. The market really has been expecting the economy to weaken. Certainly, it was a greater chance probably at the beginning of the year that we were going to be heading into a recession. There were a lot of people that thought that if we did hit a recession that could be deep or prolonged and I think that would have a lot more impact on those small-cap stocks. However, the economy has been holding up better than expected. And so, we do think that small-cap stocks do have much better valuations as compared with the large-cap stocks as a group going forward.

Benz: Sticking with various cuts of the market, I wanted to ask about quality because it seems like quality, as we define it at least, doesn’t look cheap. You’d expect higher-quality names to fetch higher multiples, all things being equal, but is it unusual to see what we call wide-moat stocks trading as richly as they are today?

Sekera: Yeah. And when I think about quality, it goes again back to the concept of an economic moat. Does this company have specific attributes that that company will be able to generate those excess returns on invested capital? And if so, how long will those excess returns generate that cash before it gets competed away? And when I think about wide-moat stocks, it’s interesting that actually wide-moat stocks lag the market to the downside, actually sold off more last year, whereas typically I would expect high-quality companies to perform better to the downside, which is what we had seen historically. But a lot of the downside last year was in a lot of those technology mega-cap stocks, which had a much higher beta to the downside, and that actually provided investors an opportunity last year to pick up a lot of those individual stocks trading at very low valuations. But of course, those wide-moat stocks have rebounded. I know the Wide Moat Focus Index was up, I think, over 20% year to date, whereas the rest of the market, when I measured that, was only up about 13% or 14%. So, to some degree, that’s played itself out here in the first half of the year.

Ptak: That’s a good segue to the next question we wanted to ask, which is, whether you think it’s true that quality used to be associated with countercyclicality, that high-quality stocks were more defensive, and to the extent that’s changed, do you think that investors need to recalibrate their expectations about the risk and return profile of wide-moat stocks going forward?

Sekera: I don’t think so. I think it was unusual what we saw in 2022. We did see a lot of the different parts of the market sell off to levels that had gotten back to just really, really low valuations. In fact, the market itself, when it bottomed out in October of last year, had gotten to a price/fair value, where the last time we saw it that low was actually back in 2011. And if you remember, in 2011, we had two things that were going on. We had the debt ceiling crisis here in the U.S. Then we had the sovereign debt crisis and the banking crisis over in Europe. So, we do think that the market overall had sold off just way too much last fall compared with our valuations. And I think it was probably more of an outlier that we saw how much those wide-moat stocks, as that momentum was pushing the market down, actually fell more than the market. So, I think going forward, I would suspect that we’d probably get back more toward that historical norm, where those high-quality or wide-moat stocks would hold their value better to the downside, especially in a more normalized environment. Even if we do have a recession, we do expect, according to our economics team, that any recession would be relatively short and shallow.

Benz: Sticking with that, I wanted to ask you about macroeconomic questions. Do you think that the typical long-term investor should even factor in things like will there be a recession when they’re making their investment decisions?

Sekera: I do, but I think it’s to a much lower degree than I think what the media portrays. And of course, the media is always trying to get people excited about what’s going on in the markets and always really trying to hype up whatever the current events are. But really, when I’m thinking about macroeconomics and investing, I’m really watching more the trends than I am watching any one individual economic release. And so, I think it’s really more an indicator for the longer-term trends for the individual stocks and thinking about how much these stocks and these companies will be able to make over the long term in different types of macroeconomic environments. So, for example, I know that we do think that here in the short term, the economic growth rate in the U.S. will slow over the next couple of quarters. That growth rate will really bottom out probably at the beginning of next year and then reaccelerate to the upside. But I know our own view is that the U.S. economy, as it rebounds, our view of that economic rebound is much higher than the consensus view. And so, I think that is part of the reason why we do think that stocks do remain undervalued is because we do expect to have pretty good economic tailwinds two, three, four years out from today.

Ptak: What are the macro indicators you pay the most attention to and of those which might directly inform an investment decision you’d make? And I’d qualify that question to note that you said it’s the trend you pay more attention to than it is maybe an individual data point, but all the same, there’s probably some that you pay a little bit more attention to than others—which are those and which might inform an investment decision?

Sekera: Well, first and foremost, I would have to mention I do keep pretty close contact with Preston Caldwell. He is the head of our U.S. economics team. And for those that are interested in our view in economics, he does put out his economic pulse and puts out regular updates on the economy and his views. So, I would highly suggest reading through his publications there.

But as far as watching the macroeconomic environment, my own personal focus is going to be on the leading economic indicators published by The Conference Board. To me, that provides a much more holistic view of the economy and the trend in the economy than necessarily trying to watch any one individual metric. I’ll leave that up to Preston.

Benz: So, how about inflation? Because inflation seems to be gradually tapering off, but the yield on the 10-year Treasury bond has risen. Why is that happening?

Sekera: Well, again, it gets to the point where I think investors do need to separate what’s happening in the short term versus a longer-term view and longer-term projections. So, inflation isn’t moderating nearly as fast as I think the market would prefer. So, to some degree, we may have some people that are pricing in a higher probability that inflation may be elevated for longer. I also think that short-term interest rates are high enough now that they’re attracting more investors to the shorter end of the curve and maybe away from the longer end of the curve. As you’re getting these higher rates here in the short term, you take on much less duration risk than you do in the longer end of the curve.

And then, we also just have the supply/demand dynamics. The Fed is still in its quantitative easing mode. So, they’re letting bonds roll off—they’ll have to be refinanced in the marketplace. So, we’re seeing additional supply there. But when we’re thinking about the 10-year and where the yield will be going forward, we do think that this 4% area that we’re in right now, if that’s not the peak, we expect that that’s probably pretty close to the peak and that over the next couple of years, we do look for the 10-year Treasury yield to be coming back down.

Ptak: If we do have a recession, it seems like it will have been the most predicted recession in history, as it seems like people have been expecting that outcome for a while. Is that typical? And if not, is there a reason to question whether a recession is the surest thing some forecasters seem to think it is?

Sekera: Our own base-case scenario right now is no recession and that hasn’t changed even since the beginning of the year. We do expect that the probability of a recession remains higher than what that probability has been in the past. I think Preston right now is looking for potentially a 30% probability of a recession. But having said that, if there were to be a recession, our view is that any recession would be relatively short and shallow.

Benz: Bonds took a beating last year. They’re up a little bit this year, but down after inflation. So, what does history suggest will be the tipping point where higher bond yields more than compensate for capital losses from rising interest rates?

Sekera: Right now, I would look for when bond yields provide investors with a positive real rate of return over inflation, and that combined with inflation being on a downward trajectory is really that tipping point, I think, that you’re looking for. And generally, I think we’re either at or getting pretty close to that there right now. Inflation does continue to keep moderating. In fact, our U.S. economics team is looking for inflation to drop to a 2% year-over-year run rate by the end of this year and to average slightly below 2% next year and thereafter. So, I do think that with the 10-year at 4%, I do think that now is probably a pretty good time for investors to think about being able to extend the duration in the fixed-income market and be able to lock in some of these higher yields for now.

Ptak: Just to follow up on what you mentioned a moment ago—I think that you indicated that we’re expecting inflation to come down. Maybe you could just talk briefly about what it is you expect to drive inflation to those levels. A recession, as we expect, is disinflationary. So, I suppose that would be one variable that would explain it. But what else?

Sekera: I think a lot of it comes down to the factors that actually had caused a lot of the inflation in the first place. So, we had seen a lot of different bottlenecks, a lot of different supply disruptions, which had worked their way through the system, causing some supply issues and causing prices to rise. We see a lot of those working themselves out now. Energy prices at this point are certainly well off the highs that we saw, especially from when Russia first invaded Ukraine. And we also expect that energy prices will be on a longer-term downward trajectory. In fact, our team that covers the energy sector, their long-term forecast for oil is for $55 a barrel for West Texas Intermediate that’s currently, I think, around $70 right now. So, it’s a combination of those things that drove inflation higher in the past we think are behind us. And so, we don’t have those same kinds of dynamics going forward, as well as a lot of the demographic changes that Preston utilizes in his inflation model.

Benz: I wanted to ask about the yield curve, which remains inverted with shorter maturity bonds, sporting higher yields than longer bonds. That sort of inversion has been a good predictor of recessions in the past, but not this time, at least not so far. Why?

Sekera: Well, you have to remember, too, that the Fed only controls the short end of the curve. And that’s really an indicator of what they’re doing for monetary policy. And as they’ve been tightening the monetary policy, they’ve been raising the short-term rates and that has brought up the short-term yield. Whereas I do think that some investors are out there still thinking of a recession here in the near term. And I think a lot of those investors may have revised their portfolio allocations to reduce their equity exposure and move that money into bonds with the expectation that if we do enter a recession, stocks would fall during that recession and then they could move that money back into stocks. So, I know with our outlook of sequential growth slowing, we do expect that as that growth rate slows and then with inflation continuing to keep coming down, that a hike that we expect here in July will be the last hike for this monetary-tightening policy cycle. And at that point, the Fed will pause. And we do think that the combination of lower inflation as well as a slowing economy will actually give the Fed the room that it would need to then start easing monetary policy. I believe our projection is that they would actually start cutting interest rates in February of next year. And then, Preston does expect that the Fed then would be able to cut interest rates relatively quickly over the course of 2024. And as those interest rates are coming down, that actually then will provide a tailwind to the economy next year and keep us out of a recession.

Ptak: I wanted to spend a few minutes on credit and risk. High-yield spreads have narrowed pretty meaningfully over the past year. What does spreads tell us about risk appetite and also what does it tell us about the likelihood of a recession?

Sekera: The High Yield Index on a spread basis has done pretty well thus far this year. I think the Morningstar US High-Yield Index, the average credit spread started about 480 at the beginning of the year. Last I checked, we’re getting pretty close to 410 right now. And I think, the market was just pricing in a much higher probability of a recession at the beginning of the year, which, of course, in a recessionary environment would lead to an increase in both downgrades and defaults. Our base case was no recession. So, at the beginning of the year, we did think that corporate credit spreads were relatively attractive. But with the economy more resilient than expected and some of the economic metrics we’ve seen more recently still showing the economy slowing but not dipping into recession, I think investors, high-yield investors, are pricing in a lower probability of a recession, which means that you don’t need to get as much extra compensation over the underlying interest rate because you don’t have as many potential defaults or downgrades coming.

Benz: Money-losing firms got crushed, but they perked up a little bit lately. Is this a sign that conditions have improved, and credit and capital aren’t as tight as they’d become? Or do you think it’s that investors are anticipating that these money losers will turn profitable at some point?

Sekera: Well, it’s always hard to know when investors are anticipating those companies that are currently cash flow negative as to when they would turn profitable. But I do agree that the credit markets and the capital markets aren’t necessarily as tight as they’ve become. Talking to some of our colleagues over at PitchBook, they do note that there is still plenty of capital available in the private equity markets and in the venture capital markets that is looking to be put to work. But as with anything, I would try and caution investors not to necessarily try to read too much into the short-term dynamics here. When you look at those types of companies, they’re going to be very volatile as to slight changes in the outlook can result in pretty large price swings. And a lot of that could just even just be investor sentiment having an outsize effect. So, again, generally, I would expect that financing is available for those companies when it’s needed. But it’s probably going to be at much tighter terms and higher interest rates than they would have had before.

Benz: Relatedly, I think people came into this year, or at least some people came into this year, thinking that cash having such a high interest rate, offering such a high hurdle rate, that riskier assets would continue to struggle. That hasn’t really happened. So, what has that experience taught us?

Sekera: A couple of things, I think. So, one, valuations really are always going to end up determining market returns over a longer time period. And I do think that sometimes the markets act like a pendulum in the short term that you can see the market swing from being overvalued and then swing too far to the downside to being undervalued and going back and forth, both from a market perspective as well as an individual stock perspective. And in our view, the market had just gotten to be too far undervalued last fall. And even though there were still some negative sentiments for the economic outlook based on those valuations, I think that brought some investors back into the marketplace.

And then, thinking about cash and those high short-term rates, you also have to remember that we had those really low rates a couple of years ago with zero interest-rate policy. And you had some investors that moved out of the fixed-income area when fixed-income bonds were paying such rock-bottom yields, moving into the equity space, using equities almost as like fixed-income substitutes, especially areas like the consumer defensive and utilities that paid high dividend yields. So, I think a lot of those investors have already made those reallocations back to where they should have been, back into fixed income and out of stocks.

Ptak: I wanted to switch over and talk about real estate. Everyone seems to be talking about how they’re worried about commercial real estate, the office subsector in particular. It seems we share some of those concerns, but have they been more than priced in? And if so, does that present a buying opportunity in your opinion?

Sekera: It’s a yes and a no answer. So, I do agree that I think that the urban office space in particular could still see some downward valuation adjustments. But away from that space, we do see a lot of opportunities in commercial real estate and a number of the REITs that we cover we do think are pretty undervalued at this point. So, I would just recommend for investors in that real estate area, look for those areas where you see foot traffic either steady or returning. So, for example, a couple of the stocks that are invested in Class A shopping malls with the pandemic well behind us, we’ve seen foot traffic in those malls return back toward prepandemic levels. Plus, I think it’s also interesting in the real estate area where they’ve made changes to the actual real estate itself in order to bring in that foot traffic. So, like, the Class A shopping malls have made themselves much more experiential over the years and less reliant just purely upon the retailers. So, for example, you’ll see a lot more restaurants and physician offices, even gyms, things like that in order to bring the foot traffic back into the malls.

Some of the other areas that I would highlight would be the data centers. I just think that there’s still a long-term secular trend for more data and more storage needs. And I think artificial intelligence adoption actually could also bolster the case for the data centers. Areas like senior housing, again, you still have that long-term secular trend for an aging population. So, we see that supporting the senior housing market. And other areas, too, that never really sold off as much as some of these other areas but still do provide some good returns from dividend income and maybe like the medical office space.

Benz: I want to ask about residential, because Morningstar is expecting residential construction to pick up next year, thanks to lower mortgage rates and more affordable prices, but rates are still pretty high. So, what do we think brings mortgage rates down from here and what makes us confident it will be enough to induce reluctant sellers who have those low mortgage rates locked in to list their homes?

Sekera: So, we do forecast that interest rates will come back down next year. So, thinking in terms of the federal-funds rate, I know that we’re expecting that to decline from 5% right now. That will end up averaging about 4%, maybe a little bit over 4% in 2024 and then fall much further all the way down to a little bit over 2% in 2025. And of course, that would then bring down those buyers and the adjustable-rate mortgage area, since those are going to be tied to the short-term rates. And then, as far as long-term mortgages, we do forecast that the 10-year U.S. Treasury will decline to an average of 3.5% in 2024 and fall even further all the way down to 2.5% on average in 2025. So, our thesis is really that in the residential construction market, currently there isn’t enough existing homes to satisfy that new household formation. So, I think it’s a combination of those lower mortgage rates, improved affordability, as well as that demand from new household formation is going to spur the new construction over the next couple of years.

Ptak: Well, Dave, thanks so much for sharing your insights and perspectives with us today. We really appreciate it.

Sekera: Of course. Well, thank you, Jeff, and thank you, Christine.

Benz: Thanks so much.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)