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Morningstar's Outlook for the Fourth Quarter

And a recap of the past quarter.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The stock market was essentially flat during the third quarter, rattled by a resurgence in COVID-19 cases, market valuations, and an acknowledgement that the Federal Reserve will begin to taper its asset purchase program. So, what can investors expect for the remainder of the year? Joining me today to share some insights is Dave Sekera. Dave is Morningstar's chief U.S. market strategist.

So, Dave, how do stocks look heading into the fourth quarter? Are we seeing more opportunities or fewer opportunities than we were a quarter ago?

David Sekera: Susan, we actually are seeing more opportunities for investors today. We do see more 4- and 5-star-rated stocks that we think are undervalued and are certainly good opportunities for investors to be able to put money to work. Now, it's interesting, as you mentioned, for the third quarter, the stock market overall was relatively flat. And actually, if you look at our price to fair value for those stocks that we cover, that composite that we put together, we still see the stock market overall being at the high end of our fair value range. So, right now, we think the market is about 4% overvalued, which is actually the same area that it was at the end of last quarter. However, based on that market action that we saw over the course of the summer, those stocks that we thought were overvalued--a lot of those growth stocks, for example--actually became more overvalued as people returned to their 2020 pandemic playbook, whereas those stocks that we thought were undervalued--such as value stocks--became more undervalued over the course of the summer. That's what led us to this point now that we do see more 4 and 5-star stocks.

Dziubinski: Let's talk first a little bit about sectors. Which sectors look most overvalued as we're heading into the fourth quarter?

Sekera: Well, the two that I'd probably point to the most right now would be the healthcare sector and the real estate sector. Now, of course, just because the sector itself is overvalued from a broad sector perspective, it doesn't mean that there still aren't individual stocks within those sectors that we think are undervalued. So, for example, in the real estate sector, two stocks that I would highlight right now would be Macerich (MAC), which specializes in retail malls, and there's a new one now that is dropped down into--well, actually, rose up to 4-star category depending on how you look at it, but Americold (COLD), which I think is interesting. It specializes in cold distribution.

Dziubinski: Let's talk a little bit about the opposite then. Which sectors look undervalued to us today?

Sekera: Well, first and foremost, is still the energy sector, and that's been the sector for several quarters now we've seen as being the most undervalued. So, from a broad sector perspective, we think it's about 15% undervalued and that's across all the different categories, all the different capitalizations. Whether investors are looking to participate in the energy sector and individual stocks, which of course, I'd certainly would recommend, or ETFs or mutual funds, I do think that's a really good area that investors should be thinking about overweighting in their portfolios today.

Dziubinski: And earlier in our conversation you alluded to growth and value. Let's do a little bit of a deep dive there. How do growth stocks look these days compared to value stocks?

Sekera: In our view, the growth stocks have gotten a little bit pricey at this point. They're definitely in the overvalued category and a little bit more overvalued than where we saw them at the end of last quarter. Now, having said that, based on that market action where the large caps and the mid-caps actually outperformed this past quarter compared to small caps, which we actually saw some sell-off among a number of the different small-cap names, we actually see the small-cap category within growth overall as being undervalued. So, for investors that are interested in being in the growth space now, I'd certainly focus that as being an area to overweight in the growth category overall. Now, the value category--we think all of value right now is undervalued. Having said that, the mid-cap and the small-cap areas are certainly the most undervalued within the value category.

Dziubinski: Now let's talk a little bit about quality and high-quality stocks. We would define those at Morningstar as stocks that have carved out wide economic moats. So, are these wide-moat stocks outperforming, underperforming? Are they undervalued, overvalued? What do they look like today?

Sekera: So, our Wide Moat Focus Index actually did underperform slightly over the course of the summer. However, year-to-date, it's still handily beating the overall broad market index. We do still recommend investors to focus on companies that do have wide economic moats. And when I break down our valuations, we find that wide-moat stocks are slightly undervalued, not necessarily undervalued enough to really be making a big call there. But when you look at it relative to where we rate no-moat stocks and narrow-moat stocks, it's a much better place to be on a relative value basis. And again, there's a lot of other reasons we think moaty stocks are a good place to be. So, again, while our base case is that we expect inflation will subside next year, if we're wrong, I think wide-moat stocks oftentimes have the pricing power that would be needed for them to be able to pass through their own cost increases to their clients and then be able to maintain margins.

Dziubinski: And then, let's sum up, Dave. If investors are thinking about making some tweaks to their portfolios at the fringes right now, what in general might they be considering? Where are we seeing the value?

Sekera: Of course, that's always going to depend on individual investors' risk tolerance and their own portfolio and where they are in the investing cycle. Having said that, I would certainly focus on and be willing to recommend overweighting the value category, especially in those mid-cap and those small-cap stocks that we think are undervalued. And I think you should still have exposure to the growth space. But again, based on our numbers, we think that the small cap within growth is a better place to be.

Dziubinski: Dave, thank you so much for your time today for both the recap of the last quarter and a look forward to what might be ahead. We appreciate your time.

Sekera: Thank you, Susan. It's always a pleasure speaking with you.

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

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.