4 Stock Sectors to Skip

Key Takeaways

• Morningstar considers the healthcare, consumer defensive, and utilities sectors fairly valued.
• We think utilities would be most negatively impacted going forward if inflation sticks around.
• The energy sector started the year undervalued. Most producers are either fairly valued or becoming overvalued.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. As we head into the third quarter, the stock market looks about 17% undervalued according to Morningstar's metrics, and nearly two thirds of the stocks our analysts cover in the U.S. are undervalued. Still, there are sectors that look less appealing to us today from a valuation perspective. Here to delve into the numbers is Dave Sekera. Dave is Morningstar's chief U.S. market strategist.

Defensive Stock Sector Overview

Dziubinski: Dave, let's dig right in. In your quarterly outlook, you mentioned that most of the sectors that investors would consider defensive, which are healthcare, consumer defensive, and utilities, are about fairly valued, which kind of makes sense considering what's been going on in the economy and all the uncertainty. So, let's look at these sectors one by one, starting with healthcare. Talk about how that sector has performed this year, what do our valuations look like there, and why.

Healthcare Sector Stocks--Fairly Valued

David Sekera: Sure. So, the healthcare space, we've definitely seen a bit of a flight to safety as people were looking for those defensive stocks, again, those types of companies where their earnings aren't going to be affected nearly as much by changes in the economy, and of course, healthcare being one of those industries that if people need healthcare, they've got issues, they're going to prioritize that, and of course, they're going to end up taking those services on. So, we saw healthcare, I think, year to date it's dropped about 11%, so certainly, about half of what I think the rest of the market has dropped at this point in time. But we think that the market is pretty fully valued here. It's trading pretty much right on top of that aggregated fair value of all the healthcare stocks that we cover.

Consumer Defensive Sector Stocks' Valuation

Dziubinski: Dave, let's talk a little bit about consumer defensive stocks, which they have also significantly outperformed this year, talk a little bit about why they've outperformed and what their valuations look like.

Sekera: Of course. So, consumer defensive, as you mentioned, did outperform, although I'd say, outperformed to the downside in that, the index still has dropped 7% this year. But again, the consumer defensive area when you think about the types of stocks that are in there are going to be somewhat recession-proof. We've got food and beverage, consumer packaged goods, supermarkets, again, those staples that people are going to need on a day-to-day basis. So, when we look at our valuations there, those stocks have generally held up pretty well, and we're really looking at it trading right on top of our fair values at this point in time.

Inflation's Impact on Utilities Sector Stocks

Dziubinski: Dave, let's talk a little bit about the last defensive sector, which are utilities. Now, they retreated a bit in the second quarter after kind of coming out strong in the first quarter. So, what happened there?

Sekera: As you mentioned, in the first quarter utilities actually had a positive return, even though the rest of the market was down. Again, a bit of a flight to safety, people looking for those steady-income-earning type of companies. Now, the utilities sector is the one that we think is probably going to be most negatively impacted by inflation. So, again, when you think about utilities, they are price takers, they do not have any pricing power. They're only able to increase pricing when their regulators allow them to do so. So, in the second quarter, as inflation continued to run hotter and longer than what people expected, I think what you saw was some rotation out of that sector. And then, secondly, you also have to remember interest rates were going up in the second quarter as well. A lot of times people use utilities as a fixed-income substitute. So, once we started seeing higher interest rates, both in the sovereign-bond markets, the corporate-bond markets, I would suspect that there were probably investors that were selling out of some of those utilities stocks and putting those to work then in the fixed-income space.

Dziubinski: And then, despite the pullback, we still think utilities are about fairly valued now, right?

Sekera: They are fairly valued, although I'd say, they are probably a little bit on the high side, maybe 4% to 5% above our fair values. So, again, not getting to be so high that I would say you necessarily need to be selling the utilities, but probably a good underweight at this point in time in your portfolio. And again, if you are concerned about inflation lasting longer, our base case here is that we do think inflation will start to moderate in the second half of the year. But again, that would be the sector that would be most negatively impacted going forward if inflation is going to be sticking around.

Skip the Energy Sector Stocks

Dziubinski: Dave, the last sector we're going to talk about investors perhaps skipping today is the energy sector, which is by no means defensive in nature, but it has had quite a strong year and those stocks are about fairly valued, right?

Sekera: They are at this point. It's interesting. It was actually one of the sectors that was--I think it was the most undervalued sector coming into the year. But considering how much oil prices have risen, investors really ended up following those oil prices up and bid those stock prices up. So, right now, it's trading pretty close to our fair value estimate. There are still some opportunities there may be in the services sectors and the pipelines. But most of the producers at this point are either fairly valued or starting to get to be a little overvalued. So, I think it's probably a good market-weight position within your portfolio, because there is certainly going to be a lot of volatility, and I think it's a good sector that if you were to start seeing that move back up again, that's when you can take some profits, pare some gains on that one, reinvest that into some of the other undervalued sectors. And conversely, if you see a big pullback in energy, that would actually be a good time to start moving back into it on a more meaningful basis in your portfolio.

Dziubinski: Well, Dave, thanks for your time today and your perspective on these sectors. We appreciate it.

Sekera: Thank you, Susan.

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

For more of Dave Sekera’s market insights, watch 9 Cheap Defensive Stocks and Where to Invest Your Money in Q3 2022.