Can the Stock Market Rally Continue?

Key Takeaways

• The Morningstar US Market Index is up about 8% so far this year. Can the market rally continue?
• The market isn’t as undervalued as it was at the end of 2022.
• Growth stocks have been outperforming value stocks this year. Dave Sekera discusses whether or not he expects the trend to continue and how investors should be positioning their portfolios in response.

Stocks Are Soaring. Can It Last?

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar chief US market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks for the week ahead. Dave, one thing on your radar this week is the market exuberance we’ve experienced so far in 2023. The Morningstar US Market Index is up about 8% so far this year as of this morning. Do you think the market rally can continue?

Dave Sekera: Good morning, Susan. We certainly have had just what I would consider to be just extraordinarily strong performance thus far this year. And I think investors need to break it down and think about what those factors are that have led to this rally and really consider that to think about where things may be going forward from here.

First, in January, we did get past the tax-loss selling season in December, that certainly was an overhang and put pressure on the markets at the end of last year. Second, there is just typical seasonal strength that we see here in January, so I think that’s part of it as well. And over the past couple of weeks, we’ve seen fourth-quarter earnings now coming out, and they’re certainly not as bad as I think a lot of investors feared. Now, lastly, I would also say that the last couple percent we’ve seen here to the upside was most recently the Fed came out, and it does appear that they’re now pivoting their actions, and I think that they’re pivoting more toward balancing their actions toward their dual mandate, whereas before they really were just singularly focused on inflation.

Now, however, we do think the market is undervalued, even after this rally, but I do think the easy gains at this point are probably behind us, and we may be in for a tough slog ahead for the next couple of months. And my concern is I think the market might be getting a little bit ahead of itself here in the short term. Thinking through the next few months, in fact, our economic team is projecting that U.S. GDP will contract in both the first and the second quarter this year before it starts to expand, so I think that could bring some downward volatility in the short term, really as we see the market focus away from those fourth-quarter earnings and then start shifting its focus toward the weakening economy and the resulting pressure that we’ll see on earnings the next couple of quarters.

Dziubinski: Let’s move on, and somewhat related to one new piece of research from Morningstar, and we’re going to talk a little bit about the monthly deep dive you do into current market trends and valuation, that published actually last week on Morningstar.com. You mentioned in your report that the market isn’t as undervalued as it was at the end of 2022, but we still think it’s undervalued today, right?

Sekera: Well, that’s correct. Based on a composite of about 700 stocks that we cover that trade on U.S. exchanges, I’ll compare where those are trading versus the intrinsic values as assigned by our analysts. Coming into the year, the market was actually about 16% undervalued, but following the rally that we’ve had thus far, the market’s now at about probably 8% to 9% discount to that composite.

The Most Undervalued Sectors

Dziubinski: Let’s talk a little bit about some sectors that look the most undervalued today.

Sekera: Sure. There has been just a wide dispersion in the performance in the 11 different sectors that we cover. And I think a lot of the ones that were really the most undervalued coming into this year, that we highlighted, have actually been some of the best performing thus far this year. When I look at the three sectors that performed the best, for example, communication started out this year at a 43% discount to that composite of our fair values, it’s now only trading at a 30% discount. So less of a discount, still, in my mind, very undervalued. The consumer cyclical sector, again, one of the worst hard-hit sectors last year, traded at a 30% discount coming into the year, it’s now at a 15% discount. And lastly, looking at the tech sector, again, hard-hit last year, was trading at a 20% discount to our fair values, and now only at a 10% discount.

Growth Stocks Take the Lead in 2023

Dziubinski: Dave, growth stocks have been outperforming value stocks this year. Do you expect that trend to continue, and how should investors be positioning their portfolios in response?

Sekera: Growth certainly has been outperforming value thus far this year. But as a long-term investor, I’m really more concerned about valuations than I am looking at the short-term momentum of one category versus the other. At the end of January when we did our valuations, we noted that both growth and value were trading at about a 15% discount to fair value as opposed to those core stocks or the core category, which is trading pretty close to fair value. And that’s why we still think a barbell-shaped portfolio makes a lot of sense for most investors.

And what I mean by that barbell portfolio is to be overweight both the value and the growth category and then underweight the core category. And I think investors will be pretty well positioned with that kind of exposure at this point. And part of the reason I also like having exposure to both the value and the growth is that each one will outperform based on different dynamics over the shorter term. And then that way, if we do see one category rally more than the other, it provides investors that opportunity to rebalance into those categories that are lagging those that outperformed.

Stocks for a Growth/Value Barbell Strategy

Dziubinski: For your stock picks this week, let’s talk about a few stocks that fit with your growth-value barbell strategy, and let’s start with the growth side of the barbell and with CrowdStrike CRWD.

Sekera: Sure. CrowdStrike is currently rated 4 stars, and we do rate the company with a narrow economic moat, and it’s trading at about a 30% discount to our fair value. And the cybersecurity area, that’s an area that we do see long-term secular growth, and I think it has a lot of really attractive industry dynamics. So again, with everything going on in the world today, corporations do need to protect themselves. Whether it’s geopolitical events, ransomware, hacking, other types of cyber crime, we think that it’s important for companies to make sure they stay at the forefront of cybersecurity today. And I’d note when you look at IT budgets, cybersecurity spending itself is actually a relatively low percent of that budget, but the cost of succumbing to some sort of cyber event has huge monetary and reputational costs. So again, from a managerial point of view, it certainly makes sense to make sure that that’s not an area that you cut back spending.

Dziubinski: Your second growth stock pick this week is Salesforce CRM. What do you like here?

Sekera: Salesforce is also a 4-star-rated stock, and we rate that company with a wide economic moat. And it trades at about, I think, maybe just slightly over 20% discount to our fair value. And I’d note this is one stock in the technology sector that our analyst who covers Salesforce thinks represents one of the best long-term growth stories in the software space today. And he expects that firm can generate compound annual growth of over 20% annually for the next couple of years.

Dziubinski: And then your last pick for the growth side of that barbell is Tyler Technologies TYL.

Sekera: Tyler Technologies is currently rated 5 stars, and that’s a company we rate with a wide economic moat. And it’s trading, I think, a little over a 30% discount to our fair value today. And this is a name that I think is interesting that a lot of investors may not necessarily have heard of Tyler Technologies, but they provide software solutions and different types of services for local government entities. It is a growth name, but I do think the stock does have also some more defensive attributes, as even in a recession, government entities will rely on those software products and typically will not see the same kind of pullbacks in spending that we might see in the private sector.

Dziubinski: Let’s move over now to the value side of the barbell and some of your picks there. Start out with Citigroup C.

Sekera: Sure. Citigroup’s currently rated 5 stars. It also trades at a little over a 30% discount to our fair value. Now, typically we do try and highlight those companies that do have an economic moat, but in this case, I do think there is enough margin of safety to warrant an investment today. So while we’re not looking for a lot of earnings growth out of Citi, that stock does trade at about a 40% discount to its tangible book value, whereas most of its competitors trade at a premium. So, in this case, I think you can actually set there a clip, that 4% dividend yield, and you’re essentially looking for that stock then to accrete up over time toward that tangible book value.

Dziubinski: Your second value stock pick this week is Carnival CCL. Delve into that one for us.

Sekera: Sure. And this one I think is similar to Citigroup in that it’s rated 5 stars but does not have an economic moat. But in this case, it trades a little over half of our fair value today. And this is one that I do think is leveraged to that shift in consumer normalization that we expect for consumers to go back to prepandemic behavior. And as we see that shift back into services and away from goods, I think the travel sector is going to benefit from that.

Dziubinski: And then your last pick for the value side of the barbell is Hasbro HAS.

Sekera: Sure. So again, another 5-star-rated stock, a company with a narrow economic moat, trades a little over half of our fair value. And I think what’s most interesting about Hasbro is they actually recently announced, or pre-announced, weaker-than-expected results for the holiday season. But the stock actually traded upward after that. And I think that’s indicative that the market had already incorporated weak holiday sales into their expectations and market price. So, looking forward for this company, we do note the company’s undergoing some pretty significant cost-saving measures. And in our forecast, we also think that company is going to undergo what we call a mix shift. And so we’ll see their sales shifting more into their digital and gaming products, which are higher margins. And so the combination of the cost savings and the higher-margin-sales products, now that should bolster their operating margins over the next few years.

Dziubinski: Well, thanks for your time this morning, Dave. Be sure to join Dave and I on YouTube every Monday morning. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.

Watch “3 Recession Stocks to Consider″ with Susan Dziubinski and Dave Sekera.