- We do think the markets are still undervalued. We would caution investors to expect a lot more volatility in the months to come.
- Growth and value are the categories that are the most undervalued. Core or blend stocks are still undervalued but not nearly as much.
- We think there are a lot of good secular tailwinds within med tech and see a lot of undervalued opportunities there.
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. U.S. stocks hit new lows for the year during the third quarter. Stocks are down about 25% so far in 2022. Here today to discuss the headwinds in today's market and how investors might fine-tune their stock holdings in the fourth quarter is Morningstar's chief U.S. market strategist Dave Sekera.
Dave, let's talk a little bit briefly about the third quarter. In July and August, stocks rebounded from their lows in June, but then they tanked again in September. Talk a little bit about some of those headwinds that are facing stocks today.
Dave Sekera: Sure. Well, as you mentioned, the first half of the year the markets were just generally on a downward trend, really sold off in June and got to some pretty low valuations, in our view. Now, what really happened is those four headwinds we've been talking about since the beginning of the year really converged in June, and that's what we think pushed the market down to really kind of very low valuation levels, especially on a historical basis.
Now, in July and August, looking at some of the inflationary metrics and some of the economic metrics, we thought that some of those headwinds were starting to abate. So, between those headwinds looking like they're starting to abate and some pretty low valuation levels, we saw the market recover in July and August. Now, unfortunately, in September, it appears those headwinds really started coming back again, and as they came back, then we saw the markets sell off pretty strong going all the way into the end of September.
Now, at the end of September, the markets really looked like they did get oversold a little bit going into the end of the quarter and the end of the month. So, it's interesting. We've seen a really strong rally the past two days, the first two trading days here in October. So, it's interesting to see how much the market is coming back off of some of those lows. Now, we do think the markets are undervalued still. And I would just caution investors, though. I also expect to see a lot more volatility still in the months to come. So, those four headwinds are still out there. We're still looking to see when those inflationary headwinds are going to start coming down, when we see kind of more of a sustainable longer-term uptrend for the economy. And then, I'm also just watching the U.S. dollar, that's certainly been a headwind here for earnings as well. So, once those are playing out over the next couple of months, depending on how those metrics come out, I do think we can see some of these days where you can certainly expect the markets to move anywhere up or down 1% or 2% or even more based on when those metrics are released.
Dziubinski: Despite what will very likely be ongoing volatility in the market, you noted in your latest quarterly report that really there have been few other times where stocks have looked this undervalued, according to Morningstar's metrics. Let's talk a little bit about that in a broad sense. How does the market look from a valuation standpoint as we're here in the beginning of the fourth quarter?
Sekera: Sure. Well, as I mentioned, we think stocks right now are trading at about a 20% discount to a composite of our fair values. Now, we do look at the market differently than I think what you're going to hear from a lot of other market forecasters. So, again, a lot of other forecasters, they take that top-down approach. They have some sort of model that they're going to use to estimate earnings for a broad market index, and then they apply a forward multiple to that to come up with their one-year forward target for the market. We do the exact opposite. So, we cover about 700 stocks that trade here in the U.S. And so, we take a composite of where those stocks are trading in the marketplace today and compare that to that bottom-up intrinsic valuation conducted by our analyst team and compare it to that composite as well. So, that's how we come up with that price-to-fair value metric, which right now is showing stocks are pretty much as cheap as they've been going back through 2010, as you mentioned, only a couple of other instances, like the beginning of the pandemic or maybe going back toward the European sovereign debt crisis in 2011, have we seen valuations get this low.
Dziubinski: Let's do a deep dive and sort of peel back the onion on valuations in the market. First, let's talk about valuations across different market capitalizations and investment styles. Are there particular market caps or styles that look cheaper than others today?
Sekera: Sure. So, we do break our valuations down into the Morningstar Style Box. And when we look at it by category, I would note that the growth category and the value category are both the ones that are the most undervalued today, whereas core or blend stocks, they're still undervalued but not nearly as much and closer to fair value than those two. So, I think, from a relative value position, investors might be best-positioned today with what I call a barbell portfolio. So, again, being overweight value stocks, overweight growth stocks and then underweight core stocks. From a market capitalization perspective, I would note that both the large cap and mid-cap are trading at about the same discount to valuations today. So, I really wouldn't necessarily think too much about overweighting or underweighting one or the other of those. But I do note that small-cap stocks are the ones that we think are really trading at the biggest discount from a market-cap perspective.
Dziubinski: Let's pivot over and talk a little bit about sectors now. Interestingly, despite rising interest rates and still pretty high inflation, utilities have continued to outperform this year and are really the only sector we cover that we would consider technically to be overvalued. A lot of those defensive sectors like healthcare and consumer defensive are also kind of close to fair value. Talk a little bit about valuations across different sectors today.
Sekera: Well, as you mentioned, utilities is trading at a slight premium to our fair value estimates today. So, that would be one sector that I'd be more cautious in investing in today. It's not terribly overvalued, but it's probably played out, again as you mentioned, it's a defensive sector. I think that's probably what's helped it outperform this year. And those other defensive sectors have also held up relatively well compared to more of the cyclical sectors. It's really those cyclical sectors where we see some of the best valuations today. And so, for investors who are looking at getting involved there, you can certainly take a more broad market or broad sector exposure there. But for investors who are looking for individual stock picks in some of those sectors, I'd really recommend right now making sure that you're sticking with those stocks that are going to be much more levered to longer-term secular themes within those sectors. So, for example, we've talked about the basic-materials sector before because of the long-term structural shift to electric vehicles, we think that lithium is going to be undersupplied for the next decade, so a lot of the lithium producers we think are undervalued. On the consumer cyclical space, again, we expect to see a big shift in spending away from goods and into services as consumer behavior normalizes. So, again, I'd look for those stocks that are going to be levered toward that shift in spending within that sector.
Dziubinski: And then, lastly, let's talk a little bit about economic moats, which we use as sort of a measure or a benchmark of a company's quality. Are we seeing that wide-moat stocks are more undervalued today than narrow- or no-moat stocks? What's that look like?
Sekera: So, those wide-economic-moat stocks, those are going to be the companies that we think are very high-quality. Those are the companies that have those long-term durable competitive advantages that are going to help that company over a very long time period be able to outearn its cost of capital. So, as you mentioned, there's really two things going on in the marketplace this year. The wide moat stocks have sold off. And, in fact, depending on which wide moat stocks you're looking at, they've sold off as much, or sometimes even more than the broad market. So, they're actually trading as a group, like, in line on the valuation basis with those no-moat companies, which you wouldn't necessarily suspect would happen. So, from a fundamental point of view, I think what's going on in that sector today is that you're seeing the marketplace kind of undervalue those long-term prospects of the company. So, I think too much of the marketplace right now is probably focused on short-term earnings growth, really thinking about the third quarter and going into the fourth quarter of this year and really, taking multiples down on those stocks, in our view, probably unfairly.
The other thing that's going on is from a technical perspective, those stocks are probably getting hit a little bit harder. I think, right now, a lot of portfolio managers, especially those that have had a lot of redemptions in their funds, they're out there trying to sell stocks in order to raise cash to meet those redemptions. Well, what happens is, those high-quality stocks are going to have a deeper liquidity pool to be able to sell into. So, I think, portfolio managers have to some degree gotten to the point where they started selling, especially here in September, what they could as opposed to necessarily what they would have preferred to.
Dziubinski: That's interesting. Dave, given that we're seeing stock market valuations very near if not at the bottom that we've seen historically from a discount perspective, is it time to back up the truck on stocks?
Sekera: Well, it's certainly tempting to, I'm sure. But I think that really is going to depend on an individual investor's risk appetite. So, again, I do think now is certainly a great time for investors to be judiciously adding to the risk exposure, adding to their equity exposure within their portfolios. Personally, I like to layer into positions more. So, again, when the market is trading down, I like to be able to buy into it as the market is going down. Certainly, takes a lot of intestinal fortitude to be able to buy when the market is going down. But then, conversely, when you do see the market take some good up days in a row, that might be a better time to then take some of those gains off the table. Again, I do expect over the foreseeable future, we're going to see a lot of market volatility, at least over the next several months.
Wondering What to Invest in Right Now?
Dziubinski: Dave, for those investors who may want to judiciously add to their stock weightings as you say, what are some ideas that Morningstar has today? What are some stocks we like?
Sekera: Well, as we talked a little bit about earlier, in a volatile environment like this, I really do like sticking with those stocks that you really are confident in that are leveraged to those long-term secular themes, and I think that helps give investors the confidence to stick with those investments through the ups and downs of the marketplace.
So, one that I've actually been recently doing some more research and working with our analyst team is in the med tech space. We think there are certainly a lot of good secular tailwinds within med tech, but we see a lot of undervalued opportunities there today. So, while healthcare overall is one of those sectors that's much closer to fair value than some of the cyclical sectors, I think within that med tech space, we certainly see a couple of undervalued stocks. For example, the first would be Zimmer Biomet ZBH. So, that is a 5-star-rated stock, trades at a 36% discount to our fair value. One of the things that's going on there is, during the pandemic, you had a lot of patients that had been putting off procedures, different type of large-joint replacements over the past couple of years. So, I know our analytical team has taken a look at the backlog for the company. They estimate that backlog, based on those kinds of delayed procedures plus just kind of the natural growth in that sector, is up to two years. So, again, that would be one stock I like in that space.
The next one is going to be a little bit of a riskier situation, but I think it does have some really good strong longer-term catalysts, and that's Illumina ILMN. So, Illumina is rated 4 stars right now, trades at a 35% discount to our fair value. This is one I would recommend. Though I do think that investors [should] go ahead and dig into the company to some pretty good degree, make sure you understand some of these catalysts. But this is one of those stocks that we've identified that we do think could have exponential growth possibilities in the future. So, specifically, they do have a product in the liquid biopsy space that we expect to come to market over the next couple of years. It can screen for, I think, up to 50 different types of cancers and that really could be a game changer in cancer screening.
And then, lastly, in the healthcare space on a totally different track would be Zoetis ZTS. So, Zoetis is actually, in our view, the leader of innovative pet therapeutics. That stock is a 4-star-rated stock, trading at a 20% discount to our fair value. And when our analytical team has looked specifically at that space in pet care, they're really seeing that over time that a lot of pet owners have really been shifting their attitudes on how much they're going to be willing to spend on their pets and their pet healthcare. So, that's an area where we do see long-term secular growth.
Dziubinski: Well, Dave, thank you for your time today, for your perspective, for your stock ideas, and we'll do it again at the end of the fourth quarter. Nice to see you.
Sekera: All right. Well, thank you, Susan.
Dave Sekera discusses how a strengthening dollar could affect some companies' earnings in "What a Strong U.S. Dollar Means for Investors."