What to Expect From Stocks in 2023

Key Takeaways

• Are earnings going to be one of those catalysts that’s going to drive market volatility in the short term?
• A look ahead to some of the tech names that have recently reported earnings, including Microsoft, Intel, and Texas Instruments.
• When we look at economic growth, we do think the economy’s going to be relatively stagnant, and even potentially recessionary, in the first half of 2023.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar chief U.S. 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 or pans for the week ahead.

Dave, let’s start out with talking about earning season, which is on your radar this week. It’s started, earning season, and what are you looking for when it comes to fourth-quarter earnings? And what impact do you think earnings will have on the market? I suppose more volatility.

Sekera: It looks like futures are in the green this morning, so slightly in positive territory. But I do think the earnings are going to be one of those catalysts that we’ve highlighted that’s going to drive volatility here in the short term. Now, earnings for the fourth quarter, I don’t think they’re necessarily going to be all that bad. Generally speaking, the economy has held up here in the fourth quarter of last year, but although there may have been a bit of a slowdown in the quarter. And as far as the economic run rate, I’m looking at the Atlanta Fed GDP number, so they do have their GDP now. That’s running at a 3.5% growth rate.

Really, more importantly than earnings is going to be any guidance that management gives to us both for the first quarter and for those companies that also give annual guidance for all of 2023. So I know the analytical team and myself, what we’re really listening for is how much a soft economy in the first half of the year may impact that specific company, and then also, whether or not that impact could be enough for them to change their outlook and cut their guidance for this year. And then we’re listening for any changes or catalysts in the underlying fundamentals of the company and the sector, and how those companies are positioned against those catalysts.

Dziubinski: Dave, talk a little bit about what role quarterly earnings play in how Morningstar values stocks. If a company misses that expectation, is that really a big deal?

Sekera: Well, like anything else, it always is going to largely depend on why exactly they miss those earnings. When we think about it, as a long-term investor, we use a discounted cash flow model in order to determine what we think a company is worth, what its intrinsic value is, and that’s based on how much cash flow that company can potentially generate over its lifetime, and then we discount that series of cash flows to the weighted average cost of capital, and that tells us what the intrinsic value is worth here today.

As such, when I think about it, those short-term fluctuations in the business and earnings may not necessarily impact our valuations all that much. Sometimes a beat or a miss might change our valuation plus or minus 5%. But those larger changes in the intrinsic value when we’re looking at double-digit percent changes, that’s really when something fundamentally different has happened. Something that’s changed our view on the underlying sector or the company that could cause us then to change our longer term assumptions, revenue growth trends or earning margins, and things like that. Those really are the catalysts that are going to cause us to change our fair values into those double-digit percentages, which are really the big moves in the marketplace.

Dziubinski: Dave, let’s look ahead a little bit to some of the tech names that we have reporting this week. It’s a decent size week for tech. First up is Microsoft. What are you expecting to hear here or what are you listening for here?

Sekera: Sure. So, Microsoft, it’s currently rated 4 stars, and we do rate the company with a wide economic moat, and it trades at a 25% discount to our fair value. Now I’d note that stock has been under pressure, and essentially, that pressure’s come from a slowdown in PC sales and a slowing rate of growth in its cloud business. I know what we’re listening there for is if the businesses, generally, their clients are pulling back spending in anticipation of a potential economic slowdown in the first half, or are business is still continuing to spend on productivity enhancing software. And the other part, we’re listening for indications of growth in its Azure business, and that’s its cloud-computing business. Now, Azure has been a major growth driver for the company over the past couple of years, so any changes there certainly could change the outlook for the company. Now we do expect that there is going to be some slowdown in the rate of growth. We want to hear if businesses are beginning to delay moving their IT onto the cloud or not.

Dziubinski: And then we also have Intel and Texas Instruments reporting this week. What are you going to be watching for there?

Sekera: Well, it’s interesting, too. So, Texas Instruments is actually one of the few semiconductor companies that we think is still overvalued. It’s a true star, and it trades well above our $158 fair value. What I’m listening for there is guidance, as far as just how soft they expect semiconductor chips to get within their industrial segment, as well as their view on when they think PC sales might bottom out. And the other part that we’re going to be listening for with them is the pace of capital expenditures, and whether or not they may slow spending there. Now, Intel, on the other hand, that’s a 4-star-rated stock, narrow economic moat, that trades at a 35% discount to our fair value. Similarly, I’m also listening for what their capital expenditure spending plans are, but I also want to get a better sense of their market share. Their market share has been under pressure and we’ve seen loss in several areas, so we want to see how that may pan out over the course of this year and next.

Dziubinski: Dave, let’s pivot over to talk a little bit about some new research from Morningstar. And earlier this month, you published your 2023 market outlook. And in your report, you say that you expect 2023 to be a tale of two halves. Let’s explain what you expect for the markets in that first half of 2023.

Sekera: Sure. So, just a little bit of background. In our 2022 outlook, we noted that there were four main headwinds that the market was going to have to contend with in 2022, and that we were coming into the year of being overvalued. Now those four headwinds have certainly begun and have mostly played out. Those four headwinds being the slowing rate of economic growth in 2022, tightening monetary policy, high inflation, and rising interest rates. For the first half of 2023, I think two of those four headwinds have already really started to abate, that’s inflation and interest rates. So inflation, while still high, has been moderating and we think it will continue to come down. As far as interest rates go, we think the preponderance of the increase in long-term interest rates are behind us.

But the other two headwinds are still out there. When we look at economic growth, we do think the economy’s going to be relatively stagnant and even potentially recessionary in the first half of 2023. And it does look like the Federal Reserve is going to hike rates at least one more time, if not, two more times. From a market perspective, we do think the market itself is significantly undervalued. However, I suspect we might see the market stay in a trading range until we start to see some of those leading economic metrics that come out maybe in the second quarter or middle of the year get released, which show economic growth. And then from there, I’d expect the market really to start making more of a durable move upward.

Dziubinski: Let’s talk about that second half of 2023. The back half where you expect a shift in Fed policy and a reacceleration of economic growth. Unpack your expectations for us.

Sekera: Sure. And as you mentioned, it’s really those last two headwinds that we think will not only abate but actually start becoming tailwinds. We do think that from an economic growth perspective, we do expect the economy will reaccelerate in the second half of the year. And then more importantly, from a monetary policy point of view, I think a combination of a weak economy in the first half of the year and ongoing declining inflation, that gives the Fed the room to shift its focus. Its focus really has been primary on inflation, and I think that they’ll move back toward their dual mandate from just fighting inflation but also being able to put together an economy which can sustain maximum employment. We do think that in the second half of the year, later in the year, that they should actually start moving into more of an easing monetary policy.

Dziubinski: Then overall, would you expect stocks to bounce back in that second half of the year and maybe for some of the volatility to subside?

Sekera: We do. And again, getting back to those leading economic indicators, once I think those start to turn upward, which should be in the middle of the year, I think that provides the backdrop that the market really will be looking forward to be able to break out of this trading range that we’re in and move into that sustainable rally toward our fair values and intrinsic values.

Dziubinski: Dave, let’s pivot over to your stock picks for the week. And this week, you’re focusing on what you dubbed mega-cap stocks, which are stocks with market capitalizations in excess of $250 billion. And your first mega-cap stock pick for this week is Berkshire Hathaway. Tell us why you like it.

Sekera: So, in 2022, there were a lot of overvalued mega-cap stocks coming into the year. And of those mega-cap stocks, a lot of them really got hit very hard last year. And there’s now a lot of mega-cap stocks that we think are actually trading too cheaply. As you mentioned, the first one I’d highlight is going to be Berkshire. It’s currently rated 4 stars, trades at a 16% discount to fair value, and, as you would guess, it has a wide economic moat rating. In this case, I think it’s just a rare opportunity to be able to invest in what I might consider to be one of the ultimate value stocks. Essentially, you’re co-investing with Warren Buffett here. Yet having said that, we do believe that when Warren Buffett does end up exiting the business and is no longer managing it, we don’t necessarily think that’s going to have a huge impact on future operating results, and certainly, not as much as I think many investors believe.

Dziubinski: Now your second mega-cap stock pick for the week is Amazon. Tell us about that one.

Sekera: Amazon’s currently rated 4 stars, and it trades at a 35% discount to fair value, and that’s another one that we do rate with a wide economic moat. Now, as you might guess, that stock has been under a lot of market pressure for a while, and the reason there is it’s been up against very difficult year-over-year comparisons. As you can imagine, it had huge surges in growth during the pandemic. But I think right now investors are overextrapolating this period of low growth too far into the future. And we look at some of its underlying businesses such as AWS, which is its cloud business, it’s advertising business, and of course it’s Prime subscription business. We think that those will continue to be the main growth drivers over the next five years. And it’s interesting, because each of these business lines does have a higher margin than the corporate average. Essentially, what that means is that Amazon will actually be able to generate earnings growth over its revenue growth over the next five years.

Dziubinski: And then your last mega-cap stock pick this week is Tesla, which also reports this week, right?

Sekera: Yeah. And Tesla’s one of those ones where it’s acted like a pendulum. It was coming into the year last year being way overvalued, and we noted it ended up falling about 70% last year. Now I would note, I do think Tesla is really going to be only more appropriate for those investors that can withstand a greater amount of risk in their portfolio, but I do think that it is certainly undervalued and interesting and worth a look at this point. Now I know our analytical team recently reviewed our assumptions and our valuation, and we did lower our fair value to $220 a share from $250 a share, and that was based on some short-term production levels that we reduced.

However, when we maintain our longer-term assumptions that Tesla will grow its production to about 5 million vehicles by 2031, and we do expect fixed expense leverage to improve its operating margin over time. We think those combinations do show that the company is undervalued. And I’d say that stock has also have been under pressure just from negative sentiment here in the short term. And I think a lot of that is just due to Elon Musk spending a lot of time on his Twitter investment. But in our mind, that’s really not that much of an issue because he hadn’t really been involved in a lot of the day-to-day operations of Tesla anyway.

Dziubinski: Well, thanks for your time this morning, Dave. And be sure to start out your week with Dave and I live on YouTube every Monday morning at 8:30 Eastern, 7:30 Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.

Watch “10 Undervalued Dividend Stocks for 2023″ with David Harrell and Dave Sekera.