Stocks have rebounded, but the market remains significantly undervalued
Even after the more than 9% rally in US equities in July, we continue to view the US stock market as a whole as significantly undervalued, albeit less cheap than it was at the start of the quarter. According to a composite of the valuations of nearly 700 stocks we cover that trade in the US, the market is now at an 11% discount to its fair value.
Stock markets bottomed in mid-June and then remained in a trading range until mid-July as investors awaited second-quarter results. Earnings were mixed as a few high-profile failures dragged individual stocks down. But quarterly results have generally not been as bad as the market had expected.
But above all, the management teams did not give up on the second half of 2022. Company executives have sought to dampen expectations, but have largely failed to make any bigthe cuts to their earnings outlook for the rest of this year. With valuations at already low levels after the sell-off in late spring and early summer, this gave the market enough confidence to start reallocating capital to equities.
Key takeaways for the stock market today:
US stock market at 11% fair value discount
In our Q3 outlook we noted that we believe US equity markets are becoming oversold and that since 2010 stocks have rarely traded at such a significant discount to their intrinsic value. Indeed, in mid-June, equities were trading at their biggest discount to our long-term intrinsic valuations since the emergence of the pandemic in March 2020 and the growth scare that dragged equities lower in December 2018.
Over a longer historical period, the only other instance where our price/fair value indicator fell lower was in the fall of 2011 amid fears that the Greek debt crisis could spread to other countries.
After rallying in the second half of last month, as of July 29, the broad US stock market is trading at an 11% discount to our fair value.
According to the Morningstar US Growth Index, growth stocks jumped 14.2% in July, significantly outperforming the broader market. Following this gain, these stocks now trade at a similar discount to value stocks, while basic stocks remain closer to fair value. As such, we continue to favor a dumbbell-shaped portfolio split between an overweight in value and growth stocks and an underweight in basic stocks.
The Morningstar US Small Cap Index outperformed slightly in July, rising 10.1%, and small cap stocks remain the most undervalued by market capitalization. Large and mid cap stocks performed in line with the broader market and both categories are equally undervalued.
Look to cyclical and economically sensitive sectors for value
Across our sector valuations, Communication Services remains by far the most undervalued part of the market, trading at a 33% discount to fair value, followed by several cyclical sectors which have suffered the most. big of the massive sale over the last few months. Defensive sectors, which held their value better on the downside, are rather overvalued.
It should be noted that more than half of the market capitalization of the communications sector is concentrated in Alphabet (GOOGL) and meta-platforms (META). After earnings, we reduced our fair value on Alphabet by 6.1% to $169 to account for near-term weakness. However, we believe the market is extrapolating this short-term weakness too far into the future. Even after reducing our fair value estimate, the stock remains in 4-star territory and is trading at a 32% discount to our intrinsic valuation.
We also lowered our valuation on Meta by 9.9% to $346 following poor Q2 results and weak guidance. Like Alphabet, we think the market is too pessimistic about Meta’s long-term outlook. For example, based on Meta’s continued growth in user numbers, we believe that the company’s network effect remains intact, which is the basis for our large fluke rating. We expect further monetization of its Reels product as well as an economic turnaround to bring revenue growth back into the low-to-mid teen range beginning in the second half of 2023. Shares of Meta are trading at less than half of our intrinsic valuation, putting it deep in the 5-star category.
Also of note in the communications sector, we lowered our valuation of Twitter (TWTR) at $44 per share. We had shifted our fair value to Elon Musk’s takeover bid of $54.20 after the company accepted his takeover offer. But following his request to terminate the deal, we revised our assessment, which is now based on the underlying fundamentals of Twitter as a public company.
Consumer discretionary remains the second most undervalued sector, trading at a 16% discount to fair value. With the economy weakening in the first half of the year, this sector had been the worst performing part of the market during this period. We believe the greatest opportunities lie in areas that stand to gain from normalizing consumer behavior. We expect spending to continue to shift towards services towards pre-pandemic levels and away from goods, which had outperformed during the pandemic. For a more in-depth discussion of these opportunities, please see Spending Returns to Services; Here’s where to invest now.
Blind selling during downturn leaves wide-moat stocks discounted
At the worst of the selloff, we noticed that to cope with redemptions, many portfolio managers resorted to selling what they could rather than what they wanted. Stocks of high quality companies will generally have a larger pool of cash to sell than lower quality names.
Because of this blind selling, stocks with wide economic moats trade at a steeper discount than stocks of companies with narrow or no-moat ratings.
We continue to see a significant amount of value for long-term investors in Wide Moat stocks. In addition to their lower valuations, we also expect these companies to generally have greater pricing power. As such, they should be able to pass on any cost increases to customers and better maintain their margins, and therefore maintain their valuations in an inflationary environment.
We continue to view the broader US stock market as significantly undervalued. However, even at the current level, long-term investors should brace themselves and expect volatility to continue over the coming months.
In our outlook for 2022, we noted that there were several headwinds the market was going to face this year. The two that the market will now be watching more closely are the economic recovery and the moderation of inflation. Over the next few months, markets will be on the lookout for signs that these challenges are beginning to ease. Any indication that the economy continues to weaken and/or that inflation will stay higher for longer would most likely put further downward pressure on equities.
Based on our forecast, we think these two headwinds should start to turn into tailwinds. For example, even after factoring in the negative gross domestic product reports in the first and second quarters, we still expect real GDP growth of 2% this year. We think inflation has peaked and should start to moderate from now on.
” The month of June [CPI] report will almost certainly mark the peak of inflation as food and energy prices are expected to fall sharply in next month’s report,” says Morningstar’s Chief American Economist Preston Caldwell.
We encourage market participants to stick to plans that balance long-term investment goals with their risk tolerance. These plans should allow for periodic rebalancing to increase equity allocations when valuations decline, but also reduce exposure when valuations become excessive. Based on our view that the US equity market is undervalued, we believe now is not the time to reduce equity exposures, but to increase them wisely, especially in companies with wide economic moats. .