Markets have started November on stronger footing than previous months, but can that momentum continue? David Sekera, Chief U.S. Market Strategist with Morningstar Research, discusses current market valuations and the potential impact of slowing growth with MoneyTalk’s Greg Bonnell.
Greg Bonnell: After a rough couple of months, markets have had a good move higher to start November. So how does that set us up for the rest of the year? And what does it mean for market valuations? Joining us now to discuss, David Sekera, Chief US Market Strategist with Morningstar Research. David, great to have you back on the program.
David Sekera: Hey, Greg, good to see you, as always.
Greg Bonnell: So we’re keeping the winning streak alive, up to this point. November has a reputation for being a good month for stocks, so far living up to it. Let’s talk about where this actually leaves us in terms of valuations. What are we looking like heading into this rally?
David Sekera: We’re looking pretty good. So in our November market outlook that we published last week, as of October 31, the US market was trading at about 11% discount to a composite of those fair values of the over 700 stocks that we cover that trade on US exchanges. Now to put that in context, on a historical basis, since 2011 the market’s only traded at that much of a discount or more about 12% of the time.
Now, we have had a pretty good rally here since the Fed meeting. You know, the market’s trading at about an 8% discount right now. And to put that in context, the market’s traded at about this discount or more 25% of the time. So still well into undervalued territory, but not nearly as deep into undervalued territory as we were.
Then when we break this down into the Morningstar Stylebox, I’d note that the value category is the area that we see most undervalued in the marketplace today. That’s trading at about a 20% discount to a composite of our fair values. Core stocks trading much closer to fair value. And growth stocks trading at about a 7% discount, so pretty much in line with the overall broad market.
Greg Bonnell: OK. So we have a market now that’s entering a period of traditional seasonal strength. You said we entered this undervalued. At the same time maybe we have a Fed that’s done hiking. The market’s still trying to figure that out. So these all seem like positives, tailwinds. What about headwinds for investors? What do we need to be watching for?
David Sekera: Well, first thing in the short term, I think we have to always keep an eye on geopolitical events, whether it’s the war in Ukraine, the conflict in the Middle East. All of those certainly could have negative implications for the markets if they get worsened or if they spread any further. I’m also keeping a close eye on long-term interest rates. If they turn around and they start to meaningfully rise back up again– specifically, if the 10-year breaks through 5% and stays there– I think that would be pretty negative for equity markets, as well.
But fundamentally, over the medium term, I think the biggest headwind is just the slowing rate of economic growth. Now, our base case from our US economics team is we still are looking for that soft landing. But I’d note that our forecast is that we expect the rate of economic growth essentially to get cut in half each quarter sequentially until the third quarter of next year. We expect the economy to get pretty close to stall speed at that point and then start to re-accelerate. And of course, that slowing growth will pressure earnings as well.
So while the equity market is undervalued from the perspective of long-term intrinsic valuations, I do think that’s going to generate some volatility. And we probably could see some brief sell offs over the course of the next few quarters.
Greg Bonnell: All right, so it’s not necessarily a smooth path going forward. We’ve come to the thick of earnings season. At least for a lot of the big US names and Canada, we still have a few to get through. But what are your takeaways right now? What are you seeing out there?
David Sekera: Yeah, I mean, the takeaway here isn’t about third quarter earnings. I mean, the third quarter earnings were generally pretty good. It was easy for most companies to meet or beat expectations. Guidance was pretty low coming into the quarter. I don’t think anyone expected the US economy to be as strong as it was that past quarter. But the thing is, the outlook really has deteriorated.
And I saw FactSet the other day put out a note. And they noted that earnings estimates have been cut at twice the percentage that earnings reductions have been cut historically. So I think that does indicate the economy is slowing. That is in turn pressuring earnings growth. Yet, I don’t think it was a sharp enough reduction to make me believe that we’re on the precipice of slipping into a recession here in the near term.
Greg Bonnell: Let’s talk about recession a little bit. Because, obviously, you laid out your forecast. You see the economy evolving. But it’s been about a year and a half now of investors worried about the recession that doesn’t seem to want to arrive. The US economy has been pretty resilient.
I mean, can we skate through– and then every couple days, I see another bit of commentary saying, hey, maybe everything’s going to be just fine south of the border. So it’s a bit weaker here in Canada, but maybe the US just gets inflation under control without too much economic damage. Is that still a bit of a lofty dream?
David Sekera: Well, we’re looking for that soft landing. But unfortunately, high interest rates, tight monetary policy, tightening lending standards by the banks– they will all end up taking their toll on the economy. And we expect to start seeing that here in the fourth quarter. I’m also expecting that consumer spending, which really has been propping up the US economy, will also start slowing.
A couple of different factors there. We still have inflation working its way through household balance sheets. I think a lot of the households that had excess savings through the pandemic, those have been spent. We have student loan repayments, which are starting back up again. So I think there’s a couple of different factors that are all coming together to pressure consumer spending.
Now, as an old consumer analyst, I always agree with the adage, never underestimate the US consumer’s propensity to want to spend. But it’s going to have to come down. And that will essentially pressure the overall economy for the next couple quarters.
Greg Bonnell: So we’ve talked about this rally that we’ve had to start off the month of November. The large caps get all the attentions. The rally continues for the S&P 500, you know, the big names. Looking at the Russell 2000 right now, it’s not taking part at least today. Small caps versus large caps, what does it look like in this environment?
David Sekera: So when we break our valuations down by capitalization, small cap stocks are very undervalued as well as mid-cap. And I’d note those small cap valuations are probably pretty close to some of the lowest valuations compared to our intrinsic valuations that we’ve seen over time. The only thing is, I would caution investors, I think it might be a couple of quarters out before the small caps really begin to outperform the large caps.
The reasoning for that is that with the economy slowing, I think a lot of investors, specifically institutional investors, are going to want to hide out in large cap stocks. They’re not going to want to take the greater earnings volatility that we see in the small cap space.
But I do think that once that market begins to price in an economic rebound, probably by the middle of next year, I would expect to see a pretty quick snapback rally in those small caps, to not only catch up to but then outperform the large caps.
Greg Bonnell: All right, so an interesting look into next year, and perhaps a place where some of our viewers want to do their research. In terms of the rest of this year– November, December– before we know it, the year is going to be over. What do we need to be mindful of?
David Sekera: Well, again, just looking at the calendar, I think we need to be very careful as far as what the Fed is going to be doing at the next meeting. We have a couple of different Fed officials who were out giving their speeches today. So I’m going to be listening to hear what their language is, whether or not that really agrees with that shift that we heard from Chair Powell.
So again, watching for what the Fed may do, our own expectations that we expect that with the economy slowing, our forecast for inflation to continue to moderate. We actually think the Fed not only is going to be on pause for a while, but we think that they’re going to be in position in the first half of next year to start cutting rates. So again, I kind of want to make sure that the other Fed officials are kind of onboard with that shift in language that we’ve heard from the Fed.