Q3 2024 US Equities Outlook: is the AI Stock Trade Over?

While
the
broad
market
index
was
able
to
post
a
healthy
gain
thus
far
in
the
second
quarter,
it
was
only
able
to
do
so
on
the
back
of
concentrated
gains
in
stocks
tied
to
artificial
intelligence.
An
attribution
analysis
reveals
that
without
the
gains
from
Nvidia
(NVDA),
Apple
(AAPL),
Microsoft
(MSFT),
Alphabet
(GOOGL),
and
Broadcom
(AVGO),
the
broad
market
index
would
have
fallen
thus
far
this
quarter.

As
of
June
24,
the
price/fair
value
of
the
US
stock
market
rose
to
1.03,
representing
a
3%
premium
to
our
fair
value
estimates.
While
the
market
valuation
is
not
yet
in
overvalued
territory,
this
places
it
near
the
top
end
of
the
fair
value
range.
In
fact,
since
the
end
of
2010,
the
market
has
traded
at
this
much
of
a
premium,
or
more,
only
10%
of
the
time.

Price/Fair
Value
of
Morningstar’s
US
Equity
Research
Coverage
at
Month-End

Anything
related
to
artificial
intelligence
continued
to
surge
in
the
second
quarter.
These
stocks
are
largely
held
within
the
Morningstar
US
Growth
Index
and
in
the
case
of
Alphabet,
Meta
Platforms,
and
Broadcom
are
contained
in
the
Morningstar
US
Core
Index.
Both
of
these
indexes
have
well
outperformed
the
Morningstar
US
Value
Index.

However,
based
on
our
valuations,
we
suspect
that
the
preponderance
of
this
outperformance
is
behind
us.
As
of
June
24,
growth
stocks
are
trading
at
a
6%
premium
to
a
composite
of
our
stock
coverage
and
core
stocks
are
trading
at
a
7%
premium,
whereas
value
stocks
remain
attractively
priced
at
a
9%
discount
to
our
valuations.

While
a
rising
tide
can
lift
overvalued
AI
stocks
even
further
into
overvalued
territory
in
the
short
term,
in
the
future
we
think
long-term
investors
will
be
better
off
paring
down
positions
in
growth
and
core
stocks,
which
are
becoming
overextended,
and
reinvesting
those
proceeds
into
value
stocks,
which
trade
at
an
attractive
margin
of
safety.

Price/Fair
Value
by
Morningstar
Style
Box
Category

Based
on
these
valuations,
as
compared
with
our Q2
US
Stock
Market
Outlook,
we
now
advocate
for
moving
to
an
underweight
in
the
core
category
following
its
second-quarter
outperformance
as
compared
with
our
prior
market
weight.
We
continue
to
advocate
an
overweight
in
value
and
underweight
in
growth.
By
capitalisation,
we
continue
to
advocate
for
an
underweight
position
in
large-cap
stocks
in
favor
of
overweighting
small-cap
stocks
and
a
slight
overweighting
in
mid-cap
stocks.

Where
to
go
From
Here?

While
the
broad
market
appears
to
be
getting
frothy,
much
of
the
overvaluation
is
concentrated
in
a
few
thematic,
mega-cap
stocks.
For
example,
if
we
exclude
Nvidia,
Meta
(META)
Platforms,
and
Apple
from
our
valuation
calculation,
the
premium
drops
to
1%
from
3%.
While
not
tied
to
AI,
excluding
Eli
Lilly
(LLY)
(which
has
run
up
well
into
1-Star
territory
on
its
weight-loss
drugs)
from
the
calculation,
it
brings
the
index
down
to
fair
value.

Considering
that
AI
stocks
are
generally
at
best
fairly
valued
and
at
worst
overvalued,
we
see
much
better
opportunities
elsewhere
in
the
market,
specifically
in
the
value
category,
which
remains
the
most
undervalued
according
to
our
valuations,
as
well
as
down
in
capitalisation
into
small-cap
stocks.

While
we
may
have
been
a
little
early
on
the
call
to
start
moving
into
contrarian
plays
last
quarter,
we
continue
to
see
the
best
opportunities
among
those
sectors
and
stocks
that
have
underperformed,
are
unloved,
and –
most
importantly –
undervalued.
These
contrarian
plays
are
often
“story
stocks,”
which
are
typically
situations
such
as
emerging
turnarounds
or
other
catalysts
that
may
have
greater
short-term
risk,
require
a
greater
amount
of
analysis,
and
often
take
time
for
the
story
to
work
out.

Shifting
From
Thematic
to
Idiosyncratic

In
our 2023
US
Stock
Market
Outlook,
we
noted
that
the
broad
market
was
trading
at
a
deep
discount
to
our
valuations,
especially
growth
stocks,
and
in
particular,
the
communication
and
technology
sectors
were
among
the
most
undervalued
sectors.
In
our
Stocks
for
2023
section,
many
of
those
stocks
tied
to
artificial
intelligence
were
rated
4
or
5
Stars.
Fast
forward
to
one
and
a
half
years
later,
these
same
stocks
tied
to
AI
are
now
at
best
fully
valued,
or
at
worst
overvalued.

Performance
of
Selected
AI-Related
Stocks

Based
on
these
valuations,
as
well
as
those
stocks
closely
tied
to
both
the
AI
and
weight-loss
drug
themes,
we
think
it
is
unlikely
that
what’s
worked
for
the
past
one
and
a
half
years,
will
be
what
continues
to
work
in
the
future.

Opportunities
Across
Undervalued
Sectors
and
Stocks

Morningstar
Price/Fair
Value
by
Sector

Real
Estate

No
sector
is
hated
as
much
by
Wall
Street
than
real
estate.
Yet
this
negative
sentiment
is
also
why
we
see
numerous
opportunities
among
REITs
that
invest
in
real
estate
with
defensive
characteristics,
which
have
traded
off
in
conjunction
with
urban
office
space.
For
example,
5-Star-rated
Healthpeak
(DOC) and
4-star-rated
Ventas
(VTR) invest
across
a
diversified
range
of
healthcare
assets
including
medical
offices,
life
sciences
research
facilities,
senior
housing,
and
hospitals.
Realty
Income
(O),
rated
5
Stars,
owns
roughly
13,400
properties,
most
of
which
are
freestanding,
single-tenant,
triple-net-leased
retail
properties.
A
large
percentage
of
their
tenants
are
in
defensive
industries
such
as
grocery,
convenience,
dollar,
and
home
improvement
stores.

Energy

Over
the
long-term,
we
expect
oil
prices
to
decline,
as
our
midcycle
forecast
for
West
Texas
Intermediate
crude
is
$55/barrel.
Yet,
even
with
that
bearish
forecast
compared
with
today’s
$80/barrel
price,
we
see
value
among
much
of
the
energy
sector,
which
trades
at
a
7%
discount
to
our
fair
valuations.
We
also
think
exposure
to
the
energy
sector
provides
a
good,
natural
hedge
to
portfolios
to
hedge
against
rising
geopolitical
risk
and
if
inflation
were
to
stay
higher
for
longer.

Among
the
global
major
oil
producers,
4-star-rated
Exxon
(XOM) is
our
preferred
integrated
oil
company,
given
its
earnings-growth
potential
from
a
combination
of
high-quality
asset
additions
and
cost
savings.
For
investors
looking
for
domestic
producers,
we
highlight
4-Star-rated
Devon.
For
investors
with
a
higher
risk
tolerance,
we
suggest
looking
at
APA
(APA),
which
could
have
significant
upside
from
a
potential
play
in
Suriname.
The
evidence
to
date
suggests
a
very
large
petroleum
system
that
could
be
transformative
for
the
company.
At
this
point,
we
think
it
is
very
likely
that
one
or
more
of
the
discoveries
will
progress
to
the
development
stage,
though
none
have
been
officially
sanctioned
yet.
A
final
investment
decision
for
Suriname
is
planned
by
the
end
of
2024
with
the
first
oil
in
2028.

Basic
Materials

As
economic
growth
slows,
the
basic
materials
sector
has
fallen
out
of
favour
and
is
now
trading
at
a
5%
discount
to
fair
value.
Within
this
sector,
we
see
value
in
select
gold
miners
and
agricultural
chemicals.
Gold
miners
such
as
4-Star-rated
Newmont
Mining
(NEM) trade
at
a
deep
discount
to
our
fair
value,
even
though
we
have
a
relatively
bearish
view
on
the
long-term
price
of
gold.
If
gold
prices
stay
elevated
or
move
higher,
we
think
there
is
a
lot
of
upside
leverage.
Crop
chemical
producers,
such
as
5-Star-rated
FMC,
fell
throughout
2023.
The
agricultural
industry
overordered
too
much
product
in
2021-22
due
to
supply
constraints
and
shipping
bottlenecks.
As
a
result,
sales
were
constrained
in
2023
as
those
excess
inventories
were
used
up.
We
think
the
supply/demand
dynamics
will
normalise
this
year,
and
therefore
we
see
opportunity
in
undervalued
crop
chemical
producers.

Where
to
Be
Wary:
Sectors
Trading
at
Premiums
to
our
Fair
Values

Technology

The
technology
sector
has
a
long
history
of
swinging
between
boom
and
bust.
Right
now,
we
are
in
the
boom
stage,
where
valuations
are
becoming
increasingly
stretched
as
the
surge
from
artificial
intelligence
has
propelled
these
stocks
higher
and
pushed
the
sector
to
a
10%
premium
to
our
valuations.

At
this
point,
we
look
at
technology
stocks
as
generally
divided
into
three
buckets:
AI
and
cloud,
traditional
technology,
and
legacy
technology.

AI
and
cloud
is
where
we
see
the
highest
growth
and
positive
long-term
secular
trends,
yet
at
this
point,
these
stocks
are
generally
fully
valued
to
overvalued.

The
area
we
find
undervalued
opportunities
in
is
the
traditional
technology
stocks.
These
stocks
include
industries
such
as
semiconductors,
software,
and
services.

Among
the
semiconductors,
we
just
upgraded
our
Morningstar
Economic
Moat
Rating
on
5-star-rated
NXP
Semiconductors
(NXPI) to
wide
from
narrow.
Among
software,
we
see
value
in
4-Star-rated
Adobe
(ADBE),
which
trades
at
a
14%
discount.
Within
the
services
area,
we
see
positive
long-term
secular
trends
in
cybersecurity,
of
which
our
current
pick
is
4-Star-rated
Fortinet
(FTNT).

Legacy
technology
includes
those
stocks
that
we
think
have
their
best
days
behind
them.
This
includes
stocks
such
as
2-star-rated
International
Business
Machines
(IBM),
which
trades
at
a
23%
premium
to
our
fair
value
and
2-Star-rated
HP
(HPE),
which
trades
at
a
12%
premium.

Consumer
Defensive

The
consumer
defensive
sector
is
currently
trading
at
an
8%
premium
to
our
fair
value.
To
some
degree,
valuations
in
the
sector
are
barbell-shaped
with
several
large-cap
stocks,
such
as
1-Star-rated
Costco
(COST) and
2-Star-rated
Procter
&
Gamble
(PG),
which
are
trading
well
above
our
intrinsic
valuations.
While
we
rate
Costco
with
a
wide
moat
and
a
Morningstar
Uncertainty
Rating
of
Medium,
the
stock
trades
at
an
eye-popping
50
times
forward
earnings.

The
area
we
see
the
best
value
is
among
the
packaged
food
companies.
These
companies
have
been
under
pressure
the
past
few
years
as
they
have
struggled
to
raise
prices
as
fast
as
their
own
costs.
As
inflation
moderates,
we
expect
they
will
be
able
to
raise
their
operating
margins
back
toward
historical
averages
as
price
increases
and
efficiencies
improve.
Two
such
examples
include
5-star-rated
Kraft
Heinz
(KHC),
of
which
we
just
increased
its
moat
rating
to
narrow
this
past
quarter
and
raised
our
fair
value,
and
4-Star-rated
Kellanova
(K).

Industrials

The
industrials
sector
is
trading
at
a
6%
premium
to
our
valuations.
In
our
view,
industrials
should
remain
underweighted
in
portfolios,
especially
the
transportation
names
that
are
the
most
overvalued.
For
example,
2-Star-rated
Southwest
Airlines
(LUV) and
United
Airlines
(UAL),
which
trade
at
50%
and
38%
premiums,
respectively,
remain
some
of
the
most
overvalued
names
across
our
coverage.
In
addition,
2-Star
stocks
such
as
XPO
Logistics
(XPO) and
Saia
(SAIA) remain
at
high
premiums
of
28%
and
24%,
respectively.
One
of
the
few
areas
where
we
see
undervalued
stocks
in
the
sector
include
the
aerospace
and
defense
contractors
such
as
5-Star
Huntington
Ingalls
(HII) and
4-Star-rated
Northrop
Grumman
(NOC).

Stock
Selection
for
Sectors
Trading
Near
Fair
Value

Consumer
Cyclical

Investors
will
need
to
be
adroit
in
their
stock-picking
across
the
consumer
cyclical
sector.
Several
anecdotes
from
first-quarter
earnings
reports
may
be
the
canary
in
the
coal
mine,
indicating
that
the
compound
impact
from
two
years
of
high
inflation
is
weighing
on
the
middle-income
consumers.

For
example,
Starbucks
(SBUX) reported
a
7%
decrease
in
foot
traffic
across
its
stores,
McDonalds
(MCD)
reported
relatively
weak
results,
and
Nike
(NKE) shares
dropped
precipitously
after
it
guided
to
a
mid-single-digit
percentage
sales
decline
for
fiscal
2025.
On
the
flip
side
of
the
coin,
discounter
Walmart
(WMT) reported
an
increase
in
comparable
sales,
driven
entirely
by
traffic
growth.

Middle-income
consumers
were
originally
able
to
offset
high
inflation
over
the
past
two
years
by
using
excess
savings
from
the
pandemic,
but
those
savings
appear
to
be
used
up.
They
have
also
eaten
into
their
savings
rate,
but
savings
rates
are
already
lower
than
prepandemic
levels.
We
are
seeing
consumers
pull
back
on
those
items
that
are
considered
indulgent
as
well
as
other
discretionary
items
whose
purchases
can
be
delayed.
However,
other
areas
such
as
travel,
where
consumers
have
already
bought
or
booked
tickets
and
have
set
aside
funds
to
pay
for
their
summer
vacations,
remain
steady.

Financial
Services

A
little
over
a
year
ago,
Silicon
Valley
Bank
failed
and
stocks
across
the
entire
regional
bank
industry
plummeted.
While
we
lowered
our
fair
value
on
a
number
of
these
stocks,
market
prices
fell
further
and
faster.
One
year
later,
most
of
these
stocks
have
regained
much
of
their
value,
yet
this
is
still
where
we
see
the
best
valuation
as
the
mega
banks
are
fully
valued
to
overvalued.
Among
the
regional
banks,
we
continue
to
see
value
in
4-Star-rated
US
Bank
(USB),
which
trades
at
a
25%
discount
to
fair
value.
US
Bank
is
the
only
regional
bank
we
rate
with
a
wide
economic
moat.

Communications

The
valuation
of
the
communication
sector
is
skewed
upward
by
3-star-rated
Alphabet
and
2-star-rated
Meta
Platforms,
as
those
stocks
account
for
44%
and
24%
of
the
Morningstar
US
Communications
Services
Index,
respectively.

Within
the
sector,
we
see
the
best
value
among
traditional
communication
names.
For
example,
AT&T
(T) and
Verizon
(VZ) are
two
4-Star-rated
stocks
that
trade
at
close
to
20%
discounts
to
our
valuation
and
whose
dividend
yields
both
yield
near
6%.
Among
the
media
names,
Comcast
(CMCSA) is
rated
5
stars,
trades
at
a
30%
discount
to
fair
value,
and
its
dividend
yield
is
3.2%.

Healthcare

The
overall
valuation
of
the
healthcare
sector
has
been
skewed
higher
by
the
performance
of
Eli
Lilly on
the
back
of
its
weight-loss
drugs.
Eli
Lilly,
rated
1-Star,
trades
at
a
68%
premium
to
fair
value,
making
it
one
of
the
most
overvalued
stocks
across
our
coverage.
Elsewhere
within
the
healthcare
sector,
we
are
seeing
a
number
of
stocks
that
rarely
have
traded
at
much
of
a
discount,
such
as
Johnson
&
Johnson
(JNJ),
slip
into
4-Star
territory.
Within
healthcare
we
prefer
stocks,
such
as
5-Star-rated
Zimmer
Biomet
(ZBH) and
4-Star-rated
Medtronic
(MDT).
These
are
stocks
that
not
only
trade
at
a
discount
to
our
fair
values
and
have
long-term
durable
competitive
advantages
but
also
are
tied
to
the
long-term
secular
trend
of
the
aging
baby
boomer
generation.

Utilities

Obvious
plays
on
the
rapid
growth
of
AI
have
already
run
up
to
levels
that
we
think
are
fully
valued
to
overvalued.
As
such,
investors
have
been
looking
for
other
ways
to
play
this
growth.
Recently
we
have
seen
an
increase
in
the
number
of
stories
that
make
the
case
that
the
utility
sector
will
benefit
from
the
heightened
demand
for
electricity.
We
agree
with
this
thesis,
as
AI
computing
requires
multiple
times
more
electricity
to
power
its
semiconductors
than
traditional
computing.
In
fact,
in
our 4Q
2023
US
Market
Outlook,
we
highlighted
that
the
utility
sector
was
trading
at
valuation
levels
that
were
near
their
lowest
levels
over
the
past
decade,
yet
we
noted
that
fundamentally
the
outlook
for
the
sector
was
as
strong
as
we
had
ever
seen
it.
At
that
point,
we
had
already
incorporated
into
our
forecasts
that
the
amount
of
electricity
demand
growth
from
data
centers
would
increase
a
cumulative
46%
through
2032.

However,
in
our
view,
if
you
are
just
buying
utilities
today
to
play
this
theme,
you
are
already
nine
months
late
to
the
game.
Since
the
utility
sector
bottomed
out
on
Oct.
2,
the
Morningstar
US
Utility
Index
has
risen
28%
through
June
24.

One
utilities
stock
that
has
lagged
the
sector
but
has
upside
leverage
tied
to
AI
electric
demand,
is
4-star-rated
WEC
Energy
Group
(WEC).
There
are
several
data
centers
in
development
in
Wisconsin,
with
Microsoft
the
most
recent
to
announce
its
plans
to
build
a
data
center
in
southeast
Wisconsin.
WEC
trades
at
an
18%
discount
to
our
fair
value
estimate
and
yields
approximately
4.3%.

Key
Takeaways:

• US
  stock
  market
  at
  a
  3%
  premium,
  not
  yet
  overvalued,
  but
  getting
  stretched;
• We
  doubt
  what’s
  worked
  for
  the
  past
  one-and-a-half
  years
  will
  be
  what
  continues
  to
  work
  in
  the
  future;
• Value
  category
  and
  small
  caps
  remain
  most
  undervalued,
  shifting
  core
  category
  to
  underweight.