US Equities in Q2: Why Contrarian Picks Are Better

US
Stock
Market:
Overvalued?

Although
the
above
premium
doesn’t
necessarily
mean
the
US
market
is
overvalued,
it
has
been
valued
at
these
prices
or
higher
only
14%
of
the
time
since
the
end
of
2010.

Going
forward,
Morningstar
analysts
now
expect
further
rises
to
be
driven
by
higher
yields
across
the
market,
and
particularly
in
the
value
category,
which
remains
the
most
undervalued
by
our
assessments
–
and
in
the
small
cap
segment,
specifically.

In
October
2022,
the
three
most
undervalued
sectors
were
telecommunications,
cyclical
consumer
goods,
and
technology.
A
year
and
a
half
later,
technology
stocks
are
overvalued
and
telecommunications
and
consumer
cyclicals
are
trading
at
roughly
fair
value.
As
a
result,
it
may
be
a
good
time
for
investors
to
investigate
contrarian
picks,
and
especially
in
sectors
that
have
underperformed
and,
more
importantly,
are
undervalued.

Fed
Up,
Fed
Down:
The
Case
For
Value
and
Small
Caps

In
the
first
quarter
of
this
year,
the
US
equity
market
continued
its
rally.
As
of
8
April,
the
Morningstar
US
Market
Index
was
up
8.73%
in
US
dollars
(USD).
Although
the
rally
was
underpinned
by
better-than-expected
earnings
growth,
it
was
the
surge
in
artificial
intelligence
(AI)-related
stocks
that
provided
the
biggest
impetus
for
performance.

For
this
reason,
most
of
the
gains
were
concentrated
in
a
handful
of
stocks,
and
especially
those
with
strong
exposure
to
AI
as
a
theme.
Nvidia
(NVDA),
for
example,
is
up
90%
and
alone
accounts
for
almost
25%
of
the
market’s
performance
to
date.
By
contrast,
62%
of
this
year’s
gain
is
concentrated
in
just
10
stocks
(including
Nvidia).

At
a
6%
discount
to
our
fair
value,
however,
the
value
segment
remains
the
most
attractive,
while
the
growth
segment,
at
an
8%
premium,
remains
overvalued.
Blend
stocks,
on
the
other
hand,
are
trading
just
above
fair
value,
at
a
3%
premium.
Small
cap
stocks
are
the
most
attractively
valued,
at
an
18%
discount,
followed
by
mid
caps,
discounted
by
3%,
and,
finally,
large
caps,
which
are
trading
at
a
5%
premium.

Based
on
these
valuations,
we
suggest
overweighting
value
and
blend
stocks
in
portfolios
and
underweighting
growth
stocks.
In
terms
of
market
capitalisation
segments,
we
prefer
to
underweight
large
caps
and
overweight
mid
and
small
caps.

Morningstar’s
economics
team
also
expects
a
soft
landing
for
the
US
economy,
with
a
slowdown
in
the
rate
of
growth
in
the
coming
quarters,
but
not
enough
to
lead
to
a
recession.
This
trend
will
likely
weigh
on
growth
stocks,
to
the
benefit
of
the
small
cap
segment,
which
traders
have
avoided
lest
they
suffer
more
from
a
recession.

Morningstar
analysts
also
predict
that
interest
rates
will
fall
along
the
yield
curve
as
soon
as
the
Fed
starts
to
cut
its
benchmark
rate.
Lower
interest
rates
are
positive
for
all
stocks,
but
especially
for
sectors
that
are
overweight
in
the
value
index.
Cheaper
money
could
also
lead
to
a
recovery
in
demand
for
dividend-paying
stocks,
which
tend
to
be
overweight
in
the
value
category.
Historically,
small
caps
tend
to
do
well
when
the
Fed
starts
to
cut
interest
rates.
Finally,
a
decline
in
the
yield
curve
will
eliminate
the
risk
that
future
earnings
of
small
cap
companies
will
be
squeezed
when
they
go
to
refinance
maturing
cheap
debt.

Contrarian
Investment
Ideas
in
US
Equities

As
of
early
2023,
the
three
most
undervalued
sectors
were
telecommunications,
consumer
cyclical,
and
technology.
More
than
a
year
later,
technology
stocks
are
now
overvalued,
while
telecommunications
and
consumer
cyclical
stocks
are
trading
in
line
with
fair
value.

Based
on
an
analysis
of
the
performance
of
the
Morningstar
US
Market
index,
as
of
March
22,
the
returns
of
10
stocks
represented
approximately
62%
of
the
overall
gain
achieved
by
the
market.
While
these
10
stocks
have
led
the
index
higher,
we
doubt
they
will
continue
to
do
so
for
the
rest
of
the
year.
Right
now,
half
of
the
US
stocks
covered
by
the
Morningstar
analysts
are
rated
3-Stars
–
the
other
half
get
a
2-Star
rating.
At
the
beginning
of
2024,
however,
two
stocks
were
rated
4
Stars,
three
companies
were
rated
2
Stars.
Everything
else
was
rated
3
Stars.

Spotlight
on:
Real
Estate

Where
can
investors
find
contrarian
ideas?
Morningstar
analysts
are
looking
for
those
sectors
that
have
lagged
the
overall
market,
for
which
the
market
has
a
negative
sentiment,
and
which
are
trading
at
a
significant
discount
to
fair
value.
And
there
are
three:
real
estate,
utilities
and
energy.

Real
estate
is
the
least
loved
sector
on
Wall
Street,
as
negative
sentiment
resulting
from
declining
urban
office
valuations
has
infected
the
entire
asset
class.

In
our
view,
this
provides
investors
with
an
opportunity
to
take
a
position
on
some
stocks
that
have
been
unfairly
dragged
down.
Likewise,
some
of
the
most
interesting
opportunities
are
those
that
have
defensive
characteristics,
including
healthcare
providers
and
triple-net
leases
(a
commercial
property
lease
agreement
in
which
the
tenant
agrees
to
pay
all
expenses,
including
property
taxes,
as
well
as
rent
and
utilities).
In
the
healthcare
sector,
examples
include
Ventas
(VTR)
(rated
5
Stars)
and
Healthpeak
(DOC).
In
the
triple-net-lease
segment,
Realty
Income
(O)
(rated
5
Stars)
is
one
of
the
most
undervalued
stocks
Morningstar
analysts
cover.

Spotlight
on:
Utilities

After
reaching
something
of
an
overvaluation
in
late
2021,
the
utilities
sector
not
only
significantly
lagged
the
market
but
has
since
posted
a
loss
of
5%.
Rising
interest
rates
have
played
a
role,
as
the
current
value
of
utility
stocks
is
negatively
correlated
with
rising
yields.

However,
we
believe
the
market
has
overcorrected
to
the
downside.
From
a
fundamentals
perspective,
we
believe
the
utility
sector’s
outlook
is
as
strong
as
it
has
ever
been.
Companies
in
the
sector
will
benefit
from
the
secular
shift
to
renewable
energy
and
increased
investment
in
electricity
grid
infrastructure.
Examples
include
NiSource
(NI)
and
Entergy
(ETR)
(both
rated
5
stars).
We
also
believe
falling
interest
rates
will
boost
utilities.

The
price/fair
value
ratio
of
the
energy
sector
has
increased
in
recent
weeks.
However,
we
still
see
a
significant
number
of
undervalued
stocks.
Furthermore,
we
believe
the
sector
offers
investors
a
natural
hedge
against
further
geopolitical
risks –
or
the
risk
inflation
remains
elevated
for
longer.
Among
the
global
oil
majors,
our
choice
goes
to
4-Star-Rated
Exxon
(XOM).
US
regional
provider
Devon
(DVN)
gets
a
4-Star
rating.

Which
Sectors
Are
Overvalued?

Compared
to
fair
value,
the
industrial
goods
sector
is
the
most
overvalued.
Areas
like
transportation
and
airlines
include
some
of
the
most
overvalued
stocks
covered
by
our
research.
With
a
1-Star
rating,
XPO
(XPO)
trades
at
a
64%
premium
to
fair
value,
while
2-Star-rated
Southwest
Airlines
(LUV)
is
overvalued
by
50%.

Within
the
technology
sector,
shares
in
1-Star-Rated
ARM
Holdings
(ARM)
are
among
the
most
overvalued,
and
are
trading
at
prices
more
than
double
their
Fair
Value
Estimate.

While
ARM
will
benefit
from
the
growth
of
AI,
we
believe
the
market
is
significantly
overestimating
its
growth
potential
as
a
company.
For
the
same
reason,
Morningstar
analysts
say
Dell
Technologies
(DELL)
is
trading
at
prices
much
higher
than
our
valuation.

In
the
defensive
consumer
goods
sector,
retailers
such
as
Walmart
(WMT),
Target
(TGT)
and
Costco
(COST)
are
overvalued,
while
shares
in
companies
that
produce
packaged
foods,
such
as
Campbell
Soup
(CPB),
Kellanova
(K)
and
General
Mills
(GIS)
are
trading
at
a
discount.
In
the
finance
sector,
on
the
one
hand
we
see
a
notable
overvaluation
of
insurance
companies,
such
as
Allstate
(ALL)
and
Progressive
(PGR),
while
US
banks
such
as
US
Bank
(USB)
and
Truist
(TFC)
continue
to
show
attractive
pricing.

When
Will
The
Fed
Cut
US
Interest
Rates?

Through
March
22,
the
Morningstar
US
Core
Bond
Index,
the
benchmark
representative
of
the
broader
bond
market,
fell
0.90%.
Interest
rates
rose
at
the
longer
end
of
the
yield
curve
and
the
10-year
US
Treasury
yield
rose
34
basis
points
to
4.22%.

Morningstar
analysts
still
expect
the
Federal
Reserve
to
begin
easing
monetary
policy
at
its
June
meeting,
lowering
its
key
rate
by
25
basis
points,
and
then
cutting
further
at
each
subsequent
meeting
to
2024’s
end.
This
projection
is
is
based
on
the
forecast
that
inflation
will
continue
to
cool
throughout
the
year,
and
the
rate
of
economic
growth
is
slowing.

We
now
expect
the
policy
rate
to
fall
to
a
range
of
4%
to
4.25%
by
the
end
of
the
year
and
then
settle
between
2.50%
and
2.75%
by
the
end
of
2025.

At
the
longer
end
of
the
yield
curve,
we
expect
the
10-year
US
Treasury
yield
to
average
4.00%
in
2024
and
3.00%
in
2025.
Based
on
our
interest
rate
forecasts,
We
believe
investors
will
be
able
to
make
the
most
of
longer-dated
bonds
and
lock
in
currently-high
interest
rates.

Corporate
bond
spreads
tightened
during
the
quarter.
The
average
spread
of
the
Morningstar
US
Corporate
Bond
Index
narrowed
by
10
basis
points
to
+86.
In
the
high-yield
corporate
bond
market,
the
average
spread
fell
31
basis
points
to
+302.

In
their
mid-2023
report
on
the
bond
market,
Morningstar
fixed
income
analysts
wrote
that
corporate
bond
spreads
offered
“an
adequate
margin
of
safety
for
investors
to
compensate
for
future
downgrades
and
default
risks”.
At
this
moment,
however,
and
given
that
corporate
bond
spreads
have
continued
to
narrow,
we
believe
they
have
become
too
low
to
justify
exposure
to
this
asset
class.
Instead,
on
this,
investors
should
be
underweight.

Over
the
past
24
years,
the
Morningstar
US
Corporate
Bond
Index
spread
has
only
been
lower
than
the
current
spread
of
86
basis
points
for
2%
of
the
time.
Over
the
same
period,
the
Morningstar
US
High-Yield
Bond
Index
spread
has
been
lower
than
the
current
spread
of
302
basis
points
for
3%
of
the
time.
Spreads
on
investment-grade
and
high-yield
securities
reached
their
historic
lows
in
2007,
at
+80
and
+241
basis
points
respectively.

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