US stocks are trading at a rarely seen discount

US equities may have rebounded after brushing up against a bear market, but by our calculations, the broader stock market remains well in undervalued territory.

As of May 31, 2022, the price/fair value ratio of a composite of stocks covered by our team of equity analysts was 0.87 times. Since 2011, on a monthly basis, there have only been a few other instances where markets have traded at such a significant discount.

The current level of undervaluation is the biggest discount to fair value since the lockdowns began in March 2020 and the growth scare that drove stocks higher 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, when there were fears that the Greek debt crisis could spread to other countries. (Portugal, Italy and Spain) – and that the systemic risk of the European sovereign debt crisis was spreading to the European banking system.

Markets were also close to this level in mid-2015/early 2016 when US equities fell as slowing economic growth in China and falling oil prices weighed on market sentiment.

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Markets were very volatile in May as stocks fell for most of the month and even reached bear market territory during intraday trading on May 20. However, almost immediately after breaking through the “official” bear market marker of a 20% peak decline, stocks rallied as bargain hunters emerged.

Although we weren’t surprised by the market pullback earlier in the year, when markets were overvalued at the start of the year, we think the pendulum has swung too far the other way. We think US equities are significantly undervalued for long-term investors.

Where are stocks undervalued?

At the start of the year, we noted that the value category was the most attractive and that both core stocks and growth stocks were overvalued. Value stocks held up best during the selloff, with the Morningstar U.S. Value Index rising 0.97% year-to-date through May. Most of the sales were in the growth category; the Morningstar US Growth Index fell 28.39%.

Losses in the core equity category split the difference, with the Morningstar US Core Index falling 12.85%.

Based on our valuations, the growth class is now the most undervalued, trading at a 19% discount to our fair value, followed by the value class at an 8% discount and then the core class at a discount of 6%. Across cap levels, we continue to see the best opportunities among small cap stocks (19% discount), followed by large cap stocks (13% discount) and mid cap stocks (11% discount ).

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What will the summer months bring?

Although we calculate that the market remains undervalued for long-term investors, we also expect volatility to remain elevated over the coming months.

In our Outlook 2022, we noted that there are four main headwinds the market is likely to face this year. Each of these headwinds is hard enough for markets to navigate – and right now, we’re in the middle of the convergence of all four happening at once. Volatility is unlikely to subside until the market clears up over the next few months.

Slowdown in the economic growth rate

We recently lowered our economic growth projection in 2022 to a 3.0% increase in gross domestic product growth of 3.5%, and lowered our projection for 2023 to 2.2% from 3.0%. However, although the rate of economic growth may be slower, we continue to believe that the likelihood of a near-term recession is relatively low.

Monetary policy tightening

Following the release of the May 2022 Federal Reserve meeting minutes, stocks rebounded strongly as investors perceived the minutes to be less hawkish than expected. The market continues to expect the Fed to raise the fed funds rate by half a percent at each of the next two meetings. However, at that time the Fed will be able to reassess its outlook for inflation and economic growth and determine its path for future rate hikes. If inflation declines or the economy slows, the Fed could either slow down or suspend further rate hikes. If inflation remains stubbornly high, the Fed could maintain its hikes of 50 basis points.

Hot inflation

In addition to lowering our forecast for economic growth, we also raised our inflation forecast to 5.2% of the personal consumption expenditure index, from 4.5% this year. Although the current inflation rate remains elevated, we continue to expect inflation to begin to moderate in the second half of this year as supply chain disruptions ease and inflation eases. will encounter high year-over-year comparisons. We expect inflation to moderate further in 2023 and fall below 2%.

Rising interest rates

Year-to-date, the 10-year US Treasury yield rose 1.42 percentage points to 2.93% as of May 31. While long-term interest rates are expected to rise further during the year, the preponderance of the increase has probably already taken place. The next test for the bond market begins this month as the Fed begins to reduce its bond holdings. With the Fed no longer reinvesting proceeds from maturing bonds, the bond market will have to absorb this additional supply.

High quality companies, big discounts

Much of this year’s sale has been relatively blind in that even high-quality companies, such as those with broad Morningstar Economic Moat Ratings, have declined.

Companies rated with wide economic moats are those that have long-term sustainable competitive advantages that will allow them to generate returns in excess of their cost of capital. These companies are in the best position to weather any potential economic disruption and generally have the most pricing power.

There were eight wide-moat stocks whose Morningstar ratings moved into 5-star territory. Of the 238 companies we rate with a wide moat that trade on US exchanges, there are now 27 with a 5-star rating; at the end of 2021, there were only nine left.

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What to do now?

In these types of market environments, it is especially important for investors to have a plan that balances their long-term investment goals with their tolerance for risk.

This plan should also 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 stock market is undervalued, we believe now is not the time to reduce exposure but to increase wisely – especially in high-quality companies – by based on your investment plan and objectives.

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Garland K. Long