Quarterly Market Outlook: North American Stocks Only a Little Overvalued
The broad equity market is trading at a 3% premium to our fair value estimates.
Based on the capitalization-weighted intrinsic value of the stocks we cover in North America, we view the broad equity market as 3% overvalued. Some undervaluation remains, but opportunities are shrinking and highly idiosyncratic. Across our North American coverage, only 14% of stocks had 4- or 5-star ratings compared with 18% at the end of 2020. Just one year ago, 67% were rated 4 or 5 stars as markets overreacted in the early throes of the pandemic. Since the beginning of 2005, only 20% of the time have we had as low of a percentage of stocks that we rated as undervalued. By sector, energy remains the most undervalued by far, followed by utilities and communications. In the Morningstar Style Box, both the large- and small-cap value categories are modestly undervalued.
Less Than 15% of Our North America Coverage Trading at 4- or 5-Star Ratings - source: Morningstar
Close to Fairly Valued
Last quarter, we highlighted that several overvalued mega-cap stocks were skewing the market valuation higher. Of the 12 largest overvalued mega-cap stocks, eight declined this quarter. The combination of declining prices in these stocks and increases to our fair values have brought the market much closer to fair value. Many of our fair value estimates were lifted to account for the increase in our economic outlook for 2021 and 2022 and to incorporate stronger earnings expectations. In last quarter's outlook, we also noted that according to a composite of our valuations, value stocks were significantly undervalued at the end of 2020 compared with the rest of the market and small cap stocks were cheaper than large- and mid-cap stocks. After outperforming this quarter, value stocks are only 3% undervalued and small-cap stocks are now 5% overvalued. Generally, undervalued stocks have become much more idiosyncratic and less correlated to category valuation.
Morningstar US Market Index posts strong gains QTD and YTD - source: Morningstar
After lagging growth stocks for the past few years, value stocks finally outperformed. Through March 26, the Morningstar US Value Index surged 13.39% compared with the US Growth Index, which declined by 0.53%. Overall, value stocks generated the most gains, as the broad US Market Index rose 5.98%. Similarly, small-cap stocks, which were left behind in 2020 as investors were concerned about their ability to survive the pandemic, outpaced large-cap stocks. The US Small Cap Index rose 11.87% so far this year, whereas large-cap stocks increased only 4.68% and mid-cap stocks rose 8.28%.
Value stocks remain slightly undervalued - source: Morningstar
The broad U.S. market is overvalued by only 3%. We continue to expect that value stocks will outperform core and growth over the long run. Value stocks should benefit from the strong economic resurgence in 2021 and 2022. But following the strong outperformance in the first quarter, we no longer expect small-cap stocks to outperform. Comparatively, large-cap stocks are less overvalued than mid- and small-cap stocks.
Undervalued stocks hard to find across any market capitalizations - source: Morningstar
Even after it surged 34.71%, we continue to see value in the energy sector. At a price/fair value of 0.82, it remains the most undervalued by far. In other sectors, utilities and communications are slightly undervalued. After significant underperformance and incorporating some fair value increases, the technology sector is no longer as overvalued as it was at the end of last year. The most overvalued sectors are the two most economically sensitive, basic materials and industrials, where we think investors are extrapolating near-term growth expectations too far ahead.
Value stocks attractive compared with core and growth stocks - source: Morningstar