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What's Undervalued Today?

We take a look, sector by sector.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The stock market continued its upward trend during the summer. How do things look as summer collapses into fall? Joining me today to discuss the current market environment is David Sekera. Dave is Morningstar's chief U.S. market strategist.

All right, Dave, let's jump right in and begin by talking a little bit about how the market performed during the summer. What did returns look like?

David Sekera: Well, returns were actually really good this summer. So I'd say the old adage, "Sell in May and go away" certainly wasn't correct this year. So just looking at the Morningstar U.S. Equity Index, we went up 8% from the end of April through the end of August. And considering we're up 20% year-to-date, that's a pretty substantial amount of those percentage of the returns.

Dziubinski: Now, the technology sector in particular did really well during the summer. I think gains were in excess of 15%. What drove that performance? And how do we think valuations look with tech stocks right now?

Sekera: Well, there's a couple of different things going on in the tech sector which really drove those returns. So, first of all, second-quarter earnings generally were pretty strong across the entire sector. And we're looking at pretty strong returns again, here, coming up in the third quarter. Now, tech did have a little bit of a tough time at the beginning of the year when interest rates were going up. However, with interest rates actually coming back down this summer, that took a lot of the pressure off of what we consider to be those long duration stocks, those growth stocks of which technology has a lot of those names in there as well. So, with that pressure being off, that certainly helped the sector as well.

But as you mentioned, it's really only been the past two months that most of the returns this year in the tech sector have really occurred. And I think part of that, too, is just looking at the delta variant and the surge in new cases that we've seen over the past two months. I think a lot of investors are taking out that 2020 playbook and reinstituting that a little bit where they've probably been scaling back in some of those names which could be harmed if we continue to do have more cases coming up--again, those typical names being in restaurants, retail, hospitality type names--and then reinvesting those proceeds back into the technology sector. Again, the sector did very well last year during the pandemic.

Dziubinski: And then how do valuations look in general with technology and across the board? What do we think--is the market overvalued today?

Sekera: Yeah. In the technology sector, specifically, we do think that there is a little bit of overvaluation there. And to some degree, I think it's just that investors are looking at those strong earnings in the second quarter and the third quarter, and probably overextrapolating that strength too far into the future. Now, having said that, there are certainly still names that we do think are undervalued in the technology sector. Two that I would recommend investors to take a look at would be Intel (INTC) and Salesforce (CRM).

Dziubinski: And then how about the broad market overall? Where do we think valuation is there--overpriced?

Sekera: Based on the composite of all the fundamental analysis and the equity research from our equity analyst team--putting that together, we do think the market is probably about 5% to 7% overvalued at this point in time. Now, having said that, you know, it's not like we necessarily think that there's going to be a market correction coming up this fall, but I would say that investors should probably temper their expectations for what returns might look like in the broad market over the next six to 12 months.

Dziubinski: Dave, real estate stocks had a really good run over the summer, but we think as a group that they're overvalued right now. What's going on there?

Sekera: That's correct. You know, we do think that real estate has run up too far, too fast here. But having said that, you know, there are pockets of undervaluation that we do see in the real estate market. A couple of the reasons I think real estate ran up is one--interest rates did come down a bit this summer. And again, interest rates are very much a big part of how you do valuation in the real estate market. So as investors have been looking at cap rates, which are your underlying interest rates, plus a spread for the risk in the real estate market, as those came down, those prices have been running up. Now, in addition to that, in the real estate market, oftentimes investors look at that as being a good long-term inflation hedge. Just because, as inflation goes up, you're able to push through higher prices on your tenants over time. So I think the combination of those two things has helped push that sector higher.

Now there are still some names there we do think are undervalued, that have lagged, the overall real estate sector and of course those are going to be the names that are going to be most impacted by the resurgence in the pandemic we've seen over the past two months. In more of the retail, restaurants, hospitality space, one name there that we think is undervalued would be Macerich (MAC), which has a lot of Class A malls in its portfolios. Another one in the hotel space that we would look at is going to be Park Hotels PK. And then, finally, another one that is interesting would be Vornado (VNO). So Vornado actually has a real estate portfolio of high-quality office space in New York, which still is in its recovery stage.

Dziubinski: Now another area that we think is overvalued is basic materials. But basic-material stocks in general didn't have that great of a summer. Let's talk a little bit about that group.

Sekera: Yeah, the basic-materials sector actually really outperformed earlier in this year. And I think a lot of that was just in conjunction with all the infrastructure spending that they're talking about in Washington, D.C., you know, the American Jobs Act, which I think had over $2 trillion worth of infrastructure spending in there. And so we saw a lot of interest in that basic-materials space. And also, just as an inflation hedge, again, in the basic-materials space, specifically commodities, you know, do hold up over time in an inflationary environment. So again, while we're not necessarily concerned about inflation lasting past this year, we expect it probably goes down toward a 2% long-term run rate after this short-term bump that we've seen. Again, a lot of investors that are concerned about inflation being persistent and lasting longer have certainly moved into that space as well. So really, where we see undervaluation in the basic-materials space are going to be in those names that actually aren't leveraged to infrastructure, because again, those names have already ran up earlier this year. Two there that I'm interested in and recommend investors to take a look at would be Compass Mineral Holdings (CMP) as well as Air Products (APD).

Dziubinski: And now we'll look at the opposite side of things with sectors, let's look at a couple that we think are, in general, undervalued, first of which is energy. We still think that area is undervalued.

Sekera: Yeah, so energy was just punished in 2020. Again, with the shutdowns, the demand, a decrease in travel, energy prices in and of themselves went down. In fact, I remember when oil hit a negative price last year, which certainly has never happened before. And generally, you know, the energy sector has certainly recovered. But at this point, we still think that energy is probably the most undervalued sector of all the different sectors that we cover. So we do still see a lot of upside potential for investors. Now, here in the short term, they have pulled back this summer. And again, that's going to be in correlation with the pandemic and the cases coming back, but again, for long-term investors, even if we do see, maybe some more shutdowns, maybe a decrease in demand for travel. We still think there's enough margin of safety in the sector and in most of those names. The investors should take a look there. Again, two names there that I would recommend taking a look at would be Exxon (XOM) as well as ConocoPhillips (COP).

Dziubinski: And then, lastly, the communication services sector looks undervalued, but there's a caveat there, right?

Sekera: There is. In the communications sector, the two names there: You have Alphabet (GOOGL), which makes up 30% of our index, is certainly going to skew the market-capitalization-weighted average of the entire sector. And so Alphabet, we believe it's trading probably about 10% below our fair value estimate at this point in time. And then Facebook (FB), that also makes up another 15% of the weight of the index. Facebook is probably trading somewhere around 8% below our fair value. Between those two names, that certainly skews the overall market valuation. And, however, I'd say those are both names that I think investors should take a look at today. Having said that, there are a couple of other names in there more in the traditional communication side. AT&T (T) would be one that we think is undervalued today, and then in more of the communication/media area, we'd recommend investors taking a look at ViacomCBS (VIAC).

Dziubinski: Well, Dave, thank you so much for your time today and for this sector perspective. And of course, everyone always appreciates a few stock ideas, too. Thank you.

Sekera: Thank you.

I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.