Can Equity Markets Continue To Rally This Year Even Amid Signs Of Slowing Growth?

Equity markets have had a strong year so far, with the S&P 500 up 17% and the Nasdaq Composite up more than 30%. David Sekera, Chief U.S. Market Strategist with Morningstar Research, looks at some of the big drivers and whether stocks can continue to move higher.

Transcript

Greg Bonnell: Well, it was a choppy summer for the equity markets, but the S&P 500 is still close to being up 16% this year on the strength, of course, of a few big tech stocks. So where could things go from here?

For more on that, we're joined by David Sekera, Chief US Market Strategist with Morningstar Research. Always great to have you on the program. We got summer behind us now, or at least the summer vacation system. It was a choppy one, but still a fairly healthy run for the year. Where do we think we go from here?

David Sekera: Well, good afternoon, Greg. Good to see you again. So it has been a strong year, choppy the past couple of weeks, but through last night, the Morningstar US Market Index -- that's our broadest measure of the market -- goes up 17.4%.

Now, I would note, that is coming off of what we thought were very undervalued levels at the beginning of the year. At this point, we do still think that the US market remains slightly undervalued. However, I do want to caution investors. I do think that returns over the remainder of this year are going to be much more muted, and in fact, I'm also concerned that we might see a bout of volatility, later half of October, maybe beginning of November.

And the reason for that is the US economy has been much stronger than expected this year, even our above-consensus estimates, I think, ended up being a little bit too low. But tight monetary policy is going to take its toll.

At this point, our base case is that the rate of economic growth in the US will start to slow here in the fourth quarter. So my concern is that when management teams start giving out their third quarter earnings and start giving guidance for the fourth quarter, maybe even start talking about 2024, I think the market might be disappointed.

Greg Bonnell: OK. So perhaps some turbulence ahead. Of course, what's got us to this point, despite some of the chop over the past couple of weeks as you pointed out, were the Magnificent Seven. Right? There's been a lot of talk, and it's not uncommon when you see a market rally talking about the lack of breadth. So let's go through the Magnificent Seven in terms of the run that they've had and where they might go from here.

David Sekera: Yeah. So through the end of the August, those seven stocks, they account for over 60% of the total market gains, year to date. So according to our valuations, six of those seven that comprise the Magnificent Seven were very significantly undervalued coming into the year. All of them have run up very substantially since then.

So at this point, one of them is still undervalued, but looking at the rest of them, five are now what we consider to be fair value territory. And one has actually just moved up too far to the upside in our view, and that's now well into overvalued territory.

Greg Bonnell: Now, those big names, those big tech names in the Magnificent Seven, obviously, they can push around that top line number in the S&P 500 on the NASDAQ, but what about the potential for more breadth in the market? If they've been getting all of the attention from investors, is there a chance for it to widen out?

David Sekera: That's what we do think. Yeah. I think we started talking about that in our June market outlook. That really, for the market rally to continue from here, it does need to broaden out into the wider market.

So from a valuation standpoint, looking at the Magnificent Seven, for the most part, I think those stocks have run their course, and in fact, when I look at the charts, I suspect I think a lot of those are actually just running out of steam at this point. So I do think we will see an increase in the market breadth going forward.

Greg Bonnell: Let's talk about then if we're seeing an increase in the market breadth, it would suggest that perhaps there are some areas of the market that could be undervalued and perhaps overlooked because of NVIDIA (NVDA) and Apple (AAPL) and all those other big tech names.

David Sekera: I would highlight value stocks. They have significantly lagged on the market rally thus far this year. In our view, that's where we see the most attractive opportunities for investors today. We also see good value in the mid-cap and the small-cap space. Both of those have lagged behind this year as well.

For people that are looking for investments in specific sectors, I would highlight communications, real estate, financials. In our view, those all remain undervalued.

Another one I'd highlight is utilities. Utilities got hurt pretty bad last month with the rise in interest rates, and that's one area that it's now getting beaten up enough, I think that's starting to look attractive as well. Then, on the other side of the coin, I would highlight technology. That is a sector that we think is slightly overvalued at this point in time.

And I think now's a good time for investors, take a look through your portfolio. You'll look through for those stocks that are overvalued and overextended. I think now is going to be a good time to lock in some profits on those type of names, and then the other two I'd highlight would be the energy and the industrial sector. Those are both pretty fully valued at this point, and I do think that both of those could be in some trouble if we do have a fourth quarter sell-off once the economy begins to slow.

Greg Bonnell: Yeah. You mentioned energy. That's interesting because I feel like the sector just sort of started taking off over the last little while. It sounds like it made up a lot of ground in a short period of time.

David Sekera: Yeah. So with the energy sector, I think you have to look past what oil prices are doing in the short term. You really need to think about what oil prices are going to do over the course of a full economic cycle. So while we do agree with the market that oil is tight right now, that's going to keep oil prices high here in the short term.

When we start looking out over the next 5, 7, 10 years, we think oil prices will be coming down. We do think that, towards the latter half of decade, with electric vehicles becoming a greater and greater portion of new vehicle sales, as well as the number of cars on the road, we do expect that, by the end of this decade, we'd start seeing a decrease in oil demand. We also expect an oil supply to come up.

Just a lot of companies have been spending too much on shareholder returns, spending a lot of money on dividends, spending a lot of money on share buybacks. I think they're going to start looking more towards growth, start doing some more exploration, production over the next few years.

Greg Bonnell: Let's talk -- you mentioned briefly off the top about we could be in for a bit of a bumpy ride as we get further into the fall and head towards the winter. So let's talk about the third quarter earnings. What's the expectation there?

David Sekera: Yeah. Third quarter earnings, I think they're actually going to look pretty good. The economy is holding up much better than anyone, ourselves included, had expected. In fact, our economics team, they just bumped up their third quarter GDP estimate.

So again, I think the risk this fall isn't going to be that companies fall short of third quarter earnings, but really the guidance that the management teams provide and the tone that they set for 2024.

Greg Bonnell: So is that the overwhelming factor? It's one thing to come out and say, hey, look at the three months that are behind us, and we did perhaps better than the market was expecting, depending on the company, but looking ahead, we're not too sure. But I feel like we've been in that sort of narrative for a while. Companies keep saying, looking ahead to this recession that hasn't shown up yet, that hasn't shown up yet.

David Sekera: Yeah, and that's also been our forecast as well. Earlier in the year, we thought the -- and again, we're not in the recession camp. Our base case is still no recession. We've been advocating the soft landing, I think since towards the end of last year. But again, when you start thinking about what's going on out there, we have high interest rates, in fact, the highest interest we've had since the global financial crisis.

Banks are definitely pulling in lending. So I think that's all going to really combine in order to soften the economy later this year. In fact, we think that there's going to be three sequential quarters of softening over the next three quarters.

Getting to the second quarter of 2024, which is where we kind of expect the economy to get to almost stall speed but not stall out. And then it won't be until the second half of 2024 that we look for the economy really to turn around and start moving upwards again. Having said all that, our GDP forecast for 2024 right now is only 1.4%.

Greg Bonnell: So if that's the macroeconomic conditions and the slowdown in the economy, if that comes to pass, what does the Fed do with that information? The big question we always get is, when do the central banks start cutting after all this?

David Sekera: Yeah, and we think the Fed is done. We've noted that for a couple of months now. We think that their job is done. They've hiked interest rates enough that they will start flowing through the economy. We also think inflation will continue to keep moderating over the course of this year. We think by early next year, Fed will get inflation down to that 2% target. And in fact, when we look at all of 2024, our economics team thinks the average inflation rate next year will actually be slightly below their 2% target.

So I think that combination of economic slowing, as well as inflation continuing to come down, not only is the Fed not going to raise rates over the next couple of months, I think that actually sets them up for, sometime in the first quarter next year, to turn around and start cutting rates.

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