During the fourth quarter, equity prices continued their march higher. Quarter to date through 21 December, the Morningstar US Market Index rose 12.78 per cent and year to date has increased 19.37 per cent.

By aggregating the fair value estimates of the stocks in our North American coverage, we view the broad market as overvalued, trading at a 6 per cent premium to the capitalisation-weighted calculation of our intrinsic value estimates. Much of the broad market-cap-weighted valuation is upwardly skewed by several significantly overvalued mega-cap stocks; even so, the rally this quarter has left far fewer pockets of undervaluation. 

Across our North American coverage, only 18 per cent have 4- or 5-star ratings. Analysing our sector coverage, only energy remains undervalued. Breaking the market down by the Morningstar Style Box reveals that only value stocks remain undervalued, especially within small-caps.

  • Trading at a 6 per cent premium to our fair value estimates, the US equity market is priced for perfection.
  • Energy is the only sector that remains undervalued, and value stocks are only category in the style box that are undervalued.
  • At a price/fair value of 1.20, technology remains the most overvalued sector in our coverage, as there are no 5-star-rated stocks and only 12 4-star stocks, accounting for less than 12 per cent of our coverage.
a chart showing Morningstar valuations

Priced for perfection

Markets often act like a pendulum, with momentum swinging prices past their fair values, both to the downside as well as to the upside. Earlier this year, our price/fair value metric fell to almost its lowest level in a decade, indicating that the market was significantly undervalued. Since the market bottom in March, price/fair value ratios steadily rose with the recovery in the equity markets. After the recent surge in equity markets during the fourth quarter, the broad equity market in the US is now trading 6 per cent above our intrinsic value. In our view, the market is priced to perfection. We forecast that GDP will rise 4.7 per cent in 2021, 2.9 per cent in 2022, and will return to almost its prepandemic trend by 2024; however, to justify the prices that many stocks are currently trading at, investors appear to be pricing in even stronger assumptions.

a chart showing mid-cap sector undervalued stocks

Quarter to date through 21 December, the Morningstar US Market Index had surged 12.78 per cent. Performance was led by small-cap stocks, which rose 28.78 per cent compared with mid-cap and large-cap stocks, which gained 18.22 per cent and 9.70 per cent, respectively. With a return of 15.55 per cent, the value category outperformed growth and core, which gained 12.13 per cent and 11.40 per cent, respectively. Gains have been broadly distributed across sectors, but energy has been the star this quarter, rising 29.02 per cent. Yet, even after this surge, at a price/fair value of 0.71, we continue to view the energy sector as the most and now only sector that remains undervalued.

a chart showing mid-cap sector undervalued stocks

Looking ahead, we maintain our expectation that value stocks will outperform core and growth over the long run. Value stocks should benefit from the strong economic rebound in 2021 as economic activity normalises. Across sectors, we continue to expect energy stocks to outperform the broader market. Through 21 December, oil prices have risen to US$48 per barrel from US$39 at the end of the third quarter, and we project oil will reach US$55 per barrel by the middle of this economic cycle.

a chart showing value stocks compared to growth stocks

The greatest near-term risk to the markets would be a hiccup in the approval, rollout, or uptake of a coronavirus vaccine. Among individual stocks, many mega-cap stocks are significantly overvalued. Any failure to meet high investor expectations could not only send these stocks down but pressure overall market sentiment. Finally, surging economic activity could lead to idiosyncratic bouts of cost inflation, pressuring operating margins if a company does not have pricing power. In such an environment, companies with a wide or narrow moat are expected to be able to quickly pass through heightened costs to customers.