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Pullback brings stocks closer to fair value

Dave Sekera, CFA  |  04 Sep 2020Text size  Decrease  Increase  |  
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After hitting a new all-time high Wednesday, the Morningstar US Market Index dropped 3.58 per cent Thursday, the largest single daily decline since 11 June.

We have checked with several market participants and reviewed our intraday indicators and charts but did not find any specific catalyst that would instigate such a significant one-day sell-off. While single-day declines of such magnitude are generally unusual (over the past decade, there have been only 18 times the market has sold off this much in a day), we are not surprised by this market pullback.

Based on the fair value estimate of the stocks that Morningstar equity analysts cover, the price/fair value metric of the median stock that we cover had risen to 1.08 on 2 September. This indicates that across our coverage universe, we considered more than half the stocks to be overvalued.

Since we began calculating this metric in 2007, there have been only a few other times that our fair value indicator has been this overvalued. In January 2018, this metric hit 1.11 prior to a 10 per cent market correction over the next three months; more recently, the metric had risen to 1.06 in January 2020.

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Source: Morningstar Direct

There was no new news today that appeared to serve as the catalyst to the sell-off. Economic metrics released this morning were either slightly better than expected or in line with consensus and continue to indicate that the economy is healing. Although still higher than in April, the number of reported new daily cases of COVID-19 remained on a generally downward trend since mid-July. No new data was released regarding the vaccines currently in or entering Phase III trials.

We are past the second-quarter earnings season, so there were no negative earnings surprises. It is too early in September for companies to start providing warnings if they are going to miss their third-quarter estimates. The market movement today just seemed to be one of those days in which selling beget more selling and few investors were willing to step in to start buying until prices had dropped substantially.

The bulk of the sell-off occurred within the technology sector, which dropped 6.08 per cent today. In our view, after being the best-performing sector thus far this year, technology is the most overvalued space within the index. According our price/fair value metric, the median stock in the tech sector was 1.24 times overvalued on 2 September. Not only is it the most richly valued of all the sectors we cover, but neither it nor any other sector has ever traded at such a high price/fair value since we started calculating this metric in January 2007. Within the tech sector, for US-listed companies that we rate, there are 56 firms that we believe are overvalued and have rated 1 or 2 stars (out of 5 stars); whereas there are only 11 stocks that we think are undervalued and rate 4 or 5 stars.

As an example of some of the companies we think are overvalued, we currently rate Apple (AAPL) with only 1 star. Our fair value estimate for the stock is $71 per share; even after falling 8 per cent today, the stock closed at $120.88, resulting in a price/fair value of 1.7. Similarly, our fair value for Adobe (ADBE) is $350, as compared with the market’s closing price of $507.80.

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Source: Morningstar Direct

Today’s pullback has brought stocks back closer to being fairly valued for long-term investors. While the market remains overvalued, we continue to see significant value within other sectors and companies. For example, the price/fair value for the energy sector is only 0.62. Since 2007, the only other times this sector has appeared so undervalued was during the market rout earlier this year and during the depths of the global financial crisis in late 2008.

Based on our outlook for energy demand to recover post-pandemic and our forecast for oil prices to rise to $55 per barrel by the middle of the next economic cycle, we see significant value in this sector. For example, within the energy sector, for US-listed companies we rate, there are 53 firms that we believe are undervalued and have rated 4 or 5 stars; whereas, there is only one stock that we think is overvalued and have rated 2 stars.

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Source: Morningstar Direct

While our price/fair value metric has helped identify periods in which the market has swung too far one way or the other, we caution that it not a tool to try to time the market. Valuations can remain high or low for prolonged periods before they revert to normalised levels. We do think it is a useful gauge among many to help long-term investors balance risk and reward within their portfolios.

is a senior securities analyst with Morningstar.

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