Economic normalisation is on the horizon and getting closer every day.

Morningstar healthcare strategist Karen Andersen has long opined that herd immunity in the United States would be reached by mid-2021. In fact, as of March 16, according to the Centers for Disease Control and Prevention, almost 111 million doses have been administered in the US. As a result, approximately 22 per cent of the US population has had at least one dose and close to 12 per cent of the population has been fully vaccinated. The seven-day rolling average of daily vaccinations was 2.43 million per day and continues on an upward trend.

As the US approaches herd immunity over the next few months, we expect pent-up consumer demand will unleash a robust economic recovery in the second half of the year. Accounting for both the economic normalisation and the recently enacted fiscal stimulus program, we had recently raised our forecast for US gross domestic product growth in 2021 to 5.3 per cent, and we expect that economic momentum will help to support the 4 per cent GDP growth we project in 2022.

Yet, with the broad stock market back up to near all-time highs, in conjunction with our estimate that the broad US equity market is about 7 per cent overvalued, are there any stocks that still have room to appreciate?

Consumer demand to shift spending back to services from goods

Beginning this summer, we expect that a wave of pent-up consumer demand will be unleashed across the services sectors, especially among those services that had been shut down. During the pandemic, consumers had shifted their spending patterns to goods, but with the economy reopening, we expect to see consumers return to restaurants, bars, and sporting events.

In addition to the normal seasonal uptick in travel for summer vacation, we expect travel-related providers will see especially strong consumer demand for flights and hotels in the second half of this year. As we detailed in “Staying Home: How the Coronavirus Changed Consumer Behaviours,” we thought that in these hardest-hit sectors, the market had overreacted and pushed stock prices down too far. At that time, there were numerous examples of stocks with Morningstar Ratings of 4 and 5 stars.

After the market overreacted to the downside, it has quickly made up for lost time over the past few months. In fact, in many cases, not only have these same stocks risen back up to fair value but they have also become overvalued and are now rated as 1 or 2 stars.

Where there’s opportunity: We do think there are some stocks that still have room to appreciate as consumer services recover, including several beverage companies. With patrons returning to restaurants, sporting events, and other public venues, we think 5-star Anheuser-Busch InBev (BUD) and 4-star Coca-Cola (KO), Molson Coors (TAP), and PepsiCo (PEP) each have upside appreciation.

Back to the malls: demise of in-person shopping exaggerated

We highlighted that the pandemic had accelerated the trend toward e-commerce, and we still continue to expect e-commerce to grow as a percentage of sales over time. Yet, as the pandemic subsides, whether it’s due to consumers’ demand for instant gratification, immediacy of need, or just the social aspect to in-store shopping, we expect that consumers will return to stores. The intensification of online retail sales has forced retailers with physical stores to accelerate the development of their own competitive online presence and merge it with their store base (known as "omnichannel").

What we have found is that in-store pickup has been highly popular during the pandemic, as it offers a speed of fulfillment unmatched by home delivery. In addition, many retailers have been focusing on revitalising their physical presence to provide a combination of service, convenience, and experience that will bring shoppers back in the doors.

While we continue to expect that there will be changes in how real estate is utilised over time, we don’t think that the shopping mall is dead. The shift in purchasing habits will have a significant impact on the overall brick-and-mortar and mall-based retailers, but we expect that the worst impact will be concentrated among lower-quality malls. In recent years, malls have been moving away from relying on the power of their location and making their sites more “experiential”--for example, by revamping closed stores for use as restaurants, physicians’ offices, exercise facilities, and other experiences that cannot be replicated online.

Where there’s opportunity: We expect that over the long term, higher-end mall REITs such as 4-star rated Simon Property Group (SPG) and 5-star Macerich (MAC) will maintain their ability to drive foot traffic and, therefore, be able to both preserve their strong tenant base as well as attract e-tailers looking to establish a physical presence.

Energy demand to rebound

After being left for dead for most of 2020, oil prices have surged higher over the past two months as the market prices account for an increasing demand for gasoline, diesel, jet fuel, and other petroleum products. Although oil prices traded in the $40 per barrel area for much of last summer and fall, we had held our midcycle oil price forecast steady at $55 per barrel on our expectation that the decline in new drilling would lead to lower supply and thus require higher prices to prompt drilling to return.

For the year to date, the price of oil has surged almost 40 per cent, rising as high as $66 per barrel.

Where there’s opportunity: As such, we continue to think that many oil producers are undervalued, such as 4-star Exxon Mobil (XOM). Among the smaller, regional oil producers, we think both Cabot Oil & Gas (COG) and EOG Resources (EOG) remain undervalued.

Further, we expect that the rebound in oil prices will spur new drilling and exploration as oil becomes profitable again for many producers. Companies such as 5-star Schlumberger (SLB) and 4-star National Oilwell Varco (NOV) will benefit.

Economically sensitive cyclical companies will flourish

As the economy ramps up in the second half of the year, cyclical companies whose earnings are the most tied to the economy will experience significant earnings acceleration. However, the market has already anticipated this impact, and the stock prices for those companies have skyrocketed over the past few months.

Where there’s opportunity: Two companies we continue to rate as 4 stars that should benefit from the economic rebound include Air Products & Chemicals (APD) and DuPont (DD).

In the industrial gas sector, demand for industrial gases is strongly correlated to industrial production, increasing roughly 1.2–1.4 times global industrial production growth. In addition to benefiting from an accelerating economy, we think DuPont is well positioned to capture profit growth from secular trends in the coming years. For example, DuPont is also exposed to the electrification of vehicles in all of its divisions as the company generates over 50 per cent more revenue per vehicle for an electric vehicle than for an internal combustion engine vehicle.

Where the pendulum has swung too far into overvaluation

Earnings growth will appear exceptionally strong across many sectors for the next few quarters; however, investors will need to be choosy about which of those stocks they invest in. The prices of those promising companies’ stocks have surged this quarter--in some cases beyond fair value to being significantly overvalued. In those cases where we think the stocks are overvalued, it appears that the market is over extrapolating the near-term rebound in growth too far out into the future. An investment in those overvalued stocks will be risky in the second half of 2021 and early 2022 because the expectations are so high. Any disappointment could cause those stocks to quickly give back their recent gains.

Two sectors indicative of this risk are the cruise lines and hotels.

We rated the cruise lines stocks either 4 or 5 stars as recently as last fall. Since then, those stocks have surged as the market prices in the expectation that cruising will soon resume.

  • Norwegian Cruise Lines (NCLH), a 3-star stock, is only trading a little over our fair value.
  • Carnival (CCL) and Royal Caribbean (RCL), both 2-star stocks, are trading 40 per cent to 50 per cent over our fair value after doubling in prices.

In the hotel sector, stock prices initially fell off a cliff last March, but we had lowered our fair values only slightly to account for the impact of the pandemic in 2020. Over the past three months, stocks for hotel companies have surged and are trading back to about where they were pre-pandemic.

  • Both Hyatt Hotels (H) and Marriott International (MAR) are overvalued and rated 2 stars, while Wyndham Hotels & Resorts (WH) is fully valued and rated with 3 stars.
  • TripAdvisor (TRIP) was rated with 4 stars as recently as last November, but after surging over 200 per cent since then, it is now significantly overvalued and rated as 1 star.

In the retail sector, stocks for those companies with significant in-person store locations have surged since emergency-use approvals were issued for the vaccines. In many cases, these stocks that were undervalued just a few months ago have risen to fair value or, in other cases, are now overvalued.

  • Macy’s (M) stock, which was rated as 5 stars as recently as November, has risen all the way back up to pre-pandemic levels and is now overvalued and rated as 2 stars.
  • Kohl’s (KSS) was also a 5-star stock in November and has surged to the point it is now rated as 1 star, as it is trading higher than where it began 2020 and is overvalued by almost 60 per cent.
  • Nordstrom (JWN) was rated 5 stars last August and has since appreciated to the point that we rate it with 2 stars.

How will the stock market price in the economic rebound?

The US stock market is in the midst of pricing in a strong economic rebound this year. Through March 15, US stocks have already appreciated 6.61 per cent. However, the overall gain has been heavily weighted toward those sectors and companies that were most negatively affected by the pandemic and will realise the greatest amount of earnings growth. For example, stocks in the value category have risen 13.33 per cent as compared with the growth category, which has only risen 1.76 per cent.

While there are still a number of undervalued stocks that we rate 4 and 5 stars, most of the stocks for those companies that will benefit the most from economic normalisation have already run up in price. In fact, in our view, the broad market remains slightly overvalued with only a few pockets of undervaluation left. As opposed to broad swaths of undervaluation concentrated in those sectors that will rebound later this year, most of the remaining stocks that we rate 4 or 5 stars have idiosyncratic characteristics that we think cause them to be undervalued in today’s market.