The same volatility that shook financial markets around the world, undermined equity valuations, and drove investors to safe-haven assets has left the US market so undervalued, even as many of the headwinds that featured so strongly during the turn of the year are also likely to be felt in the months ahead.
We wrote at the beginning of this year that stocks were overvalued and that four factors would restrict the growth of the market:
- Declining economic growth
- Monetary policy is getting tighter at the Federal Reserve
- Rising interest rates
- Inflation
The US Market Index is down 13.86% this year through the end of last month.
But we believe this selloff has taken the broad US equity market down too hard. After this decline, our measure of market valuation is now deep in the undervalued region. As per from a composite of the stocks monitored by equity research analyst team, the broad-based US equity market is currently priced 12% below its fair value.
In the New Year we observed that both core and growth were overvalued and that on relative basis value stocks were on better footing. Through the end of April, the US Value Index fell 2.08%, while US Growth Index fell 25.90% and US Core Index fell 12.09%. Currently, the value category trades at an 11% discount to fair value, and we still believe that it has strong economic tailwinds at its back.
But growth stocks have declined to the extent that this bucket is now selling at a 17% discount and now looks quite cheap for long-term investors.
At all capitalisation levels, the small-cap sector is the most undervalued, trading at a 21% discount to our fair value. The same holds true for large- and mid-cap, which is 12% and 11% undervalued, respectively. Large- and small-cap stocks have dropped about the same amount, off 14.34% and 14.27%, respectively, through the end of April. The mid-cap sector fell 11.96%.
Defensive sectors go overboard, growth sectors underdo it in flight to safety
During the market sell-off defensive sector still attracted investors but we believe in most cases investors attempt to insulate themselves from risk led them to bid up stock prices too high across these sectors. The Consumer Defensive Index, for instance, was up 2.31% in April and 0.97% year-to-date, one of just three sectors with a positive return this year. Conversely, on the Consumer Defensive sector, our price/fair value is 1.10, indicating it's priced at a 10% premium. It has now become the most overvalued sector in our coverage.
In April the Utility sector was down only 4.21% and is virtually flat for the year, up 0.08%. It’s similarly overvalued, in our view, at a 7% premium. We also believe the Utility sector would be the most adversely impacted if inflation remains higher for longer.
Lastly, the Energy sector only declined 1.66% in April but is up 36.17% year to date. And after coming into the year as the most undervalued sector, it’s now trading near fair value.
Diminishing pace of economic growth
In our 2022 outlook, we pointed out that US economic growth was decelerating from last year’s blistering pace as the economy emerged from the pandemic-induced freefall. And we now expect economic growth to slow far more than we previously predicted. At the start of April, Preston Caldwell, chief economist, reduced his forecast for US real growth domestic product to 3.5% from 3.7%, reflecting the impact from projected increases to the federal-funds rate.
Nonetheless, we still expect comparatively strong economic growth in 2023 and 2024. Our real GDP growth expectations are still above Wall Street consensus by about 2% cumulatively through 2025, owing to our more positive views on the supply side of the economy, especially labour force growth.
Watching for Federal Reserve tightening monetary policy
The biggest change in economic data over the past month is that the market now thinks that the Federal Reserve is going to tighten monetary policy more this year. The federal funds rate is likely to be at 3% at the end of 2022 and more than 3.5% by mid-2023. This will support the battle against inflation but will come at the expense of slightly slower growth in the economy in the near term. The Fed will also start to let the assets on its balance sheet roll off. They might start slow, but they will likely let the roll off of bonds get to a $95 billion per month run rate which would be more than a $1 trillion annualized run rate for removing liquidity from the market.
Rising interest rates
Following upward trends in April, interest rates steadily rose. In the short end of the curve, the 2-year Treasury yield climbed 42 bps to 2.70%, in the middle of the curve the 5-year climbed 49 bps to 2.91%, and in the long end the 10-year was up 57 bps to 2.89%. We still expect interest rates to rise this year. The five-year breakeven inflation rate is currently 3.21% and the five-year, five-year forward inflation expectation is 2.41%. We would expect to see the yield on the 10-year Treasury trade at a premium to the mean of these market implied inflation rates.
Higher for longer inflation
Our economics team raised its inflation forecast for 2022 to 4.5% from 4.2% because of higher energy prices as a result of the Ukraine war. We expect shortages and supply constraints to ultimately easing, providing further substantial deflationary impulses. We forecast five-year average inflation to be less than bond market expectations by around 0.7% a year. Our view is the bond market has massively overreacted to the short-term inflation pressures.
Insights from the first quarter earnings of FAANG+MT
No stocks receive as much investor interest as those of the FAANG (Meta Platforms, Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet stocks) plus Microsoft (MSFT) and Tesla (TSLA).
Meta Platforms
Guided by weaker-than-forecast first-quarter revenue and revenue guidance for the current quarter from Meta Platforms (parent of Facebook), we dipped our full-year projections modestly and decreased our fair value estimate 4% to $384. We consider this wide-moat name appealing since it trades around half our fair value estimate.
Meta’s first-quarter results were mixed, but what drew attention were the higher number of both monthly and daily active users, indicating that the firm’s strong network effect is still in place. Meta’s new strategy of monetising Reels, which today has much lower ad prices than its own ad inventory, contributed, in part, to a revenue miss for Meta as it dragged its user monetisation down a little on last year. But we are still confident that eventually Reels monetisation will increase as Meta makes more advertisers with its huge user base that spends more time consuming content on Reels.
Apple
After earnings, we reiterated our $130 fair value on Apple stock. Apple’s fiscal second-quarter results topped our estimates, despite challenges in the supply chain and an ongoing chip shortage, as sales of the company’s latest iPhone 13 and MacBook Pro propelled record iPhone and Mac revenue for the March quarter. But we think that the recent period of strong revenue growth will be hard to sustain as demand for Macs and iPads related to Covid-19 fades.
Amazon
After earnings, we reduced our fair value estimate 6% to $3,850 per share from $4,100. Although we expect improvement in the second half of the year, we reduced our growth and profitability estimates somewhat especially in the near term to reflect guidance and increased uncertainty.
Operating margin a worry with everything from inflation to labour and capacity excesses gnawing away at profitability which came just above the low end of guidance and well below our expectations. At the same time, second-quarter guidance is considerably below our model, because we believe profitability issues will persist for a few quarters, and possibly into next year. The highlight of results was strength in Amazon Web Service, which is benefiting from the continued migration of enterprise workloads to the cloud.
Netflix
We reduced our fair value 8% to $280 from $305 owing to subscriber growth being much lower in 2022 and slower margin expansion. Following earnings, the stock was pummeled and is now trading with enough margin of safety below our fair value that the stock rating moved into the 4-star category. This is the first time the stock traded below our fair value in more than 5 years.
Alphabet
Alphabet delivered a mixed bag in the first quarter. Revenue slightly under consensus estimates, while op margin and income beat. We reaffirmed our $3,600 fair value post-earnings. Robust search advertising and cloud growth was partly offset by higher-than-expected deceleration at YouTube. For the present quarter, management says the same dynamic of strong growth in search advertising being offset by greater-than-expected deceleration at YouTube will hold.
The ad revenue growth for YouTube was somewhat disappointing, but we feel the platform is still well positioned to monetise more content and viewers, even when competition has increased. We anticipate Q4 could mark the beginning of growth accelerating.
Microsoft
We maintained our fair value estimate of $352 following earnings. Despite some ongoing as well as new headwinds, Microsoft reported solid results across the board with revenue and earnings per share slightly ahead of our expectations. Digital transformation projects continue to drive overall demand and we are encouraged by strength in Azure. Microsoft continues to showcase its ability to grow as well as expand its margins on a large scale and we see more of that coming on both fronts.
Tesla
After Tesla’s earnings, we raised our fair value estimate to $750 from $700. The quarter was a further demonstration of our long-term thesis that Tesla could continue to raise prices as well as lower unit production costs and lower overhead expenses and thus drive higher profits.
More recently the stock had taken some heat after Elon Musk agreed to buy Twitter as investors worry that mudslinging done by Musk might take away some of his time running the Tesla company. But we don’t believe that Musk needs to micromanage the day-to-day operations, as it has proved it has a knack at ramping production and driving profitability from operating leverage. We believe Musk’s direct reports should be able to operate the different facets of Tesla as the automaker continues to scale vehicle deliveries, decrease unit production costs, and build self-driving software.
