US stocks may have bounced back from a near bear market, but by our estimations, the broad equity market is far into undervalued territory.
On May 31, 2022, a composite of the stocks covered by our equity analyst team was at 0.87 times price/fair value. “Since 2011, there have been only a handful of other months where the markets have traded to such a deep discount versus our intrinsic valuation.”
This level of undervaluation is the largest discount to fair value since the initial onset of the pandemic in March 2020 and the growth scare that brought stocks down in December 2018.
On a longer historical horizon, the only other occasion our price/fair value measure was lower was in the autumn of 2011, when fears of possible contagion from the Greek debt crisis spreading to other countries (Portugal, Italy, Spain), and systemic risk from the European sovereign debt crisis having infected the European banking system. The markets were around this level in mid 2015/early 2016 when US equity markets were in decline as deteriorating economic growth in China and falling oil prices wreaked havoc on market sentiment.
Where Are Stocks Undervalued?
In January, we wrote how the value category was the most compelling and how both core and growth stocks were outrageously priced. Value stocks have fared best in the selloff, with the US Value Index up 0.97% for the year to date through May. Much of the decline came from the growth segment; the US Growth Index sank 28.39%.
Pockets of losses within the core stock category ambled in between as the US Core Index fell 12.85%.
The growth category is now the most undervalued based on our valuations, at a 19% discount to our fair value, with the value category at an 8% discount and core at a 6% discount. Overall we maintain our view that the best opportunities remain in small-cap (19% discount), large-cap (13% discount), and mid-cap (11% discount) stocks across capitalization levels.
What Can Be Expected in the Summer Months?
Long-term investors still benefit from a market that we calculate to be below fair value, however we anticipate volatility will likely remain high through the coming months. In our 2022 Outlook, we highlighted four primary headwinds that the market would have to address this year. Any one of these headwinds is hard enough for the markets to navigate and right now we have entered into the convergence of all four occurring at the same time. Volatility is not likely to meaningfully subside until the market gains clearer visibility in the weeks ahead.
Strong Businesses at Very Cheap Prices
The selloff this year has been relatively indiscriminate in that even high-quality names including those with Economic Moat Ratings of wide have slipped. Companies carrying wide economic moats are ones that have long-term sustainable competitive advantages, which enables them to earn excess returns above their cost of capital. Those companies are generally the ones best positioned to navigate possible economic disruptions and tend to have the best pricing power.
Eight wide-moat stocks had their Ratings enter 5-star territory. Of all of the 238 companies we rate with a wide moat that trade on US exchanges, there are now 27 on our 5-star rating; at the end of 2021 there were just nine.
What to Do Now?
In such market environments, it is more important than ever for investors to have a plan that reflects a balance between their long-term investment objectives and their risk tolerances. This plan should allow for some periodic rebalancing to ramp up equity allocations when valuations are falling but also trim that exposure when valuations become extended. Having established that we believe the US equity market is undervalued, we believe now is not the time to be trimming exposures but to be adding judiciously particularly in high-quality companies through the lens of your investment plan and goals.
