US Market Outlook September 2024: Favorable Tailwinds Balance Headwinds

Key conclusions

• US stock market fully valued; long-term investors should see normalized stock returns going forward
• The upcoming elections may be difficult, but favorable winds balance the odds
• Time to Underweight the Utilities Sector

After a brief dip in early August when a weaker-than-expected jobs report sparked recession fears, stocks rallied sharply and neared their highs by the end of the month. Headwinds from easing inflation, falling interest rates and soon-to-be-eased monetary policy are offset by headwinds from slowing economic growth. For a deeper dive into each of these market dynamics, see Don’t Panic: It’s Not 2022 All Over Again, where we lay out our outlook and explain why we think investors should hold on to their equity positions.

In addition to macro momentum, stronger-than-expected fundamentals prompted us to increase our fair value estimates for a number of market-moving stocks. For example, following earnings reports, we raised our fair value estimates for several stocks with the largest market caps and whose performance could tilt the broad market averages. For example, we increased our fair value for Alphabet GOOGL by 15% to $209 per share. Following the increase, as of August 30, Alphabet received a 4-star rating because it was trading at a 22% discount to fair value. Additionally, we increased our fair value for Microsoft MSFT by 13% to $409 per share. Microsoft received a 4-star rating because it was trading at a 16% discount to fair value. While the fundamentals of each of these companies are firing on all cylinders, the lead in our fair value increases was due to an acceleration in our assumptions about the near- to medium-term growth of their cloud businesses.

Including fair value gains in light of the market recovery, the U.S. stock market price/fair value ratio as of August 30 was 1.02.

The Morningstar US Market Index rose 2.26% in August. The leader was the Morningstar US Value Index, up 2.49%, followed by the Morningstar US Core Index, up 1.96%, and the Morningstar US Growth Index, up just 1.34%.

In terms of capitalization, large-cap stocks continued to lead the market, with the Morningstar US Large Cap Index up 2.44%, closely followed by the Morningstar US Mid Cap Index, which was up 2.40%. Small-cap stocks gave back some of their huge gains from July, with the Morningstar US Small Cap Index down 0.19%.

Following these market moves, the value category remains the most attractive, trading at a 4% discount to fair value. Basics trade at the market average, and growth stocks remain the most overvalued at an 8% premium.

In terms of market capitalization, small-cap stocks remain the most attractive at a discount of 16%, followed by mid-caps at a discount of 2%, while large-cap stocks are slightly above fair value, trading at a 4% premium to the sum of our fair values.

Based on these valuations, we recommend an overweight position in value, an underweight position in growth, and a market weight in core. In terms of capitalization, we favor an underweight position in large-cap stocks in favor of an overweight position in small-cap stocks and a market weight in mid-cap stocks.

Market rotation in defensive sectors is causing valuations to be too high

As the AI-driven stocks’ momentum faded, investors shifted to defensive stocks. The Morningstar US Healthcare Index rose 5.16% in August, and the Morningstar US Consumer Defensive Index rose 5.08%. The market was led by the long-beaten Morningstar US Real Estate Index, which rose 5.37% after gaining 7.50% in July.

According to our valuations, the consumer discretionary sector is currently the most overvalued sector, trading at a 15% premium to our combined fair values. In fact, this sector contains some of the most overvalued stocks in our coverage. While many of these companies have wide economic moats and have generally performed well in the short term, we believe the market is overvaluing their long-term earnings power. For example, wide-moat Procter & Gamble PG is trading in the 2-star range, while Costco COST is trading in the 1-star range.

Among the other lower-quality names in the index, Target TGT shares have no moat at all and are rated 2 stars. Target shares rose after the company reported a 2% increase in comparable-store sales in the latest quarter, but that increase came after four consecutive quarters of negative comparable-store sales. Additionally, Target’s gain was less than half of Walmart WMT’s 4.2% comparable-store sales increase. For investors looking for stocks in this sector, we’d highlight the 5-star Kraft Heinz KHC or the 4-star Kenvue KVUE.

After rising 7.50% in July, the Morningstar US Real Estate Index rose another 5.37% in August, leaving the sector only 1% undervalued: a far cry from being the most undervalued sector at a 17% discount as recently as May 2024. There are still undervalued opportunities, and we like the fact that real estate is mostly about defensive real estate plays. For example, Ventas VTR, a 4-star rated stock that trades at a 10% discount, has a diversified portfolio of healthcare-focused properties. Similarly, triple-net tenant Realty Income O, whose retail tenants are mostly focused on defensive segments, has a 4-star rating and trades at an 18% discount.

The Morningstar US Healthcare Index rose 5.16%, giving the sector a 5% premium. However, nearly half of the monthly return can be attributed to 1-star Eli Lilly LLY, which rose 19.37% in August. While we agree with the market that there is a large addressable market for its weight-loss drugs, we believe the market is over-extrapolating the amount of growth and earnings power over the long term. We see better value in medical device makers such as 5-star Zimmer Biomet ZBH and 4-star Medtronic MDT.

It is worth noting that after the utilities sector’s strong 22.64% return for the year to date, we recently changed our stance to Underweight. While we agree with the assumption that AI developments will bolster electricity demand as they require many times more power than traditional computers, we believe this dynamic is already more than priced in. We started 2024 with an Overweight rating and noted in October 2023 that the fundamentals in the sector are stronger than they have been in decades, and in our Q4 2023 US Markets Outlook we highlighted that the utilities sector is trading near the lowest level compared to our valuations over the past decade.

For investors interested in maintaining exposure to the utilities sector, we offer several different swap ideas, such as selling 2-star Southern SO or Dominion Energy D shares and using the proceeds to buy 4-star Entergy ETR or NiSource NI shares.

Economically sensitive sectors are sinking

As a result of this market rotation toward defensive sectors, economically sensitive sectors retreated in August. The Morningstar US Energy Index was the worst performer, falling 2.15%, while the Morningstar US Consumer Cyclical Index barely managed a 0.37% gain.

As a result of this correction, the energy sector now becomes the second most undervalued sector, trading at a 7% discount to our fair values.

While we are bearish on the long-term price of oil, as our MTO for West Texas Intermediate is $55/bbl, many oil companies are trading at a discount to our internal valuations. Examples include Chevron CVX’s 4-star rating. In addition to trading with a margin of safety, we believe that energy exposure provides a good, natural hedge to the portfolio against geopolitical risk or a return to inflation.

The consumer cyclical sector is currently trading at a 2% discount to our composite valuation. While lower-income consumers remain under pressure and are cutting back where they can, spending among higher-income consumers remains strong. For example, cruise bookings appear to be strong this holiday season. Our pick among cruises is Norwegian Cruise Line NCLH, which has a 4-star rating. After falling from July highs, Amazon.com AMZN has fallen into 4-star territory as it trades at an 8% discount to fair value.

What should an investor do?

Take it easy, as it goes. With the broad stock market trading just slightly above fair value, we recommend investors position themselves in a market-weighted spot within their long-term asset allocation targets between equities and fixed income. Given the projected slowdown in economic growth over the next few quarters, stock markets could become increasingly volatile this fall, and pullbacks could present an opportunity to return to an overweight position in equities. In the stock portion of the portfolio, we continue to see the best valuations in the value and small-cap categories.