Equity markets have been under pressure since the start of September, with artificial intelligence-related stocks among the big decliners. David Sekera, Chief U.S. Market Strategist with Morningstar Research, tells MoneyTalk’s Greg Bonnell why the AI rally may be over and what is likely to happen next.
Greg Bonnell: The markets are trying to recover some of the ground that they’ve lost since the start of September. But as the momentum in those big tech names like Nvidia (NVDA) begins to stall, we’ve got to ask ourselves, is the AI trade running out of steam? Joining us now to discuss is David Sekera, chief US market strategist with Morningstar Research. David, always great to see you.
David Sekera: Good to see you, Greg. How you been?
Greg Bonnell: Not too bad. You and I have had a lot of discussions over the past two years or so about the drivers in the market. We couldn’t ignore the technology trade, the AI trade. It’s been interesting lately. I mean, we’ve seen this pullback. Is it done?
David Sekera: This is one of those instances– so, from a fundamental point of view, yes, AI in and of itself still has a long pathway of growth ahead of it. But according to our valuations, yes, we think the outperformance of AI stocks over the broad market is probably behind us.
In fact, in our third quarter outlook, we noted that as compared to our valuations, a lot of those AI stocks most closely tied to the fundamentals– we’re, at that point, getting to be fully, if not overvalued. And in that outlook, we reviewed why we expected market returns really to start broadening out specifically into value stocks and small-cap stocks.
So with the market just so hyperfocused on AI not only last year, but for the first half of this year, both the value and the small-caps have been left behind that rally. But they were both very undervalued, both from an absolute point of view as well as a relative point of view.
Greg Bonnell: Let’s talk about that rotation, because that word started cropping up over the summer. Some of the big tech names slowed down their furious pace to the upside. And people were asking, is this a true rotation? Am I really seeing a rotation on my hands? What’s your take on it?
David Sekera: Yeah. I think it did really start here in July. So, the value category and then the small caps– both were very undervalued on both an absolute basis when we looked at it as compared to our long-term intrinsic valuations on those stocks, but also on a relative value basis.
So if you looked at composites of our valuations going all the way back to 2010, both value and small-caps really weren’t that much above the lowest relative values they had as compared to the broad market. So from here, even though they’ve outperformed both in July and August, we still think they have a long runway of outperformance ahead of them.
Of course, the real recession risk here is probably putting pressure on those small-cap earnings in the short term or, if we saw AI having another big leg up in growth, then we could see people moving back into those large-cap growth stocks. But irrespective of those happening, we do think that both the value stocks and the small-cap stocks look pretty attractive here.
Greg Bonnell: Now, we did see in August a bit of turmoil and a pretty brisk sell-off in the markets, then we came back. We’ve had a rough start to September. September doesn’t have a great reputation, anyway, for stocks. And it definitely showed us what that’s all about last week.
Some people might be thinking, are we getting into another environment like 2022? That was a rough one for stocks. Why is this environment not like that one?
David Sekera: Well, we actually put out an article at the beginning of August, when we had that brief market sell-off then, about how now is different than 2022. So in our 2022 outlook at that point in time, we actually had advocated for investors to underweight equities. So from a fundamental point of view, stocks were overvalued at that point in time.
But there are also four headwinds that we identified that the market was going to have to contend with in 2022 – the first being rising inflation. The second was the increase that we expected in long-term interest rates, tightening monetary policy, and the slowing rate of economic growth.
Fast-forward to today, we think the market is pretty close to fair value as compared to our valuations. And three of those four headwinds are actually now tailwinds. So we look for inflation to continue moderating over the course of the remainder of this year and going into next year. We expect we’re on a multi-year path of decreasing long-term interest rates. And of course, we expect the Fed will start easing monetary policy next week when they meet.
So really, the only headwind right now is that slowing rate of economic growth. We are in the soft landing camp, we’re not looking for a recession in our base case. So I think right now that those tailwinds are going to be enough to be able to offset the only headwind, which is that slowing rate of economic growth.
Greg Bonnell: Now, when you talk about that– and you said you’re not in the camp of a hard landing, soft landing, you’re not looking toward a recession. Part of the market volatility in August and recently, too, has been you get a piece of economic data.
The market was waiting so long for the data to soften so the Fed could cut. The economy gets softer. And now the market’s worried that it’s going to get too soft. And then you start throwing around 50 basis points at a Fed meeting, maybe even for liftoff. But what’s your take on that?
David Sekera: So our base case from our economics team is we are forecasting the Fed to cut by 25 basis points at that meeting and then cut 25 again at each of the next two meetings. Over the course of 2025, we expect them to continue cutting to the point that we’ll get to a 3% to 3 and 1/4% range by the end of next year.
Now, when I think about the Fed’s mentality, they were definitely too late to starting to increase the Fed funds rate when inflation was going up. They thought inflation you was transitory, and it wasn’t. And they’ve really been focused on fighting inflation ever since.
So I know the market is right now pricing in a much higher probability that they may cut by 50 basis points. In my opinion, I actually think that would be negative. So yes, inflation is on a downward trend. But it is still above that 2% target. So I think the Fed still needs to focus, to some degree, on inflation. If they were cutting by 50 basis points, that would tell me that the Fed’s actually much more concerned about the economy slipping into a recession in the near term than they are worried about inflation remaining on that downward path.
In my opinion, I think if they cut by 50 basis points, the market could actually sell off on that news, and maybe even have a pretty good sell-off in that case – just like at the beginning of August, when we had the jobs report that came out and everyone was– fears about recession were heightening, and then same thing beginning of September here with the market selling off on some relatively dour economic news as well.
Greg Bonnell: Let’s put that all together and take a look at some of the sectors and your outlook for them. Let’s start with the ones that you’re more constructive on.
David Sekera: So right now, communications still looks pretty undervalued to us compared to our valuations. Now, of course, you’ve got to look at Alphabet (GOOG, GOOGL) and Meta (META), the two largest mega-cap stocks in the communication sector– Alphabet, for example, still just hitting on all cylinders. That’s a stock that we think looks relatively attractive here.
But also, the traditional communications providers also look undervalued to us. So, for example, the US wireless carriers– we foresee that industry really starting to morph into more of an oligopoly, meaning that they’ll compete less on price over time. That’s going to allow margins to rise. So a number of those stocks, we think, are undervalued and, in the meantime, pay relatively high dividend yields. So really, the risk in that sector is going to be if we see a slowdown in growth in Alphabet’s cloud business or a return of price competition, both in the wireless as well as some of that traditional media areas.
The other two sectors I’d highlight are going to be energy and real estate. Now, energy I still find particularly interesting. I think energy provides a good natural hedge in your portfolio just in case inflation were to come back or if we see heightened geopolitical risk.
But what I like about energy, too– in our models, we use the two-year forward strip price for oil, but then we bring it down over time. And our forecast for WTI, or West Texas Intermediate, is $55 a barrel in the long term. Yet, even using that long-term bearish view, we still find that a lot of these oil companies are attractively priced. Of course, the risk here in the short term– that if economic growth comes under more pressure than what we expect or a potential recession, that could lower oil prices here in the short term.
And then real estate– now, real estate was up 7 and 1/2% in July. It was up another 5.4% in August. So it’s actually now getting to be fairly valued, in our view. It had been one of the most hated asset classes on Wall Street. Personally, I’d still steer clear of office space. But we see a lot of undervalued opportunities in real estate– specifically, real estate with defensive types of characteristics, such as health care, medical offices, or personal storage space.
Greg Bonnell: I get the benefit of knowing some of your thoughts ahead of time. I find this intriguing, the areas you’re not as constructive on. In a declining interest rate environment, people talk about utilities. Why are you not constructive on utilities?
David Sekera: Well, utilities were hit especially hard in 2023, when interest rates were rising. Again, people might use utilities as a fixed-income substitute. But it dropped so far, so fast last year that, actually, utilities, and our team called this out– that the utility sector was as undervalued last October as they had ever seen it over the course of the past decade as compared to our valuations.
Now, the story this year on utilities has been all about AI, utilities really being that second-derivative trade on artificial intelligence– the reasoning that AI computing requires multiple times more electricity than traditional compute. So, everyone is now increasing that long-term forecast for electric demand.
We agree. But we’ve already modeled that in. Utilities are now up over 22% year-to-date. Sector’s now starting to trade at a premium. So now, I think, is really a good time not only maybe to think about profit-taking– or if you want to keep exposure, look to swap out of those that have run up too far, too fast into those that have lagged and still have pretty decent dividend yields.
Greg Bonnell: Quickly, I’ll ask you about the last two spaces that you’re not constructive on – consumer defensive and tech. We’ll get right back to the top of the tech stuff.
David Sekera: So, consumer defensive– that sector’s has had a very strong year thus far. This year, it’s up, I think, almost 17%. But I would note within the consumer defensive, there are several large mega-cap stocks that we think are significantly overvalued. So that is skewing the entire consumer defensive sector on a valuation basis too high to the upside.
But from a stock picker point of view, we still see a lot of names in there, like the food names that we think are undervalued– so, a good time that if you are an investor in that space, maybe instead of investing in ETFs look at some of these undervalued stocks individually.
And of course, tech– tech was undervalued at the beginning of 2023. It was up 59% last year. It’s up another 17% thus far this year. At this point, we do think that the sector is overvalued, especially a lot of these AI names. The concern here is that AI– it looks like it’s already run its race. The fundamentals are still growing a lot. But that growth, what we’re seeing the past quarter or so, is really no longer outpacing expectations.
And when I’m thinking about earnings this quarter and guidance into the end of the year, just meeting guidance for the third quarter might not necessarily be enough to keep those stocks up. And of course, the risk is that if they’re not providing ever-higher guidance going forward, I think that with current valuations where they are, there is some downside potential in those stocks for later this year– specifically, mid-October.
