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Morningstar expects over the next six to 12 months that the stock market will remain under pressure and volatility will stay high for the foreseeable future.
The equity market is “significantly undervalued” and is trading at about a 20% discount to fair value, said the firm in its Q4 outlook.
It also expects the federal funds rate will drop to 2% at the end of 2023.
Stocks will face many more months of pressure, and a bottom won’t be formed until investors in part see signs of sustainable growth in economic activity, according to Morningstar.
Equities jumped on Monday, the first trading session of the fourth quarter, after the S&P 500 last week closed out the third quarter with a loss of more than 5%.
“[With] equities selling off 24% year to date, it appears to us that the market has overcorrected to the downside,” Dave Sekera, chief US market strategist at Morningstar, said in its fourth-quarter outlook.
According to a composite of 700 stocks Morningstar covers that trade on US exchanges, he estimated the equity market is “significantly undervalued” and is trading at about a 20% discount to fair value.
Morningstar said the market this year has had to confront four headwinds: a slowing rate of economic growth, the Federal Reserve’s tightening of monetary policy, inflation running hot, and expectations of long-term interest rates rising.
This summer’s relief rally was short-lived as the market ran into further headwinds, including a resumption in the rise of the 10-year Treasury yield and US dollar strength that will lower earnings for US companies with significant business exposure overseas.
“While near-term conditions may pressure earnings in the short term, at current valuations we think the market has fallen more than enough to incorporate those headwinds. In our view, we think the market is overly pessimistic regarding the long-term prospects for equity valuations,” said Sekera.
“Over the next six-12 months, we expect that the markets will remain under pressure and volatility will remain high for the foreseeable future,” he added. “In order to establish a bottom, the markets will need clarity as to when economic activity will make a meaningful and sustained rebound, and evidence that inflation will begin to trend downward and return to the Fed’s 2% target.”
Morningstar expects economic growth to rebound starting in 2024 as the Federal Reserve pivots to cutting interest rates. It also expects the inflation problem to be “solved in 2023” as supply constraints are lifted, and the Fed’s tightening cools off the economy, with Morningstar noting it expects inflation to fall faster than consensus estimates.
The firm forecast the federal funds rate will drop to 2% at the end of 2023, and the yield on the 10-year Treasury will average 2.75%. The yield on Monday was 3.66% and had approached 4% last week.