5 Cheap Stocks to Buy Before Interest Rates Fall Further

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research services chief US market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead.

On your radar this week, Dave, are some pretty big things with the November CPI number and the Fed’s final meeting for the year among them. Let’s talk first about the November CPI number. What’s the market expecting?

Dave Sekera: Good morning, Susan. The consensus headline for CPI is for a 3.1% increase on a year-over-year basis. That’s slightly just below the 3.2% that we saw last month, but even more importantly is the core number, the core CPI. That’s what the economists really focus on. The consensus there for core is for a 4% increase year over year, which is the same as last month. Also, in addition to CPI, we also have PPI, the producer number. Now, that’s not as widely followed, but I think that also just gives another view on inflation coming in at the producer level. Which of course if you do see inflation at the producer level, then you would expect that to flow through to consumers over time as well.

Dziubinski: Dave, what might the impact be on the market if these inflation numbers come in hotter than expected?

Sekera: That’s going to depend on just how hot it comes in, if it does come in greater than expected. If it’s only a little above what the expectations are, a little bit above consensus, that’s unlikely to change very many minds out there. But if it were to come in a lot higher, a lot hotter than expected, then I do think you could see the market sell off. Because what would happen then is if it came in that high, I think that brings into question the market’s current assumption. That assumption being that the Fed is done hiking rates at this point, and in fact is poised to start cutting rates in 2024. Especially in light of that stronger than expected jobs number last Friday.

I’d also say it’s really interesting, too, so I do look at the market probabilities for the Fed cuts. Right now there’s just really a lack of conviction out there as far as what the Fed is going to do and when it’s going to do it. Now, our opinion has long been that we do expect the first-rate cut to happen here in March. I talked to Preston Caldwell end of last week and even after the jobs number came out, he’s still of that opinion. But if you look at the mark implied probability of a cut at that 2024 meeting in March, it went from as low as about a 12% probability a month ago to as high as a 55% probability. Even a 9% probability of a 50-basis-point cut before the jobs number came out. Now it’s back down to a 40% probability for that 25-basis-point cut with almost no probability of a 50-basis-point cut.

Dziubinski: Now we also have retail sales numbers coming out this week. You going to be watching those?

Sekera: Yeah. We’ll keep an eye on the retail sales number. Of course, the consumer really has been instrumental in keeping the economy afloat over the past couple years. That’s what we do expect going forward. The fourth quarter is probably especially important for retail sales with the holiday season. Now, the consensus here is for a slight dip of one 10th of a percent on a month over a month basis. But I’m really not all that worried about it. Now, if the number does come in softer than what the market’s expected, that could portend a bad omen going into that December holiday sales season. But essentially, as we talked about before, we’re looking for holiday sales this year really to be in line with inflation as compared to what holiday sales were last year.

Dziubinski: Moving on to the main event this week, Dave, the Fed meeting. What’s the market expecting?

Sekera: The market right now is pricing in no change in the federal-funds rate. That the Fed will hold study at that 5.25% to 5.50% range. The market will look for any change in the actual written language in the statement that’s released immediately after the meetings. But really what the market’s going to be focused on will be the commentary from Chair Powell during the press conference that he has afterward. Now, if you remember on our Oct. 30 show, before the November Fed meeting, we talked about how we thought the Fed officials really needed to start shifting their messaging. They really needed to start preparing the markets for when they’re going to reverse course and begin to ease monetary policy. The Fed really never wants to come out and surprise the markets when they start moving changes in the monetary policy. Then after the November meeting, we discussed how the messaging was shifting more toward a balanced approach between inflation and employment. I think at that point in time what that told the market is that the Fed was becoming more comfortable with inflation continuing to moderate. I think now what the market is looking for and they’re waiting to hear is more signaling that the Fed is now starting to think about when they’re going to start cutting rates. That way, at the January meeting, they can then be in a position to be able to give the market some forewarning that they are looking at starting to loosen monetary policy at that March meeting.

Dziubinski: On to earnings, you talked in your December market outlook on Morningstar.com about how overvalued the tech sector is. We have a couple of pretty high-profile tech companies reporting this week in Oracle ORCL and in Adobe ADBE. What do we think of these stocks heading into earnings?

Sekera: We do think both of these stocks are overvalued at this point. We have Oracle, I believe they report tonight after market close. That’s currently a 1-star rated stock. It trades at a 47% premium to our fair value. I think that stock is up about 37% year to date. When I look at our coverage across the U.S., that’s probably one of the more overvalued stocks out there in our view. Then after market close on Wednesday, we’ve got Adobe. That’s a 2-star rated stock. It trades at a 17% premium. Interestingly, that was a 4-star rated stock at the beginning of the year. It’s now up 77% year to date. Thus, it is now, in our view, moving well into that overvalued territory.

Dziubinski: It seems like a pretty kind of busy week. Given all that’s going on, should investors be bracing for some volatility this week maybe?

Sekera: We shall see, but I don’t think so. I’m really not all that concerned about CPI. I think it would have to come in a lot hotter than consensus for it really to start changing anyone’s view on inflation. I can’t imagine the Fed does anything other than hold interest rates steady at this point. If there is volatility, it’s going to come during the press conference when Chair Powell is giving his commentary. For example, if you were to come out with a really strong view that rates do need to stay higher for longer, then I could see a pretty swift selloff in the markets, but that just isn’t my expectation for this week.

Dziubinski: Got it. Well, let’s move on to some new research from Morningstar. The first piece of research we’ll talk about today concerns the market’s largest stock, in Apple AAPL. Morningstar changed its fair value estimate of the stock and one of its ratings, too. Tell us about the changes.

Sekera: Yeah. It was a pretty modest change as far as the fair value. We bumped that up 6% to $160 a share, but we did lower our Uncertainty Rating down to Medium from High. The increase in the fair value is really just due to some relatively modest changes that we made in our revenue estimates within our five-year forecast period. Then the reduction in the uncertainty is based on our higher conviction in Apple’s ability really to be able to offset kind of the ups and the downs of consumer spending cycles with its premium and more differentiated products and services.

Dziubinski: Now, given this new fair value estimate and this change in uncertainty, does Apple stock look like a buy today?

Sekera: In our view, no. We still think it’s overvalued. It is a 2-star rated stock. It still trades at a 22% premium to our fair value. What that means is that according to our analysis, we think the stock is trading too far above our assessment of its intrinsic valuation. Right now, we do think that the market is probably forecasting more free cash flow over the course of Apple’s lifetime than what we’re currently forecasting in our long-term projections. What it means is when you’re buying the stock here is that we do think as a long-term investor, you would end up probably earning less than the company’s cost of equity over the long term.

Dziubinski: Let’s talk about your bond market outlook, which just published on Morningstar.com and will be available to viewers via a link beneath this video. Before we look ahead, let’s take a look back over 2023. How’d the overall bond market do?

Sekera: After the worst year in history in bonds last year, fixed income did bounce back a bit and is in positive territory this year. For example, if I look at the Morningstar core bond index, and that’s really our proxy for the overall broad market, through Dec. 5, that was up 2.77%. I would note that return is still depressed this year. We did see some price depreciation as interest rates did rise. That offset some of the yield that otherwise investors would’ve earned.

Dziubinski: What parts of the bond market performed the best in 2023?

Sekera: Bonds that trade with a credit spread over Treasuries performed the best thus far this year. For those of you not that familiar what credit spread is, that’s additional compensation that you receive as an investor over maturities with comparable U.S. Treasuries. That compensates for added risk of different types of bonds that have credit risk of downgrades or defaults. For example, in the asset-backed securities market, also known as ABS, those rose a little bit over 5%. But the biggest winner this year were corporate bonds. The Morningstar corporate bond index, our proxy for investment-grade corporate bonds, that’s up almost 5.5%. In the junk-bond market, the Morningstar high yield index was up over 10%.

Dziubinski: What does the yield curve look like as 2023 is winding down?

Sekera: Taking a look at the yield curve, it’s more inverted now than it was at the end of last year. That’s really just because the Fed did hike the federal-funds rate pretty substantially over the first half of 2023. If I look at the curve in the very shortest end of the curve, one-month T-bills rose 140 basis points. That was really in relation to the Fed. I think they hiked about 100 basis points at that point in time. Then on the longer end of the curve, the yield on the 10-year rose, but it only rose 30 basis points, getting up to 4.18% as of the 5th.

Dziubinski: We’re heading into 2024 with higher interest rates than we had coming into 2023, but we have seen yields on the 10-year Treasury drop over the past few weeks after peaking at around 5%. What’s Morningstar’s forecast for both short-term and long-term rates in 2024?

Sekera: For 2024, we do forecast both short-term and long-term rates will be coming down. Our current forecast in the short term is that the Fed will start cutting the federal-funds rate. We expect that to get down to a range of 3.75% to 4.00% by the end of the year. In fact, we expect that to continue to keep coming down in 2025, getting down to 2.25%. On the longer end of the curve, our forecast is for the 10-year to average 3.6% over the course of 2024, also remaining on a downward trend going into 2025 and averaging about 2.75% in 2025.

Dziubinski: Then given your expectations, Dave, what parts of the bond market would you expect to do the best in 2024?

Sekera: Based on that interest-rate forecast, I do think long-term bonds should perform the best in 2024. Right now, it does look like a better return in the short term because you are getting that higher yield, but you get very little price appreciation over time with short-term bonds. Plus, when you buy those short-term bonds, you’re subject to whatever the prevailing interest rates are when it matures, when you need to then reinvest those proceeds. Considering you do expect short-term rates to fall, you get that higher yield for a little while, whether that’s six months, one year, two years. But as those short-term rates fall, you’ll get a total return lower when those rates fall over that same time period.

Now, long-term rates are slightly lower right now, but you get the added duration effect of those long-term rates. What that means is that long-term bond prices will increase the further out on the yield curve you go as those yields drop. While you’re getting those lower yields, you’re locking in what’s going to be higher yields now as compared to where they’re going to be in the future. What happens is investors are willing to pay higher prices for those bonds with those higher coupons. If yields do move as we forecast, we expect you’ll get total returns that are going to be higher in those long-term bonds based on the combination of not only the yield that you’re getting but also that price appreciation.

Dziubinski: Wrap up bonds for us, Dave. How should bond investors be thinking about their fixed-income investments today?

Sekera: Well, in our midyear bond outlook, I believe that was in maybe July that we published that, we advocated at that point investors should begin to move into bonds with longer-term maturities. We still hold that view today. Based on our economic outlook and our interest-rate forecast, we do think that those long-term bonds are the most attractive part of the curve. Just to put it in context—again, this isn’t a forecast and this is just a back-of-the-envelope estimate made—but if rates do play out as our economics team forecast, we think you could see total returns and long-term bonds over the course of next year appreciating as much as 8% to 9%. Half of that is going to be the amount that you would earn on the yield, and the other half would be from price appreciation.

Then switching gears a little bit, taking a look at the corporate bond market, I’m actually not as excited about corporate bonds right now as I was in our 2023 outlook. Corporate credit spreads have tightened the levels that I think, while they’re still adequate based on our economic outlook and our interest-rate forecast, they’re by no means cheap anymore. My concern here is that as the rate of economic growth slows over the next couple of quarters, that could generate some negative market sentiment in the markets. We could see some investors start pricing in potentially higher rates of defaults or higher rates of downgrades. You could see credit spreads in the first half of 2024 begin to widen out a little bit. But then I think once you’re in the middle of the year, once the market then begins to price in that economic recovery we expect later in the year, I’d expect spreads to go back to where they are now. That’s why overall, I think a market-weight or a neutral position in corporates is probably the right way to go.

Dziubinski: Let’s move over to the stock picks portion of our program. Now, given Morningstar’s interest-rate outlook for 2024, you’ve brought viewers five undervalued stocks that stand to benefit if your bond market expectations pan out. Now, your first two picks are from what many investors consider to be interest-rate-sensitive. That’s the utility sector. Your picks are Entergy ETR and NextEra NEE. Why?

Sekera: Well, on Entergy, I think we’ve talked about this one a number of times. We’ve highlighted it on our show. Really, it’s right now just the go-to name in our utility team for exposure for the utility sector. The reason there is that, according to our equity research team, it just has the most attractive combination of yield, growth, and value at this point in time. Now, that stock has been moving up probably the last month, month and a half, it’s now moved into 4-star territory from 5-star territory, but it still trades at a 15% discount and offers about a 4.4% dividend yield. Then taking a look at NextEra, that’s also a 4-star rated stock, 19% discount, 3.1% dividend yield. That’s really one of the more undervalued stocks under our utility coverage. Maybe not as much yield as what we’re seeing in some of the other utility stocks, but a large margin of safety and some better upside potential.

Dziubinski: Now, real estate stocks are also typically rate-sensitive. Your next two stock picks are undervalued REITs, Realty Income O, and Healthpeak Properties PEAK. What do you like about these two REITs in particular?

Sekera: Realty income is currently rated 5 stars, it trades at a 28% discount, and has a 5.7% dividend yield. Now, realty income is what’s known as a triple net lease provider. That means that the tenant pays all the property expenses, the real estate tax, the insurance, the maintenance, and so forth. Essentially what that does is that takes a lot of the risk off the plate as far as how fast those expenses rise out of the equation for the lesser, which in this case is Realty Income. We think that one is very well set up for interest rates coming down. The other one is Healthpeak. It’s another 5-star rated stock, it trades at a 42% discount, has a 6.4% dividend yield. Now, it is a no-moat as most of our real estate coverage, but it has a Medium uncertainty. The company just has a diversified healthcare portfolio. Mostly medical offices, some life science assets, and a handful of other senior housing hospital and skilled nursing facilities. But overall, I do like the defensiveness of the healthcare industry for real estate.

Dziubinski: Then lastly, this last pick might surprise viewers, Dave, since we just talked about how expensive the technology sector is. The pick is a tech stock. It’s Teradyne TER. Explain yourself?

Sekera: Of course, even though the tech sector itself in our view is overvalued, there’s always going to be some stocks that are undervalued even within an overvalued sector. The explanation here is when you think about the growth rate of a stock and what the value of that stock is, the higher the growth rate, the more your valuation is going to be based on those future free cash flows that are generated further and further out into the future. As compared to value stocks, where more of the value is going to be based on the upfront performance of that company. When you lower interest rates, to some degree, it almost acts like a bond. The lower interest rates actually increase the present value of those projected future free cash flows. I suspect that as interest rates do decline or we expect them to decline over the course of next year, I think you’re going to see a market sentiment change and looking to pick up these longer duration stocks.

Right now, according to our evaluation, growth stocks in general are fully valued, and tech stocks in particular are overvalued. To play that potential improvement in sentiment in these long duration stocks, I took a quick screen here looking for undervalued tech stocks in which we think the fundamentals are also set to improve. Long-winded answer, but that’s what brings me around here to Teradyne. Teradyne provides testing equipment for semiconductors, circuit boards, and wireless devices. The stock is currently rated 4 stars. It’s a company we do rate with a wide economic moat. Company doesn’t pay much of a dividend, but it does have a very wide margin of safety to its intrinsic value. In this case, even if the demand for this stock next year isn’t from being a longer duration stock and that’s not necessarily a catalyst to make it move up, we still think it’s a stock that’s about 37% undervalued.

Dziubinski: Thanks for your time this morning, Dave. Viewers interested in researching any of the stocks that Dave talked about today can visit Morningstar.com for more analysis. Dave and I will be back live next Monday at 9:00 a.m. Eastern, 8:00 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.