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What's Driving the Latest Big Drop in Stocks?

Worries about inflation’s toll on earnings sparked the plunge, but stocks are now far undervalued.

Tom Lauricella 20 May, 2022 | 4:04PM
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Tom Lauricella: Hi, I'm Tom Lauricella, chief markets editor for Morningstar. I'm here with Dave Sekera, our chief U.S. market strategist. We are here to talk about what's been happening in the stock market. We had another big down day, 4% on Wednesday. Dave, what's happening out there?

David Sekera: Well, it seemed like there was a little bit of panic-selling today. Just looking at the screens, everything sold off, and I wouldn't be surprised if there were some portfolios out there that were being unwound today. Essentially, from what I could see, anything that had a bid was getting hit. So, I think the main cause for today's selloff was just investor concerns, inflation, which we've noted, has been running hotter and longer than I think what people expected. It's really going to end up hitting earnings even harder than what the market has already been pricing in.

So, I was instigated early this morning how we saw weak earnings coming out of Target. Target stock ended up falling about 25% today. So, really, the short story on that stock is that this no-moat-rated company was unable to pass through a lot of their cost increases and saw significantly higher shipping charges. Now, we had rated Target with 2 stars before today's selloff, but we think the stock selloff was probably actually overdone. Now, we plan on reducing our fair value by about 10%, but I think this is a good example of how the market can sometimes overshoot to the downside.

LauricellaWhat's the bigger concern here? We had that particular issue with Target and its earnings. As you noted, the idea that inflation is running hot, that's not new. That's been going on for months. What is the bigger concern? Is that we're sort of hitting an inflection point in terms of inflation's impact on corporate profits and not just consumers' pocketbooks? What's happening here?

SekeraI think the Target earnings really just hit home with seeing just how much that impacted their earnings, and I think as people are now updating their models and thinking through over the next couple of quarters and even over the next couple of years, trying to figure out, especially for these companies that don't have pricing power, just how much is that going to hit their operating margins going forward. And so, that's why we saw that bring down in the retail sector a lot of valuations today.

LauricellaNow, if we take a look at just the move that we had, a 4% down day, that's a big move.

Sekera: That is a big move. I couldn't even tell you offhand the last time I remember seeing a 4% move.

LauricellaAnd what does it tell you about the market when we can have a 4% swing in just one day? What does it tell you about conditions out there? What does it tell you about investor sentiment? What's the takeaway from seeing something like a 4% move in a single day?

SekeraWe've been opining for a while that we expect to see this volatility continue. And it kind of gets back to, in our 2022 outlook, we noted that there were four main headwinds coming into the year. And that was the slowing rate of U.S. economic growth, that was the Fed increasing or raising monetary policy, as well as we still are waiting to see the impact of quantitative tightening this summer, inflation running hot, interest rates rising. Any one of those factors on their own is sometimes hard enough for the market to be able to price in, much less over the past couple of months the confluence of all four of those factors coming together.

Now, what I would say is, at the beginning of the year, we did think that the market was overvalued, and we weren't surprised to see the market selloff for the first couple of months of the year. But over the past couple of weeks, past couple of months, we actually think the market is swinging too far to the downside. Sometimes the market does act like the pendulum, and it just moves too far to over- and too far to undervaluation. Based on today's decrease, we had noted that we thought that the market was already undervalued. Incorporating today's–the amount that it went down, it's probably about 18% to 19% undervalued as compared to a composite of the fair value estimates on all of those stocks that we cover here at Morningstar.

LauricellaFor an investor who might just be looking at the headlines, they see a 4% down day, they see more scary news about the impact of inflation, what would you say to investors to help them take a step back and put this into perspective?

SekeraAgain, as a long-term investor, hopefully, you should have already put together your own investment plan based on your own risk tolerances and your own long-term goals. Looking in the market today, we actually think now is actually a good time to be looking at a lot of those stocks that we rate with wide economic moats. Those are going to be the companies that can work through any kind of economic dislocations. Those are the ones that will typically have the best pricing power, especially those that we rate with a low or a medium Uncertainty Rating. We're seeing lots of those companies now getting caught up in this downdraft. Companies that over the past decade rarely have ever traded below our fair value estimates in many cases are now trading at 4 stars or even 5 stars. So, those are the ones that I would think that investors today should be looking at and actually adding to their portfolios.

LauricellaIs this a time then for investors who had some cash in their portfolio, the proverbial dry powder, to start putting it to work, and if so, where would you be focusing?

SekeraWe do think that there are certainly a lot of buying opportunities out there for investors that do have cash, a lot of opportunities especially in the growth space. The growth space, of course, has been hit the hardest thus far this year. Some of the stocks there that we've noted would be stocks such as Amazon.com, Alphabet, Meta Platforms, Microsoft, large-cap growth stocks that have been trading anywhere between now 25% to 50% discounts to our fair values that we think have just gotten caught up in this selloff and have just been pushed down too far.

LauricellaAt this point, though, should an investor–even an investor putting money to work–should they expect continued volatility, be braced for more swings, maybe not 4% in a day, but still a lot of bouncing around?

SekeraYeah, hopefully, not 4% in a day, but we do expect to see more of this volatility just as on the days that we see good headlines, when retail sales came out the other day and there were some good underpinnings there that we saw the market move up over a percent on that, and then, today, when there's negative headlines, the market moving down on that. But we do expect to see that with those four headwinds working themselves out over the next couple of months, until the markets get better clarity as far as how those headwinds are going to work out over the second half of the year, yes, definitely expect to see that kind of volatility.

LauricellaGreat. All right, Dave, thanks very much for joining us here this afternoon.

SekeraThank you.

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Tom Lauricella  Tom Lauricella is Editor for Morningstar Direct, the firm’s cloud-based investment analysis platform.

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