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The Long View
Dave Sekera: A Market Outlook for 2025 and Beyond
00:49:37
The chief market strategist for Morningstar Research Services discusses which sectors look especially over- and undervalued today, the outlook for interest rates and inflation, and the potential economic and market impacts of tariffs.
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- [00:01]
Jackson Financial
At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial, Inc. Jackson National Life Insurance Company, Lansing, Michigan, and Jackson National Life Insurance Company of New York, Purchase, New York.
- [00:27]
Disclosure Announcer
Please stay tuned for important disclosure information at the conclusion of this episode.
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Christine Benz
Hi and welcome to the Longview. I'm Christine Benz, Director of Personal Finance and Retirement Planning for Morningstar.
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Dan Lefkovitz
And I'm Dan Lefkovitz, strategist for Morningstar Indexes.
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Christine Benz
On the podcast this week, we welcome back Dave Sicara. Dave is the Chief US Market Strategist for Morningstar Research Services. In his role, Dave publishes research and commentary on the state of the markets and economy and is a leading voice on Morningstar.com and our other platforms. Dave and Susan Jabinski also do a weekly show for Morningstar.com called the Morning Filter. Before assuming his current role, Dave was a Managing Director for DBRS Morningstar. Prior to joining Morningstar in 2010, Dave worked in the alternative asset management field. He earned his bachelor's degree in Finance and Decision Sciences from Miami University and holds the Chartered Financial Analyst designation. You can follow him on x Morningstar Markets. Dave, welcome back to the Longview.
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Dave Sicara
Oh, thanks. Thank you, Christine. Good to speak with you again.
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Christine Benz
Yeah, we're glad to have you here. I wanna start by talking about your experience at Morningstar. You were originally a corporate credit analyst, is that right? And I'd like to talk about that and what prompted your switch into equity research.
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Dave Sicara
Sure. So I started at MorningStar in early 2010 and I was embedded in the Equity Research Group. My title back then was actually securities analyst, and I covered both credit and equity. But the real intent of my job and why they hired me was to help them that corporate credit research business. And we were leveraging off of the work that was already being done, all the financial models that all the equity analysts were already doing in order to build that business. And then over time, as we built out that corporate credit research business, Morningstar decided that they wanted to transition it into an NR sro, so a nationally recognized statistical rating organization, also known as a rating agency. And so then I worked for a number of years working with Morningstar, working with the SEC in order to help get that designation. So really, it was really always trying to utilize my own experience prior to coming to Morningstar, where I've covered pretty much the entire capital structure of a company all the way from senior secured bank debt, bonds, investment grade high yield, all the way down to equities and options and leverage that experience to pulling together the way that Morningstar did that equity research and leveraging it into that corporate credit research.
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Dan Lefkovitz
So then talk about your transition into your current role as market strategist and what exactly does it entail on a daily basis?
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Dave Sicara
Sure. So in the summer of 2020, during the pandemic, Morningstar really identified that we had a hole and that we really had a need for someone that could be able to synthesize a holistic market view using all of that bottom up intrinsic valuation work that we do on all of those individual stocks. And so I use that as really a bottoms up basis to put together a valuation for the broad overall market. But then we also then break it down into the Morningstar style box so we can identify different parts of the market, whether it's by style or capitalization, might be overvalued, undervalued. We break it down by sector so we can identify which sectors we might see opportunities versus which sectors might be overvalued that might want to steer clear of, and then also be able to identify individual stocks that might be overvalued or undervalued, that we can help our clients be able to position their portfolios to take advantage of dislocations that you have in the marketplace. Yeah, I like to joke a lot of times. I think actually I have probably one of the best jobs here at Morningstar. So in my role, there's just a lot of people that I can leverage off of. I can speak to any of the equity analysts at any point in time, getting their views not only on individual stocks and their assumptions and projections and kind of why they're looking at it in certain ways, but also get a holistic view of what's going on within that sector, be able to talk to other sector directors and the interplay of what's going on, one area versus another area. So for me, it's actually just really a lot of fun. It's just one of those jobs. Every day I come to work, I get to be able to look at something new, maybe something different, learn something I hadn't seen before. And on a daily basis, every day it's going to be different coming in. It might be some days I'm going to be focused a lot more with what's going on in the markets, especially if there's a lot of news, a lot of market catalysts, a lot of volatility. In the marketplace. Again, I get to speak to all the equity analysts trying to keep up with just the flood of research that they publish on a day to day basis. That in and of itself is a job. And then of course, speaking with our clients and also highlighting our views in the media.
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Christine Benz
So Dave, my sense is that a lot of people who wear that market strategist cap at other firms are kind of top down. They're not necessarily leveraging the bottom up research that you are. Do you think that's true? That they oftentimes are looking at things like inflation and the health of the economy and that leads them to have views on various market sectors? Do you think the way you approach it is different from a lot of other people who are also strategists?
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Dave Sicara
I do think that we have a differentiated approach when we think about market valuation overall. So as you mentioned, yo, in the course of my career, what I've always seen from a lot of other market strategists is that they'll oftentimes have a model algorithm formula, something to come up with what they think S&P 500 earnings is going to be at the end of the year. Then they have some sort of forward PE multiple that they apply to that and they get to whatever their price target is. More often than not, it always seems like it's really more an exercise in goal seeking. It always seems like other market strategists are telling me the market's always 8 to 10% undervalued, whereas we do the exact opposite. We cover over 700 stocks that trade on US exchanges. We take the intrinsic valuation of all of those stocks and then we compare that to where they're actually trading in the marketplace. So we put together this price to fair value metric. So really it's just the market cap weighting of all of those stocks that we cover divided by what we think that intrinsic valuation is. And that gets us whether or not we think the market is trading at a premium or a discount to that combined valuation.
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Dan Lefkovitz
So, Dave, would you say that Morningstar's valuation consciousness and focus on economic moats lead to distinguished performance in down markets, or is that too much of a generalization?
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Dave Sicara
No, I think that's a correct generalization. But of course, when you talk performance, you have to be very careful in how you speak about performance. There's a lot of SEC rules and regulations about that. But one of the things I always really like to highlight to people is the performance of the Morningstar Wide Moat Focus Index. Now, that index is really just an index of the most undervalued stocks that we rate with a wide economic and then it's reconstituted every quarter. So again, if a stock is in that index and that stock is trading up and it's no longer one of the most undervalued, then it gets pulled out of the index and then replaced with another stock that has a wide moat that is undervalued. So when you look at the performance of that versus the Morningstar US Market Index, which is our broadest index of the stocks in the US it's outperformed on a trailing 10 year basis, but not only a 10 year basis, it's outperformed the broad market index really since inception 18 years ago ago. Now having said that, I also have to say there have been periods where that index has underperformed the market and in fact, right now on a trailing twelve month basis, it has underperformed the broad market. Now the reason is because that index is focused on those stocks that we consider to be undervalued. So if something is fairly valued or overvalued, and in this case a lot of those stocks that have really driven the market thus far this year becoming even further overvalued, aren't incorporated in that index. So right now in the index we have Alphabet, we have Amazon, we have Microsoft. But if you think about like, you know, the Fang stocks or the Mag seven stocks, you know, the other four you know, aren't in there. So again, as those stocks become even further and further overvalued in our mind, you know, those aren't encapsulated within that index. But I'd also note too that when you look at the performance, you know, of that index on a quarterly basis, we found it has both attractive upside capture and attractive downside capture, you know, attributes to it. So what we find is that to the downside, you know, these high quality names that have wide economic moats oftentimes will hold their value better to the downside and then once the market recuperates and starts to rally, because these are the stocks that we thought had the best valuation characteristics are also the ones that usually perform the best to the upside.
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Christine Benz
So Dave, I want to ask about the Morning Filter, which is a YouTube video series. It's also on Morningstar.com that you and Susan Jabinski do together. When I look at YouTube and kind of of our best performing videos, it's usually right there on top. And you're going to be launching it as a podcast. Can you talk about the genesis of that show and who you're trying to serve and what you're trying to help them with?
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Dave Sicara
Yeah, when I think about our audience, it's really for everybody. I mean, it's from anyone that has an interest in investing, personal investing. So we definitely try to address it to individual investors. We find a lot of investment advisors also really enjoy the show, and we have a number of our institutional investor clients who will watch the show as well. But really, the intent of the show is to try and help people really understand the difference between noise versus signal. And so when we work on our show every week, we try and figure out, okay, what are the things that investors should pay attention to that actually are things that can move markets, move individual stocks, highlight those, and then kind of ignore a lot of the other noise that you hear out there. So every week the show is always really kind of the three same segments. So it's always going to start off with, hey, what's coming up the week ahead that you should be paying attention to? It might be important economic indicators, might be important inflationary indicators that are coming out. What the consensus is, what our view might be, whether or not they come out higher or lower. If there's important earnings that are coming out from some of the mega cap stocks or some of the AI leveraged stocks, those have not only importance to how those stocks will trade in and of themselves, but when they come out with earnings, you might see some second derivative action with other companies within that same sector or maybe that same business line or maybe some of their suppliers where those stocks could be affected by how those earnings come out as well. The second part of the show is trying to highlight Morningstar research that we think is particularly interesting. So that might be some sector research that's been published that might be earnings notes that have come out, but things that we think are the most important thing for investors to notice that we published over the prior week. And then we always like to try and make the show as action oriented as we can. So we'll wrap up that show with our picks and our pans. Some weeks it might just be a couple of different individual stock buy ideas stocks that we think are undervalued and look attractive. Some weeks we might highlight different sell ideas stocks where we think the market's overestimating too much growth for too long and those stocks have risen too much. We'll look at different types of swap ideas. Wavy finding a sector where you might want to swap out of a couple stocks that have risen too far and a couple stocks maybe that lag behind that look attractive. So again, trying to bring to the forefront different ideas. Now, of course, on a show like that, you can't get too deep into talking about any one individual stock. So I'll try and give the broad investment thesis, maybe a couple of metrics or parameters around it. And then of course, investors that do have an interest in any one of those individual stocks can go to whichever Morningstar platform they use and research and learn more about those stocks before they make make any kind of investment decision whether or not to buy or sell those individual stocks.
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Dan Lefkovitz
You're obviously consuming a huge amount of Morningstar research from the equity team as well as other teams within Morningstar. What about external sources? Do you listen to other podcasts? Are there other sources of investment insight that you refer to?
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Dave Sicara
Yeah, I do listen to a couple of podcasts. So in addition to the long view, I'd say most of the ones I listen to are going to be what I consider to be pretty niche. Not very much as far as more general finance or market knowledge, but things that are going to be very specific to individual topics that might be interesting at any one point in time. So like the CFA Society, the CFA Chicago, both have a podcast series, so I'll keep up to date with what's going on there. One that I've been starting to listen to more recently is called Stay Vigilant, and it's put together by a University of Illinois professor. His name's Rich Excel. I met Rich a number of years ago through the CFA Society, but he used to be a hedge fund manager. And he put together and really kind of synthesized really good macroeconomic indicators, macro market indicators. Put those together in a way and explain them in a way that I haven't really heard too many other people be able to kind of put in layman's terms where he'll show the charts, kind of walk through, really kind of understand what's going on with some of the dynamics that coming from our point of view with that bottom up fundamental analysis we may not necessarily always see.
- [13:38]
Christine Benz
Dave, we want to switch over to get your market outlook. You published in December a 2025 US stock market outlook. And one key takeaway from that very helpful overview is that US Stocks are expensive, which you have previously referenced and in fact you wrote that they're priced for perfection. So I'm curious, is all of the US Expensive or just the US Large growth stocks and in turn like the total market indexes that lean so heavily on them today?
- [14:08]
Dave Sicara
Yeah, and this is one of those Cases where it really does become very helpful breaking down the broad market into a lot of its different components. So right now, when we look at the valuations across the market, yes, the market in and of itself is trading at a bit of a premium. And that premium has been increasing over the past couple months, getting to the point where it is starting to look pretty fully, if not necessarily overvalued at this point. But then when we break it down, we see value stocks as a category are still trading pretty close to fair value. And that would be an area in the market today that I think is probably one of those areas that maybe you might want to overweight in your portfolio. And then when you look at core stocks, they're trading more in line with that broad market premium. But growth stocks as a category are significantly overvalued right now. And in fact, when I look at where growth stocks are trading on a composite basis, last time we saw them trade at this much of a premium or more was back in late 2020, early 2021. If you remember back point in time, we had what we called the disruptive technology bubble. A lot of those technology stocks rose way too far, way too fast. Of course, that bubble then popped. Growth stocks came down in 2022 much harder than what we saw across the rest of the market. So again, at this point in time now might be, depending on your risk tolerance and how your portfolio is set up, a good time to maybe take some profit in that growth area and redeploy in other areas that are, if not not undervalued, at least closer to fair value and then similar when we look at by capitalization, I would note that large cap stocks today are very overpriced compared to where they typically trade over time. So again, that's another area where I think the last time large cap stocks were at the kind of premiums that we're seeing right now was back in early 2018. And of course, if you remember the second half of 2018, we did have a pretty good market sell off back then. I think it actually bottomed out Christmas Eve in 2018. We had the China, a global growth scare and a couple of other things that occurred. So again, another area where we see a lot of value in small cap stocks now, we did start to see kind of that rotation out of large and mid cap and a small cap a couple months ago. But when we look at our valuations both on the absolute as well as a relative value basis, we still think that that probably still has further room to run over the course of next year.
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Dan Lefkovitz
So at the market level, you're seeing overvaluation. Can you talk a little bit about the historical kind of ebbs and flows of that market level valuation indicator?
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Dave Sicara
Yeah, so I usually go all the way back to 2010 and I look at that broad market price to fair value indicator. So based on where valuations are today, I think it's like less than 10% of the time. Going back to 2010, had we seen the market trade at this much of a premium or more. Now, having said that, usually when it does trade at that premium, the market, even if it's overvalued, can either stay overvalued and become even more overvalued before something causes it to change. Now, when I look at the macro dynamics of the markets today, I think there's enough tailwinds that are still out there that that could keep stocks at these, what I consider to be relatively elevated valuations until earnings catch up. So I think as the economy reaccelerates in the second half of next year, we could see earnings catch up to where valuations are. So I'm not necessarily expecting to see a market correct today, unlike back in 2022. So our 2022 outlook we noted at that point in time is currently the opposite of what we had today. So at that point in time, we were looking for inflation really to start heating up. We were looking for interest rates to go up, we were looking for the Fed to start tightening monetary policy, and we were looking for the economy to weaken pretty significantly. Of course, all of that occurred and the market sold off quite a bit. In fact, it got down to some of the lowest valuation levels by October that we had seen going all the way back to 20. So when I think about that price to fair value metric at the broad market level, it's not necessarily a timing indicator because again, stocks, even if they look undervalued, can always get more undervalued to the downside. But I think it's a way for investors to try and help gauge maybe as stocks are going down, you want to get a larger and larger percent of your portfolio into those stocks as they're selling off. And then conversely, once it moves back up to fair value, that's a good time to take some of that profit off the table. And again, in an environment like today, maybe now's a good time to revisit your portfolio. Maybe you've gotten a little overextended in the stock allocation part of your portfolio. And there's the old adage on the street, no one ever went broke taking a profit. So depending on what your portfolio looks like today, maybe it is a good time to take a little bit of money off the table in the equity market.
- [18:52]
Christine Benz
I had previously referenced the broad market indexes that it seems like when we look at fund flows, investors, advisors seem to really be gravitating towards the total stock market indexes. So given that some of those large cap growth stocks, tech names in particular, are at the top of those indexes, would you say investors who are looking to those sorts of products to supply all of their US equity exposure are recording some significant risk today?
- [19:21]
Dave Sicara
Well, I think the biggest risk there is going to be the concentration risk. Last time I checked attribution analysis for this year, well over half of the market return thus far this year has really been driven by just 10 stocks. And of those 10 stocks, I believe they're all large mega cap stocks. So bigger than what you would even consider to be a large cap stock. And of course most of those are also all leveraged to artificial intelligence and the AI theme thus far this year. So when I'm looking at those 10 stocks and comparing them to where our fair values are, I'd say for the most part most of these stocks are either at fair value or even starting to get to be more overvalued. Some of them now starting to get into two stories range. So again when you buy that broad market index, you are going to be naturally overweighting those mega cap stocks that have run up as far as they have thus far this year. So names like an Eli Lilly is a name where yes, there's a tremendous amount of growth there in the short term and in fact there's going to be a tremendous amount of growth for the next couple years. But I know when you look at the fundamentals and Karen Anderson, who covers that stock, really digs into the competitive landscape there, she noted that I think there's 16 potential products that could get launched and have FDA approval by 2029. And so I think at this point that's one of those stocks where I think the market is overvaluing the stock because they're pricing too much growth too far into the future. And so that would be one of those ones that we'd be very concerned about. And if the market kind of realizes that and starts seeing potentially growth slowing down in the future, that stock potentially has a lot of downside risk. And of course as much as it's risen thus far this year and has become a larger and large percentage of an index then could skew that index to the downside.
- [21:09]
Dan Lefkovitz
Yeah, so you mentioned artificial intelligence. It's been such a powerful driver of markets over the past couple years, really since the launch of ChatGPT at the end of 2022. How are you and the team thinking about AI and its impact and what it means for investors?
- [21:24]
Dave Sicara
Yeah, and this is one where I really love the old adage about the gold rush. And they say during the gold rush it wasn't necessarily the miners that always got rich, but it was the people that sold the picks and the shovels to the miners. And so really for the past two years, it's all been about the picks and shovels. It's all about the nvidias of the world, the people that are selling the chips, people that are selling the GPUs, the network equipment, that have really seen the best growth, the strongest returns, the greatest valuations on those stocks. But when I look at that basket of AI leveraged hardware stocks, again, they're at the point where they're not fully valued. They're getting to be further and further overvalued at this point in time. So I think 2025 is really going to be the next step in the evolution of AI away from just the picks and shovels, but looking for those companies. And of course those companies, stocks that are able to leverage off of AI, are able to embed AI within their own products and services, will be able to utilize that to help them drive additional revenue growth in the future. Look for those companies that can take AI, embed it within their own business processes, make themselves more efficient, so that they will then be able to generate operating growth. Growth and more operating margin expansion. So I think that's really what the market is going to be more focused on in 2025, as opposed to just the hardware names that we've seen for the past two years. Yeah.
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Dan Lefkovitz
Okay. And are there particular areas where you and the team are particularly bullish about productivity gains and revenue growth?
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Dave Sicara
It's such a still a new technology and I think pretty much every company out there is trying to figure out just exactly what they can and can't do with AI. So it's really just much more like anecdotal evidence that we've seen thus far that have been able to embed it within some of their own products, which if nothing else, at least help them retain clients so they don't see churn in that area. And a lot of idiosyncratic areas where companies have been able to use it for driving efficiency. So one that I thought was particularly interesting was Walmart. So Walmart had made a mention that they had used artificial intelligence in order to be able to update their entire catalog of products. And they said that I think it would have taken like 100 times more resources if they had all done it by human intervention, as opposed to being able to use AI. So thinking about those kind of numbers really shows you once people figure out exactly how to use AI, how much more efficient they can end up becoming over time. And trying to understand exactly what that can end up doing. The margins in the short term and the long term is still very difficult to try and conceptualize.
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Christine Benz
Dave, I want to follow up on your comment about Eli Lilly. You noted that the team believes, or Karen Anderson believes, that it's notably overvalued today. But I noticed in your 2025 outlo that you had taken a look at the healthcare companies under coverage, and you actually feel like once you pull that out, that that sector looks fairly inexpensive, not cheap, but somewhat undervalued. Can you talk about that?
- [24:23]
Dave Sicara
Yeah, and that's a great example. When you look at price to fair value by sector, there might be some sectors, like financials today, where the sector is overvalued, pretty significantly overvalued in our mind. And when I look at the stocks, it's like the entire sector is overvalued. It's not just a couple of stocks that's skewing it upwards. Whereas with healthcare, because Eli Lilly is as large as it is, it is skewing the valuation of the health care sector higher than it would be. So again, if you were to then strip Eli Lilly out, I think that brings the price to fair value down by 7% overall, taking it from fairly valued to maybe 7 or 8% undervalued in today's marketplace. Now, when I look within the healthcare sector sector, a lot of different areas do appear undervalued. One that I think is probably most attractive to our team right now is going to be more in, like the medical devices area. You know, companies like Medtronic and Zimmer would be two that I know they've been highlighting to clients.
- [25:22]
Dan Lefkovitz
Dave, can you talk about how you interact with the team of people at Morningstar who do economic research? How do their views on, you know, GDP and interest rates and inflation influence your outlook, if at all?
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Dave Sicara
Well, to some degree, I do kind of like the Peter lynch philosophy of really just, yes, you do have to understand what's going on in the economy. But again, being more of that Bottoms up focus. Really looking at and making sure that you understand the fundamentals of the individual companies and how that plays out in their valuation over time. But yeah, I mean, I talked to Preston Caldwell, he's the chief US Economist, probably at least everywhere and a lot of times as economic indicators are coming out similar to how I think part of my job on the equity side is to help investors strip out the noise and focus on signal. I look to him to help me strip out the noise in the economy and focus on the signal as far as where maybe some of the inflection points might be in the economy overall. I also look towards his interest rate forecast, so I'll rely on him for that and then always appreciate his view on what he thinks the Fed might be doing doing with monetary policy. So again, we have that bottoms up valuation focus on the market. Really want to try and help investors make sure that their portfolios are going to be positioned to try and take advantage of where we see dislocations in the marketplace. But then look towards Preston with his economic view, his interest rate forecast and monetary policy view to really think about more like market sentiment and market dynamics as far as how the market might evolve over maybe the shorter term, but of course having your portfolio really up for the longer term.
- [27:02]
Jackson Financial
At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial Incorporated, Jackson National Life Insurance Company Lansing, Michigan and Jackson National Life Insurance Company of New York purchased New York.
- [27:29]
Christine Benz
In that market outlook, you note that the economics team is expecting inflation to fall even below the Fed's 2% target and that yields will decline in response. It seems like that would generally be a positive for stocks, but I'd like to get your take. And in that scenario, which types of stocks would stand to benefit the most?
- [27:50]
Dave Sicara
Yeah, so both moderating inflation as well as declining interest rates will be an ongoing tailwind for stocks in our view for 2025. Which is one of the reasons why I'm still relatively comfortable with the view that you should be market weight overall, even though portfolio positioning is going to be different than your general typical positioning. But I have to caution that I don't think this is necessarily just our view. When I look at a lot of the sectors, a lot of the stocks that would benefit the most from declining interest rates, a lot of those stocks have had big rallies thus far. This year. So a sector like the financial sector, especially the banks, that would make a lot more money as net interest margins expand. We're expecting the short term to come down faster than longer term interest rates. So you get kind of that steepening yield curve. A lot of those have run up so far that a lot of the mega banks are getting to be well into overvalued territory. They're U.S. regional banks that got hit back in the day when Silicon Valley bank and some of the other banks failed. Got to be very low valuations. Those are generally back towards fair value as well now. So again, a lot of that's already been incorporated in the marketplace today. Similarly, like utilities now utility sector, a lot of investors oftentimes use it as like a fixed income substitute. They look for the high dividend yields utilities often provide. But again, that's a sector that is really rallied thus far this year. It actually went from one of the most undervalued sectors in our mind at the beginning of the year to now being one of the most overvalued sectors. Of course, it's also a second derivative play on AI, just because artificial intelligence, those type of semiconductors require multiple times more electricity than traditional computing. But again, we think that story has probably run too far at this point in time. So as far as the interest rate sensitive sectors, probably the one that I see the best value for investors today is going to be the real estate sector. Of course, that was probably the most hated asset class coming into this year. Over the past couple months, we've seen more people getting increasingly more comfortable with real estate exposure. So if interest rates are coming down next year, I think more and more people get comfortable with that real estate exposure. And we still see opportunities there, especially in more real estate names that we think are more defensive in nature. My own personal view is I still kind of try and steer clear of some of the urban office space. I still think there's a lot of overcapacity there that probably will take time to get fully utilized. But some things like in the medical business, whether it's medical office buildings, research and development facilities, laboratories, other real estate with defensive characteristics, I find still very attractive today.
- [30:30]
Dan Lefkovitz
Well, you mentioned the steepening yield curve, and I think we'd be remiss if we didn't take advantage of your fixed income background and asked you for some views on the bond market. A lot of investors have been in cash. Are you seeing opportunities further out on the yield curve? And what about on the corporate side? It seems like credit spreads are pretty.
- [30:46]
Dave Sicara
Tight yeah, credit spreads are ridiculously tight in my own personal view. So. Yeah, so right now I'd still say now's a good time to lengthen out the duration of your fixed income portfolio. We are looking for interest rates on the long end of the curve to come down next year. I think we're looking at 3.6% for our forecast for 2025, getting down to 3.2% in 2026. We kind of have this multi year view of long term interest rates coming down. So if you can extend out further on the curve, lock in kind of these currently high rates, you'll benefit from both capturing that coupon as well as price appreciation as bond prices go up when rates come down. And of course then shorter end of the curve. We are looking for the Fed to cut rates throughout 2025. President's looking for the federal funds rate to get all the way down to 3 to 3.25% by the end of next year. So as the federal funds rates come down, of course then your shorter term rates will follow the Fed funds rate. So while the federal funds rate is relatively high and you're getting relatively high rates in cash, that will continue to dwindle over the course of next year. And then lastly looking at the corporate bonds market, when I look at where corporate credit spreads are, and of course corporate credit spreads is the added amount that you get paid over an equivalent duration or equivalent maturity treasury bond to get paid for the additional risk of investing in a corporate bond, whether it's default risk or potential downgrade risk. Those spreads are as tight now as I've seen them since just before the global financial crisis in 2007 and 2008. In my view, I don't think you're getting paid nearly enough to take on that additional risk. Now granted we are looking for a soft landing in the economy. We're not necessarily looking for a big pickup in default rates. You might see more downgrades. And of course when a corporate bond gets downgraded, the corporate credit spreads widen out. But again, I just don't think you're getting paid enough for that additional risk. So personally I'd much prefer staying with US Treasuries or agencies at this point.
- [32:46]
Christine Benz
Dave, you've referenced that Preston and the economics team think that inflation will stay mild and interest rates will head down. But you also discuss in your outlook the reflation trade, the idea that inflation could pick up again. So can you discuss that? And reading between the lines of your report, it seems like you think this scenario is a Realistic possibility.
- [33:11]
Dave Sicara
Yeah. So the reflation trade I really just started hearing after the election and after the reelection of President Trump. So a lot of investors now are pricing in the re acceleration of economic growth, probably re accelerating faster than what I think consensus expects it and then expecting that that re acceleration of economic growth will then reignite inflation. Inflation has been relatively sticky the past couple of months. That's not our base case from our U.S. economics team. Our base case is still we're looking for the rate of economic growth to slow here in the fourth quarter quarter, slow further in the first and second quarter until it bottoms out in the second quarter and then slowly to start re accelerating in the second half of 2025. And we are looking for inflation while it has been sticky for the past couple months to moderate over the course of next year. And I think it's really that housing section that's been stickier that what we've necessarily expected. But when we look at a lot of more real time indicators, we still expect expect it will subside over the next couple of quarters. So we are looking for that inflation rate to get below the Fed's 2% target next year. So that being our base case, it's certainly not out of the realm of possibility that depending on whatever Trump administration does that maybe we get less regulations, less government burden, depending on maybe any kind of stimulus measures. They do that. Yes, we could get that pickup in the economy faster than we expected and maybe we don't get the moderation in inflation that we are expecting. So I think there's couple of different ways that if you want to play that reflation trade, you can still do it in even areas that we consider to be undervalued today. So these would be areas that I think would be good places to invest today, irrespective of whether or not you kind of buy the inflation trade theory. So one area that we find very attractive right now would be the energy sector. And so energy has been beaten up pretty hard. Oil prices have kind of been in that upper 60 to low $70 barrel range for a while. We see a lot of very attractive oil companies today. And what I actually really like about the energy sector is we actually have a very bearish view on the long term price of oil. So if you look at our models, we expect WTI West Texas Intermediate to drop all the way down to $55 a barrel, kind of like in our mid economic cycle outlook and Brent to come down to $60, so well below where they are today. And in our model we use the forward strip, the forward two year for oil and then we decrease down towards our long term forecast. And even when you put that bearish outlook into our models, a lot of these companies are still very undervalued today. So of course if we were to see a faster reacceleration in the economy, then I would suspect they would see spot oil prices and short term oil prices to come up even faster. So I think there's actually a good amount of leverage to the upside. And even if oil prices were to stay here and end up falling over time, you're still buying these stocks at relatively large margins of safety. Interesting, interesting.
- [36:16]
Dan Lefkovitz
Wanted to ask you about tariffs. It's a big, big focus of the market now and I know you've done a lot of thinking about their impact. Talk about how you're thinking about tariffs.
- [36:25]
Dave Sicara
Yeah, I mean it's probably the biggest wild card to the market in 2025 and we'll see what happens. How much of this was just campaign trail rhetoric? How much of it's going to get implemented? How quickly is it going to implement? Implement? And of course President Trump, love him or hate him, you got to admit he's a wild card in and of himself. So to some degree just trying to figure out is this the art of the deal? Is this him putting that out there? Maybe when he takes office he does a couple of small tariffs here and there, uses that as a way to try and encourage some other countries to come to the negotiation table to try and get some concessions. Or does he go the other way? Maybe he just implements some very large tariffs right away way, uses that as a hammer to force people to come to the table and then force them to give concessions in order, then you'll start to lift a lot of those tariffs. So to some degree I think we're going to just have to kind of wait and see how that plays out. But it's one of those things that depending on what's put in place, when it's put in place, even just as important, what's going to be excluded? Are there going to be certain products that get excluded, Certain countries maybe certain allies that we exclude from those tariffs to try and understand how that may work through a company's different cost structure. Structure, and then how is a company going to address that? Is that something where do they have the pricing power that they can put those costs through to their own customers very quickly, in which case maybe that's actually a benefit for them. So again, if they're able to put those costs through and Keep their operating margins the same without having too much of a hit to volume. That actually could drive some earnings growth in the short term. Or conversely. I know with Best Buy is a good example. I think with Best Buy our analysts said 60% of the product they sell is sourced from China. Another 20% comes from Mexico. Being an electronics retailer, I don't think that there's going to be that much pricing power, a lot of competition in that area. So that would be a stock which I'd be very concerned about their ability to pass through those costs very quickly. That's one where I would expect to see operating margins contract, which of course then would end up significantly impacting the intrinsic value of that company.
- [38:34]
Christine Benz
Wanted to ask if there's a connection with the pricing power that you just referenced and this economic moat concept. It seems like potential potentially a company that has a wide moat would be sort of better situated to push through higher prices to its customers. Can you share your take on that question?
- [38:54]
Dave Sicara
Yeah. So of course, the economic moat concept just being a very Warren Buffett, Graham and Dodd esque analysis, does a company have long term durable competitive advantages that will allow that company to generate excess returns over invested capital in excess of its weighted average cost of capital over time? And if so, how? I would suspect that companies that we think have a narrow or wide economic moat more often than not will have better pricing power in the short term than what we would see from some of their competitors that don't have an economic moat. And of course, I think it's really twofold. So one, they would get the benefit from being able to pass through their own costs with that pricing power. But then also thinking more over the long term, those companies will be better situated to thrive over time as their competitors then are going to be struggling seeing their operating margins collapse. Maybe it might be areas where some of those competitors exit, maybe a specific space that they don't have any of those long term durable competitive advantages which then of course will end up benefiting those wide and narrow moat stocks even more in the future.
- [40:00]
Dan Lefkovitz
Dave, wanted to ask you about the consumer defensive sector, Consumer staples. You've described it as a mixed bag from a valuation perspective. Can you discuss.
- [40:09]
Dave Sicara
It's another good example of having to really look under the hood as far as what's going on with the dynamics of the stocks in that sector. This is another one where you have three stocks that account for about 30% of the market capitalization of the sector. You have Walmart, Costco and Procter and Gamble. Last I checked. I Think Walmart and Costco were both one star rated stocks. Procter and Gamble, two star rated stocks. With Walmart and Costco trading at very large premiums to our long term intrinsic valuation. So for example, with Walmart, fundamentals have been getting better and better the past couple quarters. Effectively what's going on with a lot of consumers and lower income and even now into middle income households, even though inflation has has moderated from where it peaked out 18 months ago, those households are still under a lot of pressure. So it's that compound impact of inflation on their budgets where their spending patterns have been shifting. And so Walmart has been able to pick up a lot of customers that had gone to traditional supermarkets that are now going to Walmart with their everyday low price program. And so they're doing better here in the short term. But we think the market is probably pricing in too much growth for too long. And so that's why we think that stock is actually over value today, even though the fundamentals have been improving here in the short term. Costco is another story where personally I just don't get it. I think that stock trades at like 50 times our forward earnings estimate for that company. Very high quality, company wide economic moat, definitely long term durable competitive advantages. But again, it's just one of these ones where we think the market is just overestimating just how long they can keep generating those excess returns that we're seeing in that stock today. So again, it's one of these ones where from a sector perspective the sector itself looks overvalued. But if you were to pull those three stocks out, it drops much closer to fair value. And we see actually a lot of value in a lot of the consumer products. Names like General Mills, Kraft, Heinz are stocks that appear very undervalued to us today. So that's how we would look to invest in that sector where we think you're capturing companies that have an economic moat, pay very high dividend yields today and trade at a very large margin of safety from their long term intrinsic valuation.
- [42:27]
Christine Benz
Let's talk about the industrial sector. That was one that you referenced in your outlook. I'm wondering if you can share what you think is going on there and whether you think there are any opportunities.
- [42:36]
Dave Sicara
Yeah, the industrial sector has actually kind of surprised me to the upside and how strong it has been thus far this year. Now this also goes back to a lot of the economy in the US has actually been much better thus far this year than I think a lot of people, ourselves included. We actually had relatively strong Growth in the second quarter a little bit slower, but still relatively stronger growth than expected in the third quarter. So a lot of the industrial companies have been outperforming what the street consensus has been for their earnings estimates. So I think that has artificially kept a lot of those stock valuations too high here in the short term. But as the economy continues to slow and slow further over the first and second quarter, I was suspecting a lot of those stocks that are probably overvalued here in the short term. You might see some corrections to where those valuations are from today.
- [43:27]
Dan Lefkovitz
What about financial services? We talked a little bit about the banks earlier and how well they've done this year. But are there other pockets within the financial services sector where you and the team are seeing opportunity?
- [43:37]
Dave Sicara
It's hard finding opportunity in the financial services sector. There's still a couple of the regional banks that are probably in that three star territory where they're trading very close to fair value, not seeing a lot of four or five star stocks because the sector itself is just broadly overvalued. Another area actually I'm very concerned about the valuations is going to be the insurance companies. So the insurance companies have had a period over the past year to year and a half, they've been able to put through a lot of increases in their premiums. That's really helped their fundamentals here in the short term. There's been a couple of different reasons why they've been able to push that through. But when we think about the insurance industry overall, very competitive area, we suspect that overall over time we'll see a lot more competition, get back into that space, a lot more premiums, unable to keep the same kind of growth rate that we've seen. And so again, another area where we think the market has overestimated the length of time that we can see this abnormal growth that we've seen in those premiums and pricing that too far into the future.
- [44:41]
Dan Lefkovitz
And what about communication services, Dave? What are you seeing there?
- [44:44]
Dave Sicara
So communication is the most undervalued sector, but that's also because Alphabet is still.
- [44:51]
Christine Benz
Undervalued, it seems persistently undervalued. Oftentimes when I do a quick look, it seems like it's often hanging out there. And I'm always wondering why that is.
- [45:02]
Dave Sicara
Well, a lot of it right now is because of all of the government investigations into Alphabet for anti competitive behavior. And so the Department of Justice had recently come out recommending that Alphabet has to or will have to divest Chrome and some of its other Business lines. So the market is very leery about whether or not that's actually going to happen. So I think that's part of the reason why you see the discount from valuation in Alphabet today.
- [45:32]
Christine Benz
So, Dave, if I'm doing some kind of rebalancing of my portfolio today, it sounds like looking at that small cap row of the style box, seeing that potentially have shored up that area and also importantly, value. Those are the two main things for my U.S. equity exposure.
- [45:49]
Dave Sicara
Exactly. The value category being pretty close to fair value, which on a relative value basis is much better than the growth category, which is in our mind significantly overvalued. And then, yes, both on an absolute value basis as well as relative value basis, the small cap category looks pretty good to us. And when I just think about the market dynamics in 2020, historically, small cap stocks have tended to do well both when interest rates are coming down and the Fed is easing monetary policy, both of what we're expecting for next year. And then I am concerned about the ability for the growth sector, the growth category, to remain at these kind of high valuations. So if we are correct, the economy does slow further and further over the next three quarters, we start seeing the earnings growth rate for, for all those growth companies coming down. That would be one area of the market that I'd be concerned could certainly be at downside risk.
- [46:44]
Dan Lefkovitz
Yeah, you mentioned tariffs as a big wild card that you're looking for in 2025. What about geopolitics? It seems like geopolitical risk has really been an issue lately and just curious how you're thinking about it.
- [46:56]
Dave Sicara
Yeah, and the geopolitical risk, you have to be very careful. And I guess this is also another good area to think about. The difference between noise versus signal and trying to understand geopolitical politically, what really at the end of the day can impact the US economy? What's really going to impact companies abilities to earn profits, both here in the US as well as for those mega cap companies that have earnings and revenue spread out all over the world. So I usually try and be very cautious with my analysis on how much geopolitics really might impact the markets. For some degree, it's actually probably more impacts market sentiment than it necessarily impacts the market fundamentals, certainly in the short term.
- [47:39]
Christine Benz
Well, Dave, this has been a fabulous overview. We will be tuning into the Morning Filter when it's making its debut as a podcast. It's the latest addition to the Morningstar podcast Stable. Thank you so much for being with us today.
- [47:52]
Dave Sicara
Oh, of course. Well, thank you Christine and thank you Dan.
- [47:55]
Dan Lefkovitz
Thanks Dave.
- [47:55]
Dave Sicara
It's been great.
- [48:01]
Christine Benz
Thank you for joining us us on the Longview. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts. You can follow me on social media, Hristinebenz on X, orstine Benz on LinkedIn.
- [48:20]
Dave Sicara
And Dan Lefkovitz on LinkedIn.
- [48:22]
Christine Benz
George Cassidy is our engineer for the podcast and Carrie Gretchik produces the Show Notes each week. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us@thelongvieworningstar.com until next time. Thanks for joining us.
- [48:42]
Disclosure Announcer
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