Most of Magnificent Seven stocks now fair-valued: Strategist

Following the tech sector's 2023 rallies, Wall Street keeps hoping for gains to broaden out across markets. "It does need to broaden. When you look at the market last year, it was so concentrated in the Magnificent Seven stocks. Coming into last year, a lot of them were very undervalued," Morningstar Chief US Market Strategist David Sekera tells Yahoo Finance.

Sekera comments on valuations and earnings expectations in the tech sector.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Luke Carberry Mogan.

Video Transcript

JULIE HYMAN: David, is there any area that is not going to get a tailwind from those interest rates coming in?

DAVID SEKERA: Well there's a couple of different areas of the market that we think have just run up too far too fast-- one of them being the technology sector overall. While it was one of the most undervalued sectors coming into 2023, Morningstar US Technology Index was up I believe 59% last year. At this point, it's trading about 5% to 10% overvalued in our view. So I actually see better opportunities to lock in some profits in the tech sector. Take those gains. Put them into some of those areas that lagged last year that are still undervalued.

JOSH LIPTON: It's interesting, Dave, when we talk about tech, it wasn't so long ago, we would have plenty of bulls come on the show and say, listen part of the reason they were bullish about 2024 is because they expected to see this broadening in the rally, David. But really, as we sit here in January, we're all just talking about big tech again, right? I mean, can the rally continue if it stays so focused, or no, it does need to broaden?

DAVID SEKERA: It does need to broaden. So when you look at the market last year, it was so concentrated in the Magnificent Seven stocks. Coming into last year, a lot of them were very undervalued. I mean, six of those seven stocks were either four or five star rated stocks in our view. At this point, it's exactly the opposite. Six of those seven stocks are actually now all three star stocks. They're all pretty close to fair value, in our view.

We actually think Apple has run up too high. That's now a two-star rated stock. So I think that story is behind us. That's a 2023 story. When we look for value today, now broadly speaking, we think the market is pretty close to fair value. We're not seeing a lot of upside away from just kind of normalized returns going forward for the market itself. But when we break it down, we do see value in the value sector.

So value stocks as a category do trade at a 10% discount to our fair value. I think that's a good area to overweight today. I probably underweight core stocks. Maybe underweight growth stocks slightly as well. But we also still really like the small cap sector. Small cap stocks on average trading at about 16% discount to our fair value. On a historical basis, that's still very undervalued. So I do think that those will end up catching up over the course of this year, especially more into the second half of the year.

JULIE HYMAN: David, if I may to go back to tech for a moment, I mean, maybe you weren't saying it, but, man, if I had $1 for every person in the last year who told us the rally has to broaden to continue and it didn't broaden and it continued, right?

So I mean, I understand what you're saying about the valuations being different now than they were then, but it hasn't come to pass. I'm just wondering what exactly is going to change. Like, are these tech companies going to disappoint with their earnings? Or what will be the catalyst to have that flip?

DAVID SEKERA: Yeah, I think there's a number of different things. I mean, from just that top down macroeconomic outlook, we do expect that the economy is going to soften. We're looking for three sequential quarters this year of the rate of economic growth slowing, bottoming out in the third quarter. But we are in the soft landing camp. We're not looking for a recession. We think it's probably only a 25% probability.

And even if we do have a recession, our US economics team think it's going to be relatively short and shallow at that point. We also do think interest rates will end up coming down over the course of this year as well. So between the economy slowing, but not going into recession, I think that's going to weigh on the tech sector.

We're not going to see the same kind of earnings growth that some people might be pricing in at this point. And with interest rates coming down, that'll make some of those dividend stocks looking better as well, which also will then help prop up the value category.