U.S. Stock Market 'Deep Into Undervalued Territory:' Morningstar

Citing a 0.75 price/fair value for the consumer cyclical sector, Sekera suggested that "the market is overreacting to concerns of a possible near-term recession. In the event of a recession, we think it would be short and shallow and that the sector already factors in enough of a margin of safety at its current valuation.

"Many of the services-oriented companies in this sector should benefit as the pandemic continues to recede and consumer spending behavior normalizes and shifts back to services and away from goods."

Defensive sectors, including consumer defensive, health care and utilities, generally have performed relatively well this year and are trading closer to fair value, with utilities slightly overvalued,  according to Sekera.

Morningstar expects more volatility in the next six to 12 months. Before finding the bottom, the markets need a better picture of when inflation will tame and trend toward the Federal Reserve's 2% target and when economic activity will meaningfully rebound.

While Morningstar expects gross domestic product to remain sluggish — reaccelerating in next year's second half — the firm predicted the Fed will end its tightening policy by year-end 2022 as inflation moderates in the next few months and subsides in 2023.

The Fed should have the room it needs to start easing monetary policy by late 2023, Sekera wrote. Morningstar predicted the Fed's benchmark interest rate will drop to 2% at year-end 2023.

In this market environment, investors should have a plan that balances their long-term investment goals with their risk tolerances, Sekera recommended.

"This plan should also allow for periodic rebalancing to increase equity allocations when valuations decline but also reduce exposure when valuations become overextended," he wrote.

Given Morningstar's view that the U.S. equity market is undervalued, he added, "now is not the time to be reducing equity exposures but to be adding judiciously," especially in companies with "wide economic moats," (which Morningstar defines as companies with sustainable competitive advantages trading at attractive valuations) based on their investment plan and goals.