Most Undervalued Asset Classes, Equity Sectors, Segments

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Author’s note: This article was released to members of the CEF/ETF Income Laboratory on April 15, 2022.

JP Morgan’s Guide to the Markets is exactly what it says on the box: a comprehensive, in-depth guide to global investing markets. It includes a wealth of quantitative information on US and international stocks, bonds and other investment securities, as well as broader macroeconomic conditions. The guide includes detailed information on stock valuations, including comparisons across industries, regions, segments, and more. I thought an article reviewing the most undervalued of these, including relevant ETFs, would be of interest to readers.

The Global X Russell 2000 Covered Call ETF (RYLD), which invests in US small cap stocks, deserves a special mention. The fund focuses on small cap stocks, which are currently undervalued, have returned 12.6% and have significantly outperformed year to date as small cap stock valuations have normalized. The fund is a fantastic investment opportunity, but riskier than average. I last covered RYLD here.

Most Undervalued US Stock Market Segments – Small and Cheap

US growth stocks are still trading at relatively high valuations as investors are willing to pay high prices for strong growth. Growth stock valuations are, on average, 45% higher than value stock valuations. This figure rose to 75% in 1Q2022, significantly above the historical average. Growth stocks were last so expensive during the dotcom bubble.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Relatively low equity valuations are largely driven by small cap enhance stock market valuations. Large and mid caps seem reasonably valued, only small caps are cheap.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Given the above, focusing on US small-cap value stocks to take advantage of normalizing valuations seems like a reasonable idea.

The Vanguard Small-Cap Value ETF (VBR) is a low-cost index fund offering broad exposure to these undervalued stocks. This is a simple and straightforward bet on US small cap value stocks, and it should outperform as valuations normalize. I last covered VBR here.

The Avantis US Small Cap Value Fund (AVUV) is an actively managed fund in the same space. AVUV is a more aggressive play on the same titles, with a better track record, but also a bit more risky. I last covered AVUV here.

I don’t know of any small cap stocks dividend stocks, but the Global X Russell 2000 Covered Call ETF is close. RYLD focuses on US small cap equities, writes covered calls on its holdings and produces a return of 12.6%. Although the fund is not a simple bet on US small-cap value stocks, it should outperform if sector valuations normalize. I last covered RYLD here.

All three funds have outperformed year-to-date as improving economic fundamentals, rising interest rates and bearish sentiment in the tech industry prompted investors to sell overvalued tech growth stocks for buy old economy value stocks that are undervalued. VBR has underperformed over the past decade, in which the technology has significantly outperformed, but outperformed in the 2000s following the dotcom bubble. AVUV has slightly outperformed since inception, an incredibly strong performance given current market conditions, due to significant alpha/smart investment decisions. RYLD has underperformed since inception as the fund’s covered call strategy significantly reduces potential capital gains, and capital gains have been extremely high for most of the fund’s history.

A quick chart of fund performance and performance.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

In my view, all three funds are appropriate bets on US small-cap value stocks. VBR is the simplest. AVUV is the riskiest, but the one with the strongest potential returns. RYLD has the highest yield, by far, but is a more complicated and less straightforward play on small cap stocks.

Most Undervalued US Equity Sector – Energy

The US equity industry segments are all overvalued relative to their historical averages, with one exception: energy. US energy stocks are currently undervalued by 20%, both on an earnings and yield basis. For comparison, the S&P 500 is currently overvalued by 25% on both measures. Energy is moderately cheap, the broader market is moderately expensive, so the valuation gap between these two is quite large, all things considered.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Given the above, and with relatively high oil prices, the energy industry seems like a solid bet going forward.

There are several simple and diversified energy ETFs, including the Energy Select Sector SPDR ETF (XLE) and the Vanguard Energy ETF (VDE). These offer wide exposure to the said industry and are simple games on the same.

For income investors and retirees, the Global X MLP & Energy Infrastructure ETF (MLPX) is a particularly strong bet. MLPX invests in midstream energy companies, which focus on the transportation and distribution of energy products. Midstream energy companies tend to have more secure and resilient revenue streams and higher returns, with MLPX itself earning 4.6%. Intermediate energy companies are also less exposed to energy prices. Losses are relatively small when prices fall, gains are relatively small when prices rise. I last covered MLPX here.

MLPX and XLE have significantly outperformed over the past twelve months or so, driven by improving economic fundamentals, rising oil prices and increasingly bullish investor sentiment. Long-term results are broadly negative, with both funds significantly underperforming the S&P 500 as oil prices have been quite low over the past decade.

A quick chart of fund performance and performance.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Most Undervalued Stock Region – International

US stocks consistently trade at higher valuations than comparable international stocks as investors are willing to pay high prices for the stability, resilience and strength of the US economy and corporate sector. International stocks are generally around 14% cheaper than US stocks, but the gap has widened to 32%. This is a significant gap, the widest in decades. International equities are also performing moderately better than comparable US equities, currently around 1.7%, compared to a historical average of 1.1%.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

It is important to note that the economic fundamentals and expected growth rates in most international markets are quite strong, such that such a large valuation gap seems unwarranted.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

As with other market segments, there are several simple and diverse international equity index ETFs. These include the Vanguard Total International Stock ETF (VXUS) and the iShares Core MSCI Total International Stock ETF (IXUS). Both offer large-scale exposure to international stock markets and play an important role on the same.

For income investors and retirees, there is the Vanguard International High Dividend Yield ETF (VYMI). VYMI invests in international equities with an above-average dividend yield and offers investors a diversified portfolio of international equities with a yield of 4.2%. I last covered VYMI here.

VXUS and IXUS have slightly outperformed year-to-date as valuation spreads have mostly refused to budge. VYMI, on the other hand, has significantly outperformed, due to the fund’s focus on cheap, high-yielding stocks, which have performed relatively well in recent months. All three funds have underperformed significantly over the past decade as international equities have lagged US equities for the same.

A quick chart of fund performance and performance.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Most Undervalued Fixed Income Asset Class – Emerging Markets Debt

Finally, the most undervalued fixed income asset class is dollar-denominated emerging market bonds. These are posting returns about 0.6% above their historical average, even as interest rates and yields have fallen across the board.

Fixed Income Valuations

JP Morgan Guide to the Markets

Bonds have low potential for capital gains, so investors should not expect these undervalued bonds significantly outperform even if yields shrink, but there is still potential for returns, capital gains and above-average returns.

The VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) is a simple, diversified dollar-denominated emerging markets bond index ETF. HYEM offers wide exposure to the said industry and directly plays on the same. HYEM has a yield of 6.1%, outperforming most relevant bond sub-asset classes. HYEM has underperformed in recent years as the fund’s Chinese holdings suffered significant losses following negative developments in the country’s construction sector. The fund’s Russian holdings were also wiped out in the aftermath of the Ukrainian war, although they did not make up a significant percentage of the fund. I last covered HYEM here.

A quick chart of fund performance and performance.

JP Morgan Guide to the Markets

JP Morgan Guide to the Markets

Conclusion

Undervalued equity market segments and asset classes offer investors the potential for strong, above-market returns. The asset classes and funds featured here are all undervalued and could outperform in the months and years ahead. Hopefully this article was an interesting, helpful and informative starting point for investors interested in undervalued asset classes and funds.

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