This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on May 16 - 22, 2016.

The current market is slightly undervalued at -1.5%, the Morningstar Second Quarter 2016 Markets Observer says. The most undervalued opportunities appear to be across all value-oriented and small-cap industries.

Morningstar’s director of economic analysis, Robert Johnson, says in an email interview that growth and larger stocks have fared better than value-oriented and small-cap stocks as investors remain risk averse. Small-cap and value-oriented stocks are generally riskier.

Things are not as cheap as they were, he says, especially when as recently as February, the discount was as much as 15%.

“Overvaluations across the whole universe seldom exceed 5% to 10%, but discounts have got very close to 50% at the end of bear markets, to put the current reading in perspective,” he says.

Johnson says Morningstar calculates a fair value — based on the present value of discounted cash flow — for each stock and compares that to the current stock price in order to determine whether the stock is overvalued or undervalued.

The report also notes that negative interest rates are becoming more common as more economies search for growth, with Japan and Germany currently in negative interest rate territory because of their extensive quantitative easing programmes designed to stimulate growth.

“The one-month interest rate in the UK and Japan is higher than the one-year rate. This unusual circumstance signals that the market thinks rates are going to decline even further in those countries,” the report says.

Johnson says higher short-term rates and lower long-term rates — a negative sloping yield curve — often indicates that investors are expecting a slowing economy.

On whether investors should set their eyes on investing in undervalued countries, Johnson says Morningstar tries to avoid individual country recommendations. However, he says a small difference from fair values is usually not terribly meaningful in either direction.

“Large discounts are usually the most meaningful indicator. Overvaluations are not usually large across broad stock markets — even overvalued markets can last for a substantial period of time. Proper asset allocation, designed for the investor’s risk tolerance, is a much better long-term strategy than chasing valuation from one market to another,” he says.

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