US markets are priced to perfection, but will it last?

• Since 2010, less than 10% of the time has the market traded at a 4% premium or more to our valuations.
• The macrodynamic tailwinds that supported 2024 are fading.
• With the market trading at the high end of our fairly valued range, positioning is increasingly important.
• Value stocks and small-cap stocks still trade at attractive discounts.

As we enter 2025, the tailwinds we identified last year that propelled the market higher in 2024 are receding. The rate of monetary policy easing is slowing, inflation has become sticky, long-term interest rates have swung upward, and the US economy is slowing. Even more importantly from a sentiment standpoint, spending on artificial intelligence hardware is shifting to increasing at a decreasing rate as opposed to increasing at an increasing rate. According to Brian Colello, Morningstar’s equity strategist for the technology sector, “spending on AI graphic processor units and hardware is less likely to provide anywhere near the massive positive surprises we saw in 2024 as this fast-moving megatrend is better understood.”

The next test for the markets is beginning as companies start to report earnings. We are not as concerned about fourth quarter earnings as economic growth appears to have remained healthy, but we are concerned that management teams may look to lower the bar on the market’s expectations for earnings growth in 2025 as the rate of economic growth is poised to slow.

In our view, the bigger wild card in the first quarter will be what President Donald Trump may or may not do regarding his assertions to implement new tariffs on imports. The questions on everyone’s minds are just how much of this tariff talk is campaign trail rhetoric? How soon will these tariffs be implemented? How big will they be? What countries and products will be taxed? And just as importantly, what countries and products may be excluded?

US market valuation bumping up against the high end of fairly valued

Based on a composite of our intrinsic valuations of the more than 700 stocks we cover that trade on US exchanges, as of Jan. 6, 2025, we calculated that the US equity market was trading at a price/fair value estimate of 1.04. This represents a 4% premium to our fair value estimates. While this might not sound like much of a premium, since the end of 2010 the market has traded at this premium level or higher less than 10% of the time.

At this point, we think investors should remain at a market weight position according to their allocation target based on their risk profiles. However, with the market trading at the high end of our fairly valued range, we are becoming progressively cautious, and positioning is increasingly important.

With stocks fairly valued, how should investors position themselves in 2025?

Based on our valuations, we expect little price appreciation at the market index level until earnings catch up to valuations—which isn’t likely to occur until the second half of the year. In such an environment, undervalued value stocks, especially those that pay relatively high dividends, look especially attractive to us.

Based on our valuations, by market capitalization, we advocate for investors to:

• Overweight: Small-cap stocks, which trade at a 14% discount to fair value.
• Market weight: Mid-cap stocks, which trade at a 2% discount to fair value.
• Underweight: Large-cap stocks, which trade at a 6% premium. The last time large-cap stocks traded at a higher premium was in 2018, right before the market corrected later in the year.

Based on the Morningstar Style Box, we advocate for investors to

• Overweight: Value stocks, which trade at an 8% discount to fair value.
• Market weight: Core stocks, which trade at a 3% premium to fair value.
• Underweight: Growth stocks, which trade at a 24% premium to fair value.

Since 2010, growth stocks have traded at this much of a premium or higher less than 10% of the time. The most recent example occurred in early 2021, right before the disruptive technology bubble popped. While investors should maintain some exposure to growth stocks in their portfolio, we think now is a good time to lock in some profits and underweight the growth category in order to overweight value stocks, which remain at an attractive discount to our valuations and remain market weight core stocks.

By market cap, small-cap stocks remain attractive on both an absolute valuation basis and relative to the broad market.

Notable changes in sector valuations and outlooks

The divergence across sector performance, in conjunction with our valuation changes over the course of the year, has had a wide range of effects.

For example, communications was the most undervalued sector coming into 2024, yet it is now only 5% undervalued, making it the fifth most undervalued. Real estate was the second most undervalued and following a sluggish 2024 is now the most undervalued.

Utilities was one of the more undervalued sectors coming into the year. In 2024, the sector rose almost 27% as utilities became a second derivative play on AI growth, as AI requires multiple times more electricity than traditional semiconductors. As such, it is now one of the more overvalued sectors.

The financial-services sector was trading at a few percent discount to fair value, but as the Fed cut interest rates and the yield curve normalized, the sector skyrocketed more than 31%. As the second most overvalued sector we see a lot of opportunities to sell and lock in profits, as we think the market is overestimating the improvement in net interest margins over the long term.

Technology was trading at a premium to fair value coming into the year. It remains at a 7% premium even after incorporating a number of very large valuation increases across the sector over the year. Similarly, the industrials sector started the year at a premium and remains at a 5% premium today.

Consumer cyclical started the year at a slight premium, but following Tesla’s TSLA meteoric rise after the US presidential election, the sector is now the most overvalued at a 19% premium. The increase in Tesla accounts for almost 40% of the entire sector’s return.

Stocks in the energy and healthcare sectors significantly lagged the broad market. With so much focus on AI over the year, we think the market is overlooking a lot of value in these two sectors as both remain at discounts of 10% and 8%, respectively.

Last, the basic materials sector was the only one to register a loss last year, but we think the market is overly pessimistic about its long-term outlook. We see a significant number of undervalued opportunities as the sector trades at a 7% discount to our fair values.

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