US stock market outlook: tariffs are 2025's wild card

Key Takeaways

• Since 2010, less than 10% of the time the market traded at a 5% premium or more.
  
  
• With the market trading well above the fair value, positioning becomes increasingly important.
  
  
• Macrodynamic tailwinds may keep valuations elevated until earnings catch up.

Outlook for the rest of year

Third-quarter earnings season is in the rearview mirror, fourth-quarter guidance was generally solid, we’ve survived the US elections, and Nvidia’s stock has hardly budged after its results. The Federal Reserve meets to determine its next step in monetary policy in mid-December, but for the most part, we expect a quiet end to the year.

Stocks are up over 27%, and institutional investors aren’t going to want to rock the boat or make any big moves until next year. There will likely be some final portfolio positioning in the first half of the month, selling off losers and tax-loss harvesting, but by mid-December, portfolio managers will have their portfolio where they want it by year end.

US stocks are bumping up against their historical highs as macrodynamic tailwinds continue to overwhelm headwinds. However, we think further upside over the short term is limited until earnings catch up to valuations over the next few quarters. In our view, it appears that stocks are priced to perfection, and valuations do not have any room to allow for any margin of error or unexpected negative catalysts.

As of Nov. 29, 2024, according to a composite of our valuations, the US stock market is trading at about a 5% premium to fair value. That premium may not sound like much, but since 2010, the market has traded at this premium or less than 10% of the time.

Heading into 2025

While stocks may be getting overvalued and priced to perfection, there are good reasons to suspect they can stay that way until either earnings catch up to valuations or there is a catalyst that could lead to a correction.Macrodynamic tailwinds include our forecasts for moderating inflation, declining interest rates, easing monetary policy, and a soft economic landing.

Morningstar’s economics team forecasts inflation to moderate over the next year, dropping below the Fed’s 2% in 2025.

In the short end of the yield curve, our economics team expects the Fed will continue to lower the federal-funds rate, dropping all the way to a 3% to 3.25% range by the end of 2025.

In the longer end of the curve, interest rates have bounced higher since the Fed began to ease monetary policy. Yet, our economics group expects this bounce will be short-lived and projects the yield on the US Treasury 10 year will fall back to 3.60% next year.

In addition to easing monetary policy in the US, the European Central Bank is expected to ease its monetary policy, and China recently announced a host of fiscal and monetary stimulus measures to prop up its economy.

In addition to these tailwinds, following the election, the market is now not only anticipating the extension of the 2017 Tax Cuts and Jobs Act but also pricing in a high probability of additional tax cuts to the corporate tax rate as well as personal tax rates.

The market also expects that the Trump administration will loosen regulatory burdens, thus spurring faster economic and earnings growth rates. In addition, traders expect the new administration will ease the amount of scrutiny applied to mergers and acquisitions for antitrust concerns, thus allowing an uptick in buyouts in 2025, especially in the technology sector, which had been under close examination.

Wild card for 2025: To tariff or not to tariff

The most significant wild card on the table for 2025 will be the potential implementation of tariffs. The question being—how much tariff talk was campaign rhetoric versus how much may become reality?

Depending on the details of what tariffs are applied, to which specific geographies and/or products, how much the tariffs may be, and—just as importantly—what may be excluded from tariffs will have significant implications on corporate margins and stock valuations.

Many companies that import a significant amount of their products, such as Best Buy (NYS: BBY), could see their margins compress, as we expect they would be unable to quickly pass through all of the added costs to their customers. Looking forward, we expect there will be a wide range of valuation outcomes from relatively little to a lot, depending on the amount of margin compression and how long that compression will last.

Yet, not all companies would be negatively affected. Companies with greater domestic sourcing, or sourcing from areas that are not subject to tariffs, as compared with their competitors may benefit. Other companies that have strong pricing power may be able to quickly pass through those added costs, and assuming only a modest pullback in volume could see their earnings rise.

In addition to the potential impact on individual stock valuations, the imposition of tariffs will have impacts on the broader economy and bond markets. According to Preston Caldwell, Morningstar’s chief US economist, “Tariffs are highly likely to drag on real GDP, but the impact on inflation and interest rates depends on the fiscal and monetary policy response.

For example, if the proceeds from tariffs are used for tax cuts, the tariffs would be more inflationary or would lead to higher interest rates as a result of the Fed’s response to inflationary pressures.”

Positioning has become increasingly important

In a market that is edging into an overvalued territory yet has strong tailwinds, we think portfolio positioning has become increasingly important. Investors should look to underweight those areas that are not only overvalued but also at greater downside risk.

Yet, investors should not only overweight those areas that are undervalued but also benefit from those tailwinds propelling us into 2025.

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

• Overweight: Small-cap stocks, which trade at an 8% discount to fair value.
• Underweight: Mid-cap stocks, which trade at a 5% premium to fair value.
• Underweight: Large-cap stocks, which trade at a 5% premium. In fact, the last time large-cap stocks traded at a higher premium was in 2018, right before the market corrected late that year.

By Morningstar Style Box, we advocate for investors to:

• Overweight: Value stocks, which trade at fair value.
• Market weight: Core stocks, which trade at a 2% premium to fair value.
• Underweight: Growth stocks, which trade at a 17% premium to fair value. Since 2010—growth has rarely ever traded at such a high premium. Only during the 2020-21 “disruptive tech bubble” did growth stocks trade at a higher valuation.

According to our valuations, on both an absolute and relative value basis, we think the rotation into small-cap stocks and value stocks still has room to run. Historically, small caps do well when the Fed is easing monetary policy and interest rates are coming down. Not only are value stocks more attractively valued, but we think the rotation into value will pick up steam as the economy slows and earnings growth for growth stocks begins to slow.

Is the reflation trade on the table?

The reflation trade is to position one’s portfolio into those sectors and stocks that would stand to benefit the most in an environment where the economy reaccelerates after a slowdown/recession and reignites inflation. In such an environment, cyclical sectors that are most correlated to the economy and those companies with the strongest pricing power would be expected to outperform the broad market.

Following the reelection of Donald Trump, we have heard more investors considering repositioning their portfolios in anticipation of the reflation trade being the theme for 2026. These investors expect the Trump administration would enact policies that spur economic growth and loosen regulatory overhang that may have stunted economic growth. While this is not our base case, we see several sectors that we think are undervalued and attractive irrespective of whether the reflation trade comes to fruition or not.

To the upside, we see value in the energy sector, which trades at a 4% discount to a composite of our fair values. While we have a relatively bearish outlook on the long-term price of oil and forecast prices for West Texas Intermediate and Brent crude will drop to $55 and $60 a barrel, oil stocks are trading at levels that inherently place oil prices and demand even lower. We also think that energy stocks provide investors with a natural hedge against any expansion of geopolitical turmoil or against a rebound in inflation.

On the upside, in an environment where global economic growth rises faster than expected, we think rising oil prices would provide a significant amount of positive leverage to these stocks. One such undervalued stock includes 4-star-rated Devon Energy (NYS: DVN), which trades at a 20% discount to our fair value. We view Devon as a steady, low-cost provider whose assets are on the low end of the US shale cost curve.

Another example includes the basic materials sector, especially those chemical companies that have pricing power. One such example is the 5-star-rated Dow (NYS: DOW). This stock trades at a 37% discount to our fair value. Over the past few years, Dow suffered from both supply chain disruptions and a broader global economic slowdown. As a commodity chemicals producer, Dow’s results are subject to high operating leverage where a small increase in volumes would have a large impact on profits.

While healthcare would not traditionally be considered a candidate for the reflationary trade, it is one of the few sectors we see trading at a discount. In fact, while the entire sector trades at a 2% discount, that discount is even greater if you exclude the impact of large-cap 2-star-rated Eli Lilly (NYS: LLY), which trades at a 37% premium to fair value.

Excluding Eli Lilly, the healthcare sector trades at a 6% discount. Some of the best valuations include medical device-makers such as 4-star-rated Becton Dickinson (NYS: BDX), Medtronic (NYS: MDT), and Edwards Lifesciences (NYS: EW). We also see a number of idiosyncratic opportunities where we don’t think the market is correctly valuing the value of drug markets pipelines such as Bristol-Myers (NYS: BMY), Amgen (NAS: AMGN), and Gilead (NAS: GILD).

Sectors to underweight

On the downside, in an environment where inflation is rising and pushing interest rates higher, we would underweight interest-rate-sensitive sectors such as the utility sector. The utility sector has risen substantially this year. After having started the year as one of the most undervalued sectors, it is now one of the most overvalued, trading at a 16% premium to fair value.

While an expanding economy should benefit the industrials sector, we think industrial stocks are already trading at too high of a valuation for long-term investors. Examples of overvalued stocks include 1-star-rated transportation stocks such as no-moat United Airlines (NAS: UAL), Delta Air Lines (NYS: DAL), XPO (NYS: XPO), and Saia (NAS: SAIA). Even high-quality companies such as wide moat-rated Caterpillar (NYS: CAT) and John Deere (NYS: DE), which are rated 1-star and 2-star, respectively, are significantly overvalued. The only undervalued opportunities we see in this sector are either those that have had idiosyncratic issues such as 4-star-rated United Parcel Service (NYS: UPS), which has been under margin pressures, or defense stocks such as 4-star-rated Northrop Grumman (NYS: NOC).

The financial services sector has skyrocketed higher this year in anticipation of a steepening yield curve, which in turn is expected to bolster net interest margins. Yet, here too, we think the sector has traded too far to the upside. Wide moat-rated JP Morgan (NYS: JPM) trades at a 40% premium to our fair value, placing it well inside 1-star territory. Among the other major US banks, both Wells Fargo (NYS: WFC) and Bank of America (NYS: BAC) are rated 2 stars.

Another area within financials we think has run too far includes the insurance agencies. Progressive Corporation (NYS: PGR) and Allstate Corporation (NYS: ALL) are both rated 1 star. While insurance companies have been able to benefit from favorable underwriting conditions and higher interest rates, we expect underwriting premiums will begin to contract, and the impact of higher interest rates will be overstated.

From a sector perspective, the consumer defensive sector is one of the more overvalued, trading at a 15% premium to fair value. However, the sector valuation is skewed higher by 1-star-rated Costco (NAS: COST) and Walmart (NYS: WMT), as well as 2-star-rated Procter & Gamble (NYS: PG) as these three stocks comprise 31% of the Morningstar US Consumer Defensive Index. Excluding these from our sector valuation, the consumer defensive sector trades at a 5% discount to fair value.

While Costco and Walmart are both experiencing rapid earnings growth as consumers search for value in a world where the compound impact of two years of high inflation has boosted prices ever higher, at a P/E ratio of 50 times and 33 times our forecasted earnings, respectively, we think the market is overestimating their long-term growth prospects. We see much better value among the food manufacturers such as 5-star-rated Kraft Heinz (NAS: KHC) or 4-star-rated General Mills (NYS: GIS), or alcoholic beverage companies such as 4-star-rated Constellation Brands (NYS: STZ).

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.