US Stock Market Outlook: No Longer ‘Priced to Perfection’

Tariffs announced by President Donald Trump were significantly higher than what Morningstar’s US economics team had originally contemplated in its forecasts. As such, the team has made the following changes to their projections.

Economic Growth

Morningstar senior US economist Preston Caldwell lowered our forecasts for real gross domestic product GDP.

• 2025 to 1.2% from 1.9%

• 2026 to 0.8% from 1.6%

• 2027 to 2.1% from 2.5%

Over the next few quarters, GDP reports may be skewed by the amount of imports made before the tariffs and then from inventory adjustments as that supply is used. We may also see importers try to postpone additional purchases in the hope that tariffs will be lifted before their required replenishment. However, while reported GDP per quarter may vary based on these factors, over the course of 2025, we expect real economic activity will slow sequentially throughout the year.

While our base case envisions positive, albeit sluggish, growth rates, our economics team is now estimating that there is a 40% to 50% probability of a recession this year.

Inflation

Our US economics team also increased its forecast for inflation as measured by the Personal Consumption Expenditures Price Index, or PCE Index.

• A PCE forecast of 3.3% in 2025 as compared with the prior forecast of 2.4%.

• A core PCE forecast of 2.6% in 2026 as compared with the prior forecast of 1.9%.

Where Are We Now?

In our 2025 US Stock Market Outlook, we noted that the market entered the year trading at a rare premium to a composite of our fair valuations. In fact, since 2010, less than 10% of the time had the market traded at that much of a premium or more.

Morningstar US Equity Research Coverage Price/Fair Value Estimate

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As such, at the beginning of the year, we noted that we had become progressively cautious and that positioning was even more important than usual. According to our valuations, we recommended that investors overweight the value category, market-weight the core category, and underweight growth stocks. Growth stocks, in particular, were significantly overvalued, trading at their highest premium since early 2021, the height of the tech bubble. We specifically recommended that investors should lock in profits in growth stocks in order to use the proceeds to overweight value stocks.

For the year to date through April 4, the Morningstar US Market Index sold off 13.76%, and from its high on Feb. 19, it has sold off 17.66%. Yet, not everything is as bad as it appears on the surface. For the year to date, the Morningstar US Value Index only fell 5.06% as compared with the Morningstar US Core Index’s 15.20% decline. The Morningstar US Growth Index plunged 17.54%.

In our 2Q 2025 US Market Outlook, we noted that artificial intelligence stocks had entered a bear market, as many had sold off 20% or more since they peaked just before the emergence of DeepSeek. While much remains unknown about the true costs and capabilities of DeepSeek, it was the catalyst that has caused the market to recalibrate its growth expectations for AI and reevaluate the high valuations on those stocks.

By sector, we recommended to:

• Underweight consumer cyclicals, financials, consumer defensive, technology, and utilities.

• Market-weight communications and industrials.

• Overweight real estate, energy, healthcare, communications, and basic materials.

For the year to date, several of the sectors we viewed as the most overvalued have now fallen the most, whereas undervalued sectors have generally fared better.

In the fixed-income markets, we recommended lengthening the duration of your bond portfolio to lock in the high interest rates. Yet, while lengthening duration, we also recommended sticking with US Treasuries and underweighting corporate bonds, as both investment-grade and high-yield corporate-bond spreads were too tight and did not adequately compensate investors for the credit rise.

In 2025 through April 4, the spread of Morningstar’s US Corporate Bond Index widened 32 basis points to 111, and the spread of Morningstar’s US High Yield Bond Index widened 148 basis points to 438. Widening credit spreads have limited the return for the investment-grade index, which has underperformed the core bond index and led to a loss in the high-yield index.

What Should Investors Be Doing Today?

We think valuations have fallen enough for investors to begin to move into a small, tactical overweight position. The amount an investor should be willing to overweight will be based on their long-term investment goals and risk tolerance. Investors have their own portfolio management styles, and this is not investment advice or a recommendation but an example as to how some investors may manage their portfolios by dollar-cost averaging. The first step is to determine what your maximum overweight position in US equities would be as a percentage of your total investment portfolio. For example, some investors with a targeted portfolio allocation of 60% equity and 40% fixed income may be comfortable rebalancing to 70% equity and 30% fixed income.

Start moving to an overweight position by reallocating 3% of your portfolio out of fixed income and into equity. Then set a target to make your next reallocation, such as if the market falls another 5%. If the market drops to that target, move the next 3% out of fixed income and into equity. Lastly, set the next target—the market falls another 5%, for example—and if the market hits that target, invest the remaining 3%. From April 4, when an investor gets to that full overweight position, the market will have fallen a total of 24% for the year to date and a total of 33% from its high on Feb. 19.

With little precedence to gauge the longer-term impact of the tariffs and how they may or may not be renegotiated in conjunction with very high market volatility, now is not the time for most investors to be reaching too far down the risk spectrum. It seems likely that there could be a significant amount of negative sentiment in the market until there is greater clarity regarding the impact and duration of tariffs. Additionally, as more clarity develops around the duration and magnitude of tariffs, the reactions by trading partners, and exemptions to tariffs, analysts will likely further update fair values.

Based on our valuations, we continue to recommend the following positioning by style:

• Remain overweight the value category, which trades at a 22% discount to fair value.

• Begin to move to an underweight position in the core category, which trades at a 13% discount to fair value, from a market-weight.

• Begin to move to a market-weight position in the growth category, which trades at a 15% discount to fair value, from an underweight position.

By capitalization,

• Remain overweight small-cap stocks, which trade at a 29% discount to fair value.

• Begin to underweight mid-cap stocks, which trade at a 15% discount to fair value, from a market weight.

• Begin to move to a market-weight position in large-cap stocks, which trade at a 17% discount to fair value, from an underweight position.

While small-cap stocks remain significantly undervalued, it may take a while before the market sentiment shifts to a positive view on small caps. Historically, small-cap stocks do best when:

• The Federal Reserve is easing monetary policy,

• The economy is viewed as bottoming out and poised to start to rebound.

• Long-term interest rates are declining.

That is not the environment we currently find ourselves in. Today:

• Monetary policy is especially cloudy.

• Morningstar expects the US economy will be much weaker than originally projected as the tariffs are higher than the US economics team expected.

• Only one characteristic is positive for small-cap stocks, and that’s the decline in long-term interest rates. However, this is due to investors heading for safety in US Treasuries.

Sector Valuations

Following the broad market selloff, only the consumer defensive and utilities sectors remain overvalued. Even then, consumer defensive is only overvalued because it is skewed by 1-star-rated Walmart WMT and Costco COST and 2-star Procter & Gamble PG, the three largest companies by market capitalization in the sector.

Among the other sectors, communications is the most undervalued, trading at a 32% discount. While 5-star Alphabet GOOGL and 4-star Meta Platforms META account for a large degree of the undervaluation, we see many undervalued opportunities among the more traditional communications names.

Technology has now fallen to the point where it is the second-most undervalued sector, trading at a 22% discount to fair value. We see a significant number of opportunities across both the traditional technology stocks as well as those tied to AI, which have fallen too far in this bear market.

Energy is the third-most undervalued sector, trading at a 19% discount to fair value. We see a significant amount of value among the oil exploration and production companies, even after we lowered their fair values to account for the reduction in the two-year forward strip price for oil. Our long-term price assumption is $55 per barrel for West Texas Intermediate crude and $60 per barrel for Brent, both lower than today’s spot prices. Plus, we think energy will act as a natural hedge in your portfolio if inflation were to ramp higher and/or geopolitical risk were to put oil supply distribution chains at risk.

Characteristics to Look for in Stock Selection

From an individual stock perspective, we’re seeing an increasing number of stocks dropping into 4- and 5-star ranges. While evaluating these opportunities for your portfolio, we recommend looking for the following characteristics:

• A wide or narrow Morningstar Economic Moat Rating.

• Stocks already trading at a large margin of safety from our intrinsic valuation.

• An attractive dividend yield.

• A stock that is considered to be defensive by the market.

• A stock that is categorized as a value stock.

• A stock in an undervalued sector.

• No or low direct impact from tariffs.

• An intrinsic valuation based on a relatively modest growth rate as opposed to an assumption for especially rapid growth.

• A solid balance sheet with little refinancing risk, preferably with investment-grade credit ratings.

• A stock trading at a modest earnings valuation (that is, forward P/E ratio).

A few examples of stocks with these characteristics include Campbell CPB, Exxon Mobil XOM, and International Flavors & Fragrances IFF. For a discussion on these stocks, please see 3 Stocks to Buy and Hold During Tariff Chaos.

Fixed-Income Positioning

Based on projections from Morningstar’s economics team for interest rates to decline over the next few years, we recommend maintaining the long-duration profile that we recommended at the beginning of the year. While the easy near-term gains are probably behind us following the recent bond rally, over the next few years, we expect fixed income to provide returns in line with their current yields with some additional upside potential as yields fall over the next three years. We also maintain our recommendation to underweight corporate bonds. While corporate credit spreads have widened, we still don’t think they have widened enough to appropriately compensate investors for elevated downgrade and default risk.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.