Q3 2025 Stock Market Outlook Key Takeaways
- Following the rally, US stocks are once again trading at a slight premium to our fair value.
- Growth stocks in particular soared to an especially high premium.
- Small-cap stocks remain very attractively valued, but it may take a while before they start to work.
Oftentimes stock markets act like a pendulum and swing from overvalued to undervalued and back to overvalued again—and this year has been one of those times. While we continue to guide investors to invest for the long term, recent short-term market swings created opportunities.
In our 2025 Market Outlook, we noted that the US stock market started the year at a rare premium to fair value. The release of DeepSeek in January was the catalyst that began the selloff in overvalued and overextended artificial intelligence stocks and the downside was further exacerbated following the announcement of the April 2 tariffs. The market fell to a rare discount to fair value, and in our special Market Outlook update published on April 7, 2025, and on the April 7 episode of our weekly podcast, The Morning Filter, we moved to an overweight recommendation on US stocks. Soon thereafter, stocks began an especially steep recovery as the tariffs were put on pause and the market realized DeepSeek was not the threat to AI spending as initially feared.
As of June 30, 2025, the US equity market was trading at a 1% premium over our fair value estimates. While not unprecedented, since 2010 the US stock market has only traded at a higher premium less than 30% of the time.
Looking forward, we suspect that volatility will return this summer. The first tariff deadline looms on July 9, followed by the beginning of second-quarter earnings season, and then the second tariff deadline will quickly approach in mid-August. At the current premium, the market is not providing any margin of safety in order to provide a downside cushion if tariff negotiations go awry or earnings guidance for the third quarter disappoints investors.
As Markets Trade at a Premium, Positioning Especially Important
With the markets back to trading at a premium to a composite of our fair values, positioning is even more important than usual. We continue to advocate for an overweight position in the value category as it trades at a 12% discount to fair value. In order to fund this overweight, we also advocate for an underweight in growth category as it trades at an 18% premium to fair value. Rarely do growth stocks trade at such a large premium, and the most recent instance was in December 2024, right before the bear market in AI stocks began.
By capitalization, small-cap stocks remain very attractive, trading at a 17% discount to our fair value estimate. With large-cap stocks trading at a 2% premium, investors can fund an overweight in small caps with a small underweight in large caps.
Not only are value stocks undervalued on an absolute basis, they remain near some of the most undervalued levels relative to the broad market over the past 15 years. In a market that is becoming overvalued, we see value in the relatively higher dividend yields found in the value category. Undervalued stocks with higher dividend yields can provide investors with both upside appreciation potential from the stock price as well as a return while you wait. In addition, these lower-duration types of stocks should trade off less than the broad market in a downside scenario.
Not only are small caps undervalued on an absolute basis, they remain near some of the most undervalued levels relative to the broad market over the past 15 years.
Historically, small-cap stocks have performed best when the Fed is easing monetary policy, long-term interest rates are falling, and the economy is poised to begin rebounding. That does not appear to be the case in the near term, and while these stocks are undervalued, it may not be until later this year that they start to work. From a monetary policy point of view, the economics team from Morningstar Wealth Management expects the Fed will cut the federal-funds rate twice this year. While they forecast the rate of growth with slow sequentially through the end of the year, they forecast the economy will start to slowly reaccelerate in early 2026. Long-term interest rates are currently trading near their 2025 projection level but should begin a multiyear year downward trend later this year.
Where We See Value by Sector
Sector valuations generally rose as a rising tide across the stock market lifted all boats. Undervalued sectors converged toward fair value, and overvalued sectors became even further overvalued. The exception to the rule were the healthcare and energy sectors. Losses across these sectors have brought both further into undervalued territory.
Healthcare
Healthcare stocks fell out of favor as uncertainty as to how changes in government policy and reimbursement weighed on sentiment. For example, many companies that sell scientific instruments, laboratory equipment, diagnostics consumables, and life science reagents sold off on concerns that reduced government spending will impair their earnings growth. While that may come to fruition for those that supply government-sponsored laboratories, we expect spending among private enterprises to remain steady and think the market is overestimating the downside risk. For example, wide-moat Thermo Fisher Scientific TMO is rated 5 stars after falling 18% year to date. We also see value among the medical-device makers such as 4-star-rated Medtronic MDT and Zimmer Biomet ZBH who continue to have a tailwind as demographic aging leads to increased demand for joint replacements, pacemakers, defibrillators, heart valves, stents, and insulin pumps.
Energy
Energy stocks fell in sympathy with oil prices, which declined to $65/barrel from $71.50. With their large market capitalizations, 4-star-rated Exxon XOM and 3-star-rated Chevron CVX were the greatest detractors to the sector, although losses on those stocks were in line with the broader drawdown on oil names. Fundamentally, we think oil stocks are undervalued, even after incorporating our relatively bearish view on oil prices. In our valuation models, we use the market’s forward strip price for oil for the next two years and then step the price down toward our midcycle price forecast of $55/barrel for West Texas Intermediate crude oil. In addition, we think oil companies provide investors with a natural hedge in their portfolio if inflation were to stage a comeback or geopolitical risks were to push oil prices higher.
Communications
Communications was the second-best-performing sector this year, yet it still remains the most undervalued. Within the communication sector, returns were especially concentrated. Meta Platforms META and Netflix NFLX accounted for 93% of the sector’s return for the first half of 2025. Although mega-cap stock, Alphabet GOOG, remains rated 4 stars and skews the broad sector valuation down, we continue to see significant value in many traditional communication and media stocks as a broad swath of the sector is rated 4 or 5 stars.
Real Estate
The real estate sector continued to lag the broad market again this year. There was no significant return concentrations as the amount of gains only slightly edged out losses. We continue to prefer real estate with defensive-oriented characteristics such as medical office buildings, research and development, multifamily housing, cellphone towers, and self-storage facilities. One example is 5-star-rated Healthpeak DOC, a REIT that invests in a diversified healthcare portfolio of medical office buildings, life science facilities, senior housing facilities, and hospitals. In our view, the market valuation of the stock is implying valuations on the underlying real estate well below where these types of facilities have been selling on the open market.
Overvalued Sectors
The financials sector has been one of the better-performing sectors this year, but we think the market is overestimating the amount of long-term earnings growth. Stocks across the sector are broadly overvalued as the number of overvalued stocks is triple the number of undervalued stocks. Each of the mega-cap US banks—JPMorgan JPM, Bank of America BAC, Citigroup C, and Wells Fargo WFC—are rated either 1 or 2 stars. Credit services companies such as 2-star-rated Visa V and American Express AXP are overvalued, as well as insurance providers such as 1-star-rated Progressive and 2-star-rated Chubb CB and Marsh & McLennan MMC. For investors looking for opportunities in financials, one of the few undervalued stocks left is 4-star-rated US Bank.
The consumer defensive sector remains the most overvalued, yet the sector valuation is skewed into overvalued territory by 1-star-rated Costco COST and Walmart WMT as well as 2-star-rated Procter & Gamble PG. These three stocks account for 34% of the market capitalization of the index. Excluding these three stocks, the rest of the sector trades at a more reasonable 6% discount to fair value. We find stocks for packaged food companies, such as 5-star-rated Kraft Heinz KHC, which trades at half of our fair value, to be particularly compelling.
The utility sector is broadly overvalued and offers few undervalued opportunities. While we incorporate heightened demand for electricity in our financial forecasts, as AI computing requires multiple times more power than traditional computing, we think the market is overestimating too much growth for too long.
Within the industrial sector, the number of overvalued stocks outweighs the number of undervalued stocks by 50%, with some of the largest market-cap stocks rated 1 or 2 stars. Considering we expect the rate of economic growth will decelerate sequentially over the course of 2025, we’d be especially cautious investing in industrials and would require significant margins of safety to guard against slowing earnings over the short term.
While the technology sector is overvalued, we still see targeted investment opportunities as our confidence in secular tailwinds, such as cloud computing and the long-term expansion of semiconductor demand, remains unchanged. Yet, within the tech sector, generative AI stands out as the most important investment theme. Among hardware providers, 3-star Nvidia continues to struggle to keep up with the voracious demand for its products. Cloud vendors (3-star-rated Microsoft’s Azure MSFT, 3-star Amazon’s AWS AMZN, and 4-star Alphabet’s Google Cloud Platform) continue to build additional capacity yet remain capacity constrained. Lastly, software providers such as 4-star-rated ServiceNow NOW are increasingly incorporating AI capabilities within their products.
What’s an Investor to Do?
After the selloff and subsequent snapback rally, we think now is an especially good time for investors to rebalance their portfolio weightings. Specifically, we’d look to take profits in those sectors and stocks that are overvalued and overextended and reinvest into those areas that remain undervalued.
Q3 2025 Market Outlook Webinar
Interested in doing a deeper dive into this year’s market returns and our outlook?
Join me and Chief US Economist Preston Caldwell from Morningstar Investment Management on Thursday, July 10, 2025, at 11 a.m. Central/Noon Eastern as we:
- Break down our valuations and identify undervalued opportunities across categories, sectors, and stocks.
- Highlight investable long-term secular growth themes.
- Provide our forecasts for real US gross domestic product, inflation, and interest rates.
- Answer live audience questions.
Register here.
