Key Takeaways
- Separate signal from noise and focus on fundamentals and valuations.
- Even after outperforming, we continue to recommend value stocks over growth.
- Small-cap stocks have failed to deliver but remain attractive.
- Sector valuations are generally consolidating toward fair value.
Focus on the Fundamentals, Ignore the Noise
One of the hardest aspects of investing is separating signal from noise. Divining between news that identifies a paradigm shift that will either positively or negatively affect earnings (signal) versus news that garners a lot of attention yet will not meaningfully impact a company’s business (noise).
Only two months into the year and it already feels like we have had a full year’s worth of headlines. From earnings and guidance, to the DeepSeek scare, to President Donald Trump’s on-again, off-again tariffs, volatility has risen anew.
In such an environment, what’s an investor to do? Investors should focus on the fundamentals, maintain a long-term mindset, and pay attention to valuations. And that is just what our analyst team is doing, scrutinizing the long-term fundamentals underlying sector outlooks and analyzing the long-term assumptions that drive our valuation models. Considering how fluid the situation remains as to the threats of implementing tariffs, once we have specificity on the amount of tariffs that will be implemented and a base case as to how long those tariffs may last, we will adjust our projections and valuations accordingly.
US Stock Market Valuation and Outlook
As of Feb. 28, 2025, according to a composite of our valuations, the US stock market was trading at about a 1% discount to fair value. That was the first time since a year ago (when stocks pulled back following inflation data that led to a shift in interest-rate expectations) the market has traded at a discount to a composite of our fair values.
Value Is Significantly Outperforming Growth
In the 2025 US Market Outlook, we highlighted that the US stock market was bumping up against the upper end of our fair value range and investors should temper their return expectations for this year. In fact, since the end of 2010, the market had traded at that much of a premium or higher less than 10% of the time. With the market trading at the high end of our fairly valued range, we noted that we had become progressively cautious and positioning is increasingly important.
Our valuations indicate that there is still potential for the rotation into value stocks, both in terms of absolute and relative value. Value stocks are not only more attractively priced, but we believe that as the economy slows and the earnings growth of growth stocks slows, the rotation into value will accelerate.
We also continue to see an opportunity in small-cap stocks, which remain undervalued compared with the broad market on both an absolute and relative value basis.
Are the Trump Tariffs Coming to Fruition?
We had also stated in our outlook for 2025 that “what President Donald Trump may or may not do regarding his assertions to implement new tariffs will be the bigger wild card in the first quarter.” That assertion is beginning to bear fruit. Yet, for now, this may mostly be noise as it will be the final resolution of the tariff negotiations that will affect long-term valuations.
The questions now are: What will be the final resolution of the tariff negotiations with both Canada and Mexico as well as China? Which goods may be exempt from tariffs and which will be subject to them? How much will the tariffs be? How long will there be tariffs? What tariffs will be implemented in retaliation? These details will have significant implications on corporate margins and stock valuations.
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We expect that Canadian oil producers would be significantly negatively affected as a 10% tariff makes overseas medium and heavy crude more attractive to US midcontinent and Gulf refiners. Examples of other Canadian products that could be hit include lumber and potash. Companies with facilities in Mexico, such as automakers Ford F and General Motors GM and power sports equipment maker Polaris PII, would be unlikely to quickly pass through tariffs. Also, it would be hard for Mexican product distributors like Constellation Brands STZ to quickly absorb price increases.
Examples of sectors that would be negatively affected by higher tariffs on Chinese imports include apparel and apparel retailers, such as Macy’s M and Kohl’s KSS, which lack the pricing power to push through cost increases. Due to the fact that Mexico is the company’s second-largest source and China accounts for 60% of its cost of goods sold, Best Buy BBY may be particularly vulnerable. Similarly, technology companies like Apple AAPL that import electronic goods from China would have to raise prices substantially to maintain their margins.
Yet not all companies would be negatively affected. When compared to their rivals, businesses that have greater domestic sourcing or source from regions that are not subject to tariffs may gain. 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.
Positioning Remains Especially Important
In such a volatile market in which economic policy can lead to such a quick change in valuations, portfolio positioning remains especially important. No matter how the tariffs may play out in the short term, we think investors should look to overweight those areas trading at a significant margins of safety below their long-term intrinsic values and underweight those areas that are overvalued.
Based on our valuations by market capitalization, we recommend that investors:
- Overweight small-cap stocks, which trade at a 16% discount to fair value.
- Market-weight mid-cap stocks, which trade at a 2% discount to fair value.
- Slightly underweight large-cap stocks even though they trade at a 1% discount because they are more highly valued than small-caps on a relative basis.
By style, we recommend that investors:
- Overweight value stocks, which trade at a 4% discount.
- Overweight core stocks, which trade at a 3% discount to fair value.
- Underweight growth stocks, which trade at a 7% premium to fair value. While the premium has dropped considerably as growth stocks have sold off, it remains at a high premium to our valuations.
Sector Valuations Are Consolidating
With growth stocks selling off and value stocks appreciating, we have seen our sector valuations consolidate toward fair value as overvalued sectors have become less overvalued, and undervalued sectors have become less so. For example, healthcare, real estate, and basic materials were some of the more undervalued sectors at the beginning of the year, but each has moved closer toward fair value. Consumer cyclical was the most overvalued sector at the beginning of the year, but it has since returned to fair value.
Bucking the trend are communication services and consumer defensive. The communication-services sector has become more undervalued following several notable increases in our fair values on stocks such as Alphabet GOOGL and Meta META. Consumer defensive has become further overvalued and is now the most overvalued at a 17% premium. The three stocks that account for the greatest percentage of the sector’s market capitalization, Walmart WMT, Costco COST, and Procter & Gamble PG, have risen 7%, 12%, and 9%, respectively, for the year to date.
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