- As of Dec. 31, 2025, U.S. stocks trade about 4% below fair value, with small-caps (~15%) and growth (~10%) the cheapest areas.
- Most attractive sectors are real estate (defensive REITs), energy, technology, and communications, while consumer defensive and parts of financials/industrials look stretched.
- Top 2026 risks include a May Fed leadership change, sticky inflation and tariffs, global/China slowdown, private credit stress, and AI-driven concentration.
- A barbell stance—keep selective AI/growth exposure while adding quality value/income and international diversification—can help balance opportunity and risk.
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Valuation Landscape
Morningstar’s analysis reveals U.S. equities are modestly undervalued overall: approximately a 4% discount to intrinsic fair values for over 700 U.S.‐listed stocks as of December 31, 2025. Small‐caps offer the largest discount (~15%), large‐caps about 4%, with growth style stocks trading ~10% below fair value after they revised up their long‐term growth assumptions.
Sectors with Opportunity and Risk
Undervalued sectors include real estate, particularly defensive REITs (retail, healthcare, wireless towers, apartments), which trade at ~12% discount. Energy stocks like SLB, Baker Hughes, and domestic producers such as Devon are trading at deep discounts, with Oilfield Services and Energy producers among the more attractive cyclical plays. Technology and communications have lost some valuation relative to fair values due to rising fair‐value benchmarks, making many names in both the AI infrastructure and traditional software or telco areas appealing.
Overvalued or more vulnerable sectors include consumer defensive giants like Walmart and Costco, which are overweighted relative to fair value, though food names such as Kraft Heinz and Mondelez remain relatively cheap. In financials, banks are being priced for continued growth, but with risks from rate shifts and potentially squeezed margins. Industrial names tied heavily to incremental AI build‐outs may face downside if demand softens.
Macroeconomic & Policy Risks
A Fed leadership transition in May 2026 brings uncertainty, especially with potential shifts in rate policy. Inflation remains sticky in the near term, particularly via tariff‐induced supply chain pressures. Trade and tariffs likely to become more active politically. Private credit concerns and global growth—especially from China or emerging markets—pose downside risks.
Corroborating Views & Broader Market Context
J.P. Morgan Global Research projects resilient global and U.S. growth, but flags ~35% chance of recession in 2026 as risks remain elevated; also warns of sticky inflation and uneven labor market softness. Treasury yields likely to rise moderately later in the year.
Survey data (e.g., from Deutsche Bank poll) highlights a dominant concern among investors: that AI/tech valuations are overextended, followed by fears over loss of Fed independence and private credit stresses.
Morgan Stanley anticipates favorable policy and macro backdrop for risk assets, sees 14% potential upside for S&P 500 in the next 12 months; views bonds favorably in H1 2026. Commodities like metals over energy are preferred.
Strategic Implications & Portfolio Positioning
Given the modest undervaluation and elevated risks, a barbell approach may offer optimal balance: retain exposure to high‐growth (AI and tech infrastructure) names but offset this with quality, value, and income securities (REITs, undervalued energy, telecoms, consumer staples with stable cash flows).
Diversification both by sector and geography is essential—non‐U.S. markets may benefit from a weakening dollar cited by Morningstar and others. International exposure and emerging market debt for investors with sufficient risk tolerance might provide uncorrelated returns.
Closely monitor macro and policy developments: Fed description and Chair designate’s policy stance; inflation trajectory; trade and tariff actions; labor market health; and developments in private credit. Positions should be nimble with defined exit or reallocation triggers.
Open Questions
- What will be the stance and credibility of the Fed Chair after May 2026—will they lean toward easing or maintaining restrictive bias?
- How much of AI’s potential upside is already priced in, and is there risk that growth metrics won’t match lofty expectations?
- Will inflation prove persistent due to trade and federal fiscal policy influences, necessitating higher for longer rates?
- How severe could a slowdown in China or EM growth be, and what effects would that have on global supply chains and corporate margins?
Supporting Notes
- Morningstar reports that as of Dec 31, 2025, the U.S. market was trading ~4% below its composite fair value, with small‐caps ~15% undervalued.
- The technology sector now trades at ~11% discount post‐valuation increases; communications faces a ~9% discount. Value style ~5%; core at fair value.
- Real estate has a ~12% sector‐wide discount; defensive REIT names like HealthPeak (healthcare), Crown Castle (wireless towers), AvalonBay (apartments) cited as attractive.
- Energy companies SLB and Baker Hughes have improved, yet still trade at discounts; domestic producers like Devon are deeply undervalued.
- Overvalued: Walmart and Costco are 1‐star context; financials such as JPM, WFC, Citigroup are rated 2‐stars, suggesting less relative appeal.
- Macroeconomic risk factors include expected slowing GDP growth in H1 2026, heightened inflation pressures from tariffs, upcoming Fed Chair transition.
- J.P. Morgan forecasts moderate gains for U.S. equities, double digits globally, but notes risk of recession (~35%) and sticky inflation as possible dampeners.
- Survey findings via Deutsche Bank: majority of analysts believe AI tech valuations present top risk; Fed independence and private credit crises also ranked high.