September 2025 Stock Market Outlook: Will the Small-Cap Rally Last?

September 2025 Stock Market Outlook Key Takeaways

• Small-cap and value outperform, yet remain undervalued
• Fed poised to cut rates, long-term yields trending lower
• Tariffs distort GDP, economy faces slowing ahead
• Communications, real estate, energy, and healthcare offer best value

As of Aug. 29, 2025, the US equity market was trading at a level equal to a composite of our fair value estimates. The Morningstar US Market Index, our broadest proxy of the US stock market, rose 2.15% in August. The strong monthly return was driven by a broadening across those undervalued areas in the market that had lagged behind the mega-cap growth stocks, which had driven much of the gains earlier this year. The Morningstar US Value Index rose 5.05%, well outpacing the 0.40% return of our US Growth Index and the 3.01% return of our US Core Index. By capitalization, the Morningstar US Small Cap Index rose 4.58%, exceeding the 1.98% and 1.99% returns in the US Large Cap Index and US Mid Cap Index, respectively.

While both the value category and small-cap stocks outperformed in August, we continue to see attractive investment opportunities in these areas as compared with the rest of the market. The value category remains at a 3% discount to fair value, whereas growth stocks remain at an 8% premium and core stocks are close to fair value.

Small-cap stocks remain the most attractive part of the market at a 15% discount, whereas large and mid-cap are fairly valued. We have long noted that small-cap stocks have been attractive on both an absolute as well as relative value basis. Yet, we also cautioned that investing in small caps is a long-term investment, not a quick trade, and small caps should not be expected to work until later this year. However, we advocated for an overweight position nonetheless, as timing an entry point is difficult at best, and once small caps started to outperform, they would rally quickly. This recent bout of outperformance raises the questions, is this outperformance a head fake and starting too early? Or is this the beginning of a real rotation?

Historically, small-cap stocks do best when the economy is reaccelerating from a slowdown or recession, when the Federal Reserve is easing monetary policy, and when long-term interest rates are declining. It appears that two of these three conditions are coming to fruition, with the third still an outstanding question.

We expect the Fed will begin easing monetary policy at the next meeting and conduct additional easing steps throughout 2026. Long-term interest rates have been on a downward trend over the past few months, and the yield on the 10-year US Treasury has been near the bottom of its trading range over the past year. Furthermore, Morningstar’s Investment Management economics team forecast that the 10-year yield will drop below 4% in 2026 and even further in 2027.

That leaves one outstanding condition to be met: Will the US economy reaccelerate over the next few quarters? Or will it slow? From a headline perspective, it appears this condition has already been met, as the reported gross domestic product of 3.3% for the second quarter of 2025 well outpaced the 0.3% contraction in the first quarter. Yet the headline report masked the impact of importers front-running tariffs during the first quarter, thus reducing GDP, and then using that inventory in the second quarter, therefore artificially bolstering GDP. According to Morningstar’s economics team, when stripping out the impact from imports, the real underlying fundamental economy slowed from the first quarter to the second quarter.

According to the most recent Atlanta Fed GDPNow estimate, current economic metrics are running at a 3.0% pace, a relatively strong reading. However, our economics team is forecasting that the impact from tariffs will slow the economy on a sequential quarterly basis through the beginning of 2026.

Jackson Hole Optimism Meets Global Trade Friction

The US stock market got a boost from Federal Reserve Chair Jerome Powell’s speech at the annual conference in Jackson Hole in which he intimated that he was leaning toward easing monetary policy at the September Federal Open Market Committee meeting. Morningstar’s US economics team continues to expect the Fed will ease monetary policy this month at the meeting on Sept. 16-17 by cutting the federal-funds rate by 25 basis points, followed by another cut of 25 basis points at least one more time before year-end. The current forecast calls for another 100 basis points of cuts in 2026.

On the tariff front, the US and EU released additional details on tariffs in accordance with the previously agreed framework. Most EU exports to the US—including cars, pharmaceuticals, semiconductors, and lumber—will face a uniform 15% tariff while generic pharmaceuticals and precursors will receive an exemption. The announcement also reiterated several pledges by the EU to purchase energy products from the US and to make strategic investments within the US. The tariff deadline between the US and Mexico as well as with China was extended to Oct. 30 and Nov. 10, respectively. Tariff talks with Canada appear to have broken down, and additional tariffs were implemented on Canadian goods not covered by the United States-Mexico-Canada Agreement.

Where We See Value by Sector

Communications and real estate currently vie for the most undervalued sector at a 7% discount to fair value.

However, within the communications sector, undervalued mega-cap stock Alphabet skews the sector valuation lower as it was trading at a 10% discount to fair value. Much of the discount between the market price and our valuation stemmed from a difference in opinion as to the outcome of an antitrust case, which could have required Alphabet to divest Chrome and/or Android. Our opinion was that it wouldn’t happen, whereas the market was incorporating a higher probability that it would occur. The court recently released a ruling in which Alphabet won’t be required to divest these segments, thus removing this overhang from the stock, allowing the stock to appreciate to its intrinsic value.

The Morningstar US Real Estate Index rose 3.08% in August, with well over half the return coming after Powell’s speech at Jackson Hole on Aug. 22. With the Fed poised to ease monetary policy, we expect the real estate sector will benefit from lower interest rates as reduced borrowing costs will improve earnings and make their healthy dividend yields even more attractive.

The Morningstar US Energy Index rose 3.43% in August, as oil prices held relatively steady over the month. We continue to find a lot of value in the oil stocks as well as the oil-services companies, 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. If easing monetary policy spurs economic activity, we’d expect to see a rebound in oil prices as demand picks back up.

After lagging for much of the year, the Morningstar US Healthcare Index rebounded in August, rising 5.49%. However, year to date, the index remains the worst performing, only having risen 1.41%. Health insurance stocks have plummeted due to higher-than-expected medical utilization rates and costs. Global pharmaceutical stocks have been pressured by heightened uncertainty about potential changes in governmental reimbursement rates as the administration considers implementing a most-favored nations pricing regime. Within the sector, we see the most attractive value among the medical-device makers, medical technology, and medical consumable products.

Overvalued Sectors

The greatest change among the overvalued sectors in August occurred in the utility sector. The Morningstar US utility sector declined 1.37%, the only sector to register a loss. Typically, with its steady earnings and high dividend yields, the utility sector often acts like a fixed-income security. As such, lower yields should bolster prices of utility stocks. Yet, during August, long-term interest rates declined, and as the market was pricing in a near-certain cut to the federal-funds rate, the utility sector declined. In our opinion, this reinforces our view that the sector had swung too far to the upside and is overvalued. We see very little value across our coverage and note that the only undervalued utility stocks are those that are story stocks, which are undervalued for a reason.

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