Are U.S. Large-Cap Funds Fully Valued?

You wouldn't guess it from the flood of money that flowed into bond funds, but 2012 was a good year for domestic-stock fund investors. Core large-cap holdings were strong performers, with returns for large-cap blend, large-cap value, and large-cap growth categories all around 15% for the year.

With last year on the books, stocks have come a long way since the market hit bottom on March 9, 2009. The S&P 500 has gained 138% since then, through Jan. 23. Are prices getting ahead of underlying values?

Morningstar's stock analysts have developed their own measure of fair value, using a proprietary discounted cash-flow model to assess the more than 1,600 mostly large-cap names they cover. A stock with a price/fair value ratio greater than 1.0 is considered overvalued. Using that data, Morningstar calculates an overall Market Fair Value.

By that measure, larger-cap stocks overall now look fully valued. As of Jan. 24, the stocks covered by Morningstar had a median price/fair-value ratio of 1.01, up from a 52-week low of 0.85 in mid-2012. Some context: The all-time low ratio for the median stock Morningstar covered was 0.55 in November 2008.

We calculated a price/fair value ratio for large-cap domestic funds in the Morningstar500, a curated selection of funds featured in Morningstar FundInvestor. (We limited the results to recent portfolios for which we could calculate the figure on least 75% of assets.) In line with our Market Fair Value, we found the overall portfolio of Vanguard 500 Index VFIAX has a ratio of 0.96.

Not surprisingly, large-cap growth funds tend to have higher ratios than large-cap value funds', with large-blend funds' falling in between. However, the differences these days are not that dramatic. While the large-cap growth fund with the highest price/fair value ratio, Harbor Capital Appreciation HACAX, has a ratio of 1.04, some large-cap value funds are closing in on a ratio of 1.0.

- source: Morningstar Analysts

Dividends Drive Up Valuations
Investors hungry for both income and security have been favoring solid dividend-payers for the past several years. As a result, some value-oriented funds that focus on high-dividend stocks now show price/fair value ratios higher than the S&P 500's.Vanguard High Dividend Yield Index VHDYX is almost fully valued with a ratio of 0.98 and Vanguard Equity-Income VEIPX is close behind, with a ratio of 0.97. Columbia Dividend Income GSFTX is in third, with a ratio of 0.96.