Are U.S. Large-Cap Funds Overvalued?

As 2013 draws to a close, large-cap growth funds are averaging a 30% gain for the year to date, and large-blend and -value are not far behind. The S&P 500 has now gained 192% since the market hit bottom on March 9, 2009. Pundits, portfolio managers, and ordinary investors are wondering whether stock prices have outstripped their 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 are overvalued. As of Dec. 1, the stocks covered by Morningstar had a median price/fair value ratio of 1.04, up from a 52-week low of 0.95 at the end of March.

We calculated a price/fair value ratio for large-cap domestic funds rated by Morningstar's mutual fund analysts. (Results were limited to recent portfolios for which the figure could calculated on least 75% of assets.) In line with our Market Fair Value, the overall portfolio of the  Vanguard 500 Index (VFINX) had a ratio of 1.03. That's up from 0.96 when we last investigated the price/fair value ratios for funds at the beginning of this year.

Values Are Scarce
Large-cap growth funds still have the highest ratios, but bargains are now scarce even among large-cap value funds. Back in January, a number of large-cap value funds had price/fair value ratios in the 0.80s. Today, more than half of the large-cap value funds we looked at had price/fair value ratios at or exceeding 1.0.  Vanguard Value Index (VIVAX) is one of the priciest of these, at 1.02.

The lowest ratio we calculated was 0.95, for  American Century Value (TWVLX). Whether or not the fund is a great value proposition right now, its long-term prospects remain excellent. Lead manager Phil Davidson, who has run the fund since its inception 20 years ago, looks for out-of-favor industry leaders with a competitive edge, little debt, and high return on capital.

Dividend-Oriented Funds Look Better
Early this year, funds that focus on high-dividend stocks had price/fair value ratios higher than the Vanguard 500 Index's. Investors seeking both income and security had been favoring solid dividend-payers for some time, and their stock prices were relatively high. A year ago, value iconoclast Bill Nygren contended that low-growth, high-yield stocks were among the riskiest on the market, and  Oakmark (OAKMX) had a price/fair value ratio of 0.89, among the lowest we calculated.

After another year of top performance, Oakmark's portfolio is now almost fully valued by our measure, with a ratio of 0.98. This is still one of the lower price/fair ratios we calculated, but it no longer is a counterpoint to dividend-oriented funds, which have generally seen middling returns in this year's rally.  Vanguard Equity-Income (VEIPX) had a ratio of 0.97 early this year and now has a ratio of 0.98.  Columbia Dividend Income's (GSFTX) ratio rose a bit more, from 0.96 to 1.0, but it is now a better value than the market overall.

Growth Zooms Ahead
Some growth managers are more particular about price than others, but today even the growth fund with the lowest ratio,  JHancock Large Cap Equity (TAGRX), is just about fully valued at 0.99. The priciest funds-- Columbia Select Large Cap Growth (UMLGX )and  JPMorgan Large Cap Growth (SEEGX)--clock in at 1.17.

 Jensen Quality Growth (JENSX) was notably well-priced in January. The fund's team runs a low-turnover portfolio of picks that are attractively valued according to the team's long-term discounted cash flow analysis, and the portfolio had a ratio of 0.92 at the time. It is now at 1.02. The managers at  Vanguard PRIMECAP Core (VPCCX) look for stocks with good long-term growth potential but temporarily depressed valuations, but the portfolio's price/fair value ratio has risen to 1.04, from 0.94 at the beginning of the year.

The price/fair value ratio is not a buy or sell signal. In January,  Harbor Capital Appreciation (HACAX) sported the highest ratio, at 1.04. (It is now 1.13.) As noted then, there was no cause for alarm: The portfolio run by Sig Segalas and team generally has higher growth rates and higher valuations than its peers. As it turns out, selling then would have meant missing out on most of a 32.5% return so far this year.

All the funds cited above are Morningstar Medalists, which indicates that we expect them to outperform within their categories over the long term. That said, current price/fair value ratios are a reminder to rebalance and diversify.

Morningstar does not regularly calculate price/fair value ratios for open-end mutual funds. However, the ETF Valuation Quickrank includes the measure, and lends insight into how categories and sectors stack up.