Are high-quality U.S. large-cap stocks overpriced?

The overriding theme of the second quarter was a historic risk‑on rally in the U.S. The quarter started with a significant sell‑off following President Donald Trump’s “Liberation Day” tariff announcements, which rapidly reversed after Trump announced a 90‑day pause with most countries. From there, investors largely looked past the looming tariffs, concerns about rising interest rates in response to renewed inflation and/or a growing federal deficit, and a war in the Middle East. Instead, investors focused on the potential stimulative effects of continued artificial intelligence (AI) innovation, the “One Big Beautiful Bill” regarding budget reconciliation, deregulation, and potential Federal Reserve interest rate cuts in the months ahead. These considerations led to exceptionally divergent factor returns in the U.S. Broadly, we highlight three themes:

• A historically speculative quarter in the U.S., particularly in small‑cap stocks: Across the U.S. indices tracked in Figure 1, high‑risk securities generally outperformed lower‑risk securities by 10% to 20%. For historical context, this ranked in the 98th percentile in U.S. large‑caps and in the 96th percentile in U.S. small‑caps, based on rolling three‑month cap‑weighted returns since the start of 1991. For additional context, high‑quality stocks underperformed low‑quality stocks by 10% to 15%. Growth factors beat value factors by 20% to 30%, depending on the universe. These factor returns paint a picture of a high‑risk, low‑quality, speculative growth rally in which valuation concerns were not relevant. This was pronounced in small‑caps, where the least profitable stocks outperformed the most profitable stocks by approximately 10%, while the smallest companies in the small‑cap universe outperformed by more than 10%.
• A return to AI leadership: A large part of the pro‑risk, pro‑growth rally this quarter was renewed interest in potential AI beneficiaries. We have developed “AI betas” for tracking market themes and note the extreme outperformance of the top quintile of AI exposure in the U.S. large‑cap universe (Figure 2).
• Factor divergence between the U.S. and non‑U.S. markets: We highlight that the lower‑quality, risk‑on rally in the U.S. was much more pronounced than in non‑U.S. markets—for example, with high quality outperforming low quality in Japan and value beating growth in Europe. This is notable given that non‑U.S. markets had total returns that were competitive with the U.S. indices. We believe this reflects a combination of stimulative policies in the U.S., along with elevated “animal spirits.”

“A large part of the pro-risk, pro-growth rally this quarter was renewed interest in potential AI beneficiaries.”

Market insight—What we’re monitoring

One of the most important questions we’re getting from clients is what is our view on the valuation of high‑quality U.S. large‑cap stocks. We believe that question serves as an ideal case study to illustrate the Integrated Equity approach, which is a focus of this quarter’s newsletter. Our key conclusions are:

• High-quality U.S. large-cap stocks are historically expensive, although slightly less so following this quarter’s low-quality rally. The data suggest a still-elevated probability of underperformance in the coming quarters.
• However, because their quality is also historically high, we expect additional underperformance—if and when it occurs—to more likely manifest as lagging in an internal market rotation, rather than as a significant drawdown.
• We believe any future underperformance of quality would manifest differently than in the second quarter; while large-cap growth stocks led in the second quarter, we would expect value and smaller-cap securities to outperform in a broadening quality correction.

“High-quality U.S. large-cap stocks are historically expensive, although slightly less so following this quarter’s low-quality rally.”

Refresher on the T. Rowe Price Integrated Equity philosophy

In many industries and professional pursuits, such as medicine, sports, law, politics, and gaming, we see “human + machine” approaches leading to superior outcomes. These trends have accelerated with the explosion of data and computing power and with research that best practices in forecasting and prediction involve base rates and blending “outside” and “inside” views to counteract behavioral biases.

The T. Rowe Price Integrated Equity team’s core philosophy is that blending quantitative and fundamental approaches should lead to better results in investments, too. This is inextricably linked with the idea of combining outside and inside views. As a refresher:

• The outside view uses broad, relevant historical precedents to understand what is most likely to occur in a given situation. In other words, the outside view establishes “base rates” for what has happened historically in similar situations.
• The inside view uses the specifics of an individual situation to understand what is most likely to happen.

To illustrate:

• For professional sports teams, choosing which players to draft combines the outside view (quantifiable metrics like height, speed, and agility) with the inside view (individualized projections from talent evaluators).
• For economists, predicting the probability of a recession involves weighing the base rate of recessions (which are infrequent) with current economic indicators (such as gross domestic product growth and the unemployment rate).
• For our team’s process, we combine the outside view (quantitatively analyzing how stocks with similar growth rates, profitability, and valuation have performed historically) with the inside view (fundamentally assessing corporate strategy, competitive intensity, and management quality).

We now apply that approach to evaluate the pricing of high‑quality U.S. large‑cap stocks.

Valuation of U.S. large-cap high quality: The outside view

We have developed a proprietary valuation metric that values any “factor” (group of stocks) by blending several different calculation techniques and underlying metrics. Each metric has pros and cons, but blending them produces a more robust result.

We define “quality” using a proprietary blend of factors covering three broad categories:

• Stability: High-quality stocks exhibit more stable fundamentals and historical pricing, with more certainty around future earnings.
• Profitability: High-quality stocks have stronger earnings and cash flow generation.
• Debt servicing: High-quality stocks have stronger balance sheets.

Based on these inputs, our analysis suggests that high‑quality U.S. large‑cap stocks are historically expensive (Figure 3). The data are intuitive: High‑quality stocks were historically cheap during the 1998–2000 “tech bubble” and historically expensive during flights to quality leading into the 2002–2003 post‑recession junk rally, during the 2008 global financial crisis, during the  2013 ”taper tantrum” when the Fed was preparing to curtail its asset purchases, and at the height of the coronavirus pandemic.

As shown in Figure 3, early in the second quarter, quality large‑cap companies were as expensive as they had been at any time in the last 30 years. Following the low‑quality rally this quarter, the expensiveness of quality has corrected by approximately one standard deviation, yet quality still appears expensive relative to history.

This relationship tends to predict underperformance of quality (Figure 4). Here, the x‑axis shows the starting valuation of quality using the relationship shown in Figure 3. The y‑axis shows the subsequent 12‑month forward return to the long‑short quality factor. The data suggest that as quality becomes expensive, on the left side of the chart, the probability and potential magnitude of future underperformance rises substantially. The June 30, 2025 reading of approximately 1.4 standard deviations expensive is shown in the red line; historically, such levels have led to a wider range of outcomes for quality securities.

One pushback could be that this is being driven by a narrow set of companies (e.g., AI beneficiaries). We have looked at the data in multiple ways (e.g., by sector, high‑quality and low‑quality companies in isolation, market cap‑ and equal‑weighted), and the results appear to be robust. In other words, we see signs that higher‑quality stocks appear expensive across U.S. large‑cap equities, and this is not limited to mega‑cap technology stocks.

On the surface, this would suggest a potentially pessimistic outside view for the outlook for quality. However, this overstates our pessimism, as we will now discuss with the inside view.

Valuation of U.S. large-cap high quality: The inside view

There are a few reasons to partially discount the outside view shared above. First, we note three significant caveats in the above relationship:

• All previous episodes of quality being extremely expensive have occurred after market drawdowns and flights to quality (e.g., recessions). Currently, the Russell 1000 Index is near all‑time highs following a swift recovery from the early‑April drawdown. Therefore, today’s situation looks quite different. This could imply that there are legitimate reasons for quality to screen as expensive, rather than as a market in which investors are overpaying for safety, as has happened historically.
• Relatedly, previous extreme periods of quality underperformance have happened primarily due to the short leg rebounding—for example, after periods of stress, the low‑quality stocks that underperformed on the way down typically lead the recovery, causing a period of severe underperformance of quality. We see the chances of that as lower given the lack of a significant drawdown in those stocks in the recent past.
• In Figure 3, we also note a trend in the valuation of quality over the past decade. As we’ve referenced in previous newsletters, there appears to have been a fundamental shift in the economy where technology, regulation, and winner‑take‑all economics have led to significant competitive advantages for larger companies. We see this reflected in the trend line, where quality companies have become progressively more expensive over the past decade. This could simply be a reflection of their superior economics. To the extent this is true, this quarter’s market environment appears to have pulled the relationship mostly—but not fully—back to the trend line.

Next, we look at those superior economics more systematically. We observe that profitability levels—and spreads versus the rest of the universe—have increased for the most profitable companies (Figure 5). In other words, the quality level of high‑quality companies today is also historically high. If their quality is even higher today than in the past, one could argue that their valuations should also be elevated relative to history.

Finally, we note that discussions with our fundamental analysts play a large role in our evaluation of the market environment. While specific securities are outside the purview of this newsletter, we note that many of the high‑quality stocks with seemingly expensive valuations are viewed attractively by our talented analysts based on their deep inside views. These views include an understanding of these companies’ leadership positions and moats in their businesses, pricing power, secular growth potential, and management talent. In many of their bottom‑up analytical models, reasonable assumptions justify the outperformance potential for many of these companies.

Synthesis

How do we reconcile the outside and inside views? Our general conclusions are:

Quality looks historically expensive within the U.S. large‑cap universe.

• These levels of valuation would historically imply meaningful chances for underperformance.
• But we temper these concerns by noting a very different market environment today, both fundamental and quantitatively observed trends toward higher‑quality companies meriting more expensive valuations, and bottom‑up work at the firm suggesting that many of these stocks remain attractive at current valuations.

Our view is that high‑quality large‑cap companies remain somewhat expensive today, but not as much as the data suggest. We believe the probabilities are that they will underperform in aggregate at some point over the next year, but we believe it’s more likely that the underperformance will be due to the market broadening out. To the extent that current economic policies lead to continuing growth, we envision an ongoing rotation into parts of the market that have lagged over the last decade (e.g., U.S. small‑cap stocks and international stocks). In that event, we expect investors would use high‑quality U.S. large‑cap stocks as a funding source.

Of note, we are not forecasting a significant decline in high‑quality stocks. As mentioned above, severe underperformance of quality historically has been driven by the short leg. We don’t see those conditions in place today, and if there were to be a big market drawdown, we would expect quality to hold up well.

Specifically, relating our views back to the second quarter: While quality stocks underperformed, leadership was driven by speculative growth stocks. We believe this environment is not representative of how a sustained quality drawdown would unfold; rather, we expect that any sustained drawdown in quality would likely take place as the market broadens beyond high-quality large-cap growth stocks, and this environment would look different—and less speculative—than the second quarter.

Conclusion

Many clients have asked for our views on whether high-quality U.S. large-cap stocks are overpriced. We answer that question by applying the Integrated Equity framework—combining the outside and inside views. The outside view suggests that high quality is historically expensive and that similar periods in the past have led to significant underperformance of quality. However, the inside view suggests that there are economically driven reasons for these stocks to be more expensive, as high‑quality stocks are higher quality today than they’ve ever been. Also, the apparent expensiveness of quality today looks very different from what it did in previous episodes, and we therefore see the risk to high quality as more likely “modest underperformance” while funding a market rotation, as opposed to significant underperformance.

 

Appendix

Factors are our internally constructed metrics, defined as follows:

Valuation: Proprietary composite of valuation metrics based on earnings, sales, book value, and dividends. Specific value factor weighting may vary by region and sector.

Growth: Proprietary composite of growth metrics based on historical and forward‑looking earnings and sales growth. Factor selection and weighting vary by region and industry.

Momentum: Proprietary measure of medium‑term price momentum.

Quality: Proprietary measure of quality based on fundamental and stock price stability; balance sheet strength; and measures of profitability, capital usage, and earnings quality.

Profitability: Return on equity.

Risk: Proprietary composite capturing stock return stability over multiple time horizons (positive return means risky stocks outperform stable stocks).

Size: Market capitalization (positive return means larger stocks outperform smaller stocks).

Quintile spread: Also referred to as long-short returns, a quintile spread is calculated by sorting securities based on a specific characteristic or factor criterion, dividing them into five groups (or quintiles), equal-weighting the securities within each quintile, and then subtracting the bottom-quintile returns (lowest 20%) from the top-quintile returns (highest 20%).

Factors and indices cannot be invested into directly and are shown for illustrative purposes only. They do not reflect performance of actual investments nor do they reflect the reduction of fees associated with an actual investment, such as trading costs and management fees.

Other definitions:

For definitions of certain financial terms visit https://www.troweprice.com/en/us/glossary.