A False Sense of Security?

Europe made progress in the beginning of September, but with stock valuations looking full and the global economy on edge, pullbacks are still possible.

Jeremy Glaser 24.09.2012
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Stocks reclaimed plenty of multi-year highs in the beginning of September. The Nasdaq touched levels not seen since 2000, and the Dow got back to its pre-crisis December 2007 high. The market seemed to be cheering progress in Europe and mostly shrugging off disappointing U.S. jobs data.

The cheers were not totally unfounded. Europe did make a substantive step forward, and the jobs data--although disappointing--was hardly a disaster. But the world economy is far from out of the woods, and given how much stocks have run up, and how full valuations have become, investors must continue to exercise caution and should be prepared for a potential pullback.

Europe Ends Its Vacation
Europe made a real effort to bring its debt crisis under control in the beginning of September. After promising to act last month, we finally got the concrete details of the European Central Bank's plans to keep short-term borrowing rates reasonable for some beleaguered eurozone members. And the details mostly lived up to expectations. Unlike previous plans that seemed to be filled with hidden landmines, the new outright monetary transaction plan looks like it can achieve its goals. The rub is that the goals of this plan are modest compared with the size of the eurozone crisis.

The ECB is planning on buying bonds with maturities between one and three years from countries that have entered into some kind of bailout agreement with the European Financial Stability Facility or the forthcoming European Stability Mechanism. The bond buying should have the impact of reopening the short-term bond markets for some of the most indebted countries. This potentially neutralizes the troubling scenario where short-term rates rise so high for some peripheral countries that they would be unable to roll over their maturing debt and would be forced into a disorderly default. 

The ECB likely made its program conditional on participation in a broader bailout in order to dampen political opposition. Although the bank is ostensibly an independent institution, it is still very much impacted by the political winds. Germany in particular is worried about the euro being destabilized in an effort to bail out peripheral nations without imposing any structural reforms. Germany still isn't thrilled with this plan, but the conditionality helped it go down a bit easier.

The flip side is that this decision could make it somewhat harder for the ECB to back up its forceful statement that the euro is irreversible. Take Greece for example. It is almost certainly not on track to meet the requirements in its bailout agreement. If those requirements don't get tweaked, and the country is found to be out of compliance, will the ECB decline to purchase Greek bonds as it says it will? If bailout funds are withdrawn, the only chance of the country staying in the euro would be a massive intervention from the ECB. This scenario would force the central bank to either change the rules of this program or back off from its talk on the euro. Neither of these options will be attractive. It is very much an open question which way it would go.

The program may reduce some of the tail risk of a breakup of the eurozone and provide useful space for economies working within the bailout mechanism to recalibrate, but it certainly doesn't eliminate the risk altogether.

U.S. Jobs Picture Still Not Pretty
The eurozone crisis is hardly the only worry that investors have on their minds. A general slowdown in the U.S. economy could also derail corporate profits and investors' hopes.

The jobs report wasn't inspiring, but it was hardly a disaster. The economy is still adding jobs, even if at a lower level than economists had hoped for, and the enormous layoffs that marked the peak of the crisis are now a distant memory. But unemployment remains very high, workers are dropping out of the workforce, and the ranks of the long-term unemployed remain large. A robust employment recovery always seems to be frustratingly out of reach. 

Add in some disappointing manufacturing data from the ISM, and the U.S. economy appears to be treading water. GDP is still moving in the right direction, but at a glacial pace. And although the U.S. economy is not nearly as vulnerable as it once was, that doesn't mean it is isolated from problems brewing elsewhere. It is not too hard to imagine how shockwaves from Europe or a sharp slowdown in China or other emerging markets could knock the U.S. from its somewhat tenuous position.

Valuations Look Full
At the moment, the stock market doesn't seem to be too concerned about a slowdown. The broad-based Morningstar U.S. Market index is up over 15% year-to-date and tacked on another 2.5% in the last week alone. The rally has pushed up valuation levels. The median price to fair value for stocks in Morningstar's coverage universe now sits at 0.94, essentially fairly valued. Some sectors like real estate and consumer defensive are now as much as 7% overvalued. There isn't much of a margin of safety left in the marketplace. If something unexpected happens or things don't go exactly according to plan, there is plenty of room for stocks to fall.

This doesn't mean investors should rip up their asset allocations and move exclusively into cash. It does, however, point to the incredible importance of asset selection. Buying pricey stocks today is not likely to end well. Thankfully, there are still some stocks out there (particularly in the energy and basic material sectors) with decent margins of safety and strong balance sheets. Finding companies with good competitive advantages, that are trading at a discount to their intrinsic value, and with the financial strength to endure some economic weakness might not be the most exciting strategy, but it is one that should help investors grapple with the unusual uncertainty in the marketplace right now.

Jeremy Glaser is the Markets Editor for Morningstar.com.

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Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.

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