Still No Margin of Safety in the Stock Market

Last week's market decline has not left stocks cheap on the whole, but there are still some individual values to be had.

Jeremy Glaser 12.11.2012
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Stocks have had a bit of a tumultuous in the past few weeks. Mixed earnings pointed to economic weakness overseas, Spain and the rest of Europe's sovereign debt woes remained in focus, and investors continued to fret over the fiscal cliff. The broad-based U.S. Market Index dropped recently, with a similar magnitude of decline across all parts of the Morningstar Style Box and across industry sectors.

But this modest sell-off has not left stocks particularly cheap, and given the huge amount of uncertainty that remains in the market, investors remain well-served by being selective in their stock investments.

The market is essentially fully valued at the moment. The current median price/fair value ratio for the entire market is 0.94 according to our equity analyst staff, not much lower than the 52-week high of 0.98 which the market hit in September. There is more of a valuation spread across sectors. Real estate is the most overvalued sector (median price/fair value of 1.06), and energy looks the cheapest (0.88) (Data as of Oct. 26, 2012).

The overall picture is that the market as a whole isn't offering investors a suitable margin of safety, and that is likely a big problem right now given the number of potentially destabilizing events on the horizon. Although it might sound like a broken record at this point, Europe could possibly get much worse. Even if some of the very near-term risk has been taken out of the system, the underlying problems (Greece and Spain, in particular) are far from resolved. Building a unified fiscal union won't be easy, and it won't happen overnight. A collapse of the euro would be an incredible strain on the global financial system and have unknowable consequences for U.S.-based investors.

And don't forget about the fiscal cliff that is looming in the United States. If Congress does nothing, the nonpartisan Congressional Budget Office predicts that the economy will plunge into at least a mild recession. Unfortunately, doing nothing seems to be Congress' specialty these days. Given that neither side is likely to emerge from the election with a resounding mandate, it is going to be difficult to come up with a workable solution during the so-called lame duck session. Chances are good Congress will fix some of the fiscal cliff, but likely not all. As we saw during the fiscal cliff debate in the summer of 2011, even if the crisis is averted at the last minute, the debate itself can have significant effects on firms' investment decisions and consumer confidence.

These issues, along with others, such as a potential slowdown in China or Middle East turmoil leading to a rise in energy prices, mean that investors need to look for margins of safety before diving in. Buying a stock at a fraction of what you think it is really worth creates a buffer against something going wrong in the global economy. Because this margin doesn't exist in the broader market, stock-picking has become increasingly important. Investors need to look for firms that have good competitive advantages to fend off competitors and have the strength to withstand whatever the economy throws at them.


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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