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5 Things to Understand About the Market Sell-Off

Jeremy Glaser
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Stocks experienced yet more volatility this past week. Joining me to discuss what the recent market action should mean for individual investors is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you so much for joining me.

Jeremy Glaser: You're welcome, Christine.

Benz: You have five key pieces of insight for investors, but before we get into those, let's talk about what you think has been driving stocks down recently.

Glaser: It's impossible to point to one specific item that is causing all this volatility, but you have to remember that it started with worries about China that grew into worries about general global growth and emerging markets. That has led to a big sell-off in oil, which in turn caused fears over problems in the energy sector. Are there a lot of loans in the financial sector, particularly banks that maybe were lending to energy firms at pretty aggressive rates? What happens if there are a lot of defaults there? Does that create a kind of financial crisis? Does that create the kind of financial interconnectedness that we saw back in 2008 and 2009? Is that going to repeat itself? That's been a big worry.

You add in that the Federal Reserve raised rates in December, and now we're waiting to see what the Fed policy is going to be: What's the future of interest rates in the United States?

When you add all these up together, you certainly have a recipe for a lot of volatility, particularly when you came in at valuation levels that were reasonably high. The market was priced for things to go well. Then you add in all these question marks, and that's really driven stocks lower.

Benz: You say that even though stocks have fallen quite a bit so far this year, the fact that starting valuations were pretty high means that they aren't yet all that cheap.

Glaser: It's important to keep this in perspective. Even with the decline that we've seen so far this year, which has been pretty substantial in some sectors, and even with the flat year we had in 2015, over the last five years, we still have had 8% annualized returns on the Morningstar US Market Index, a really broad-based index. That's a pretty good return. When you look at it from those levels, it doesn't seem like such a big drop, even if it has happened suddenly in a very volatile fashion. It's a correction, which is something that we're going to experience in the market on a pretty regular basis and isn't something that should come as a total surprise when it happens, or be a reason to panic in any way.

When we think about valuations, we like to look at Morningstar's price-to-fair value. This metric takes our stock analysts' fair value estimates for all of the stocks that they cover, which is predominantly larger-cap names, and compares that to where those stocks are actually trading, and then we look at the median stock. Right now, the median stock is trading at about a 12% discount to what we think it's worth, which is similar to the kind of discount we saw during the eurozone crisis in the summer of 2011, but it's a far cry from the kind of discounts we saw at the depth of the financial crisis, where there was a 45%-50% discount on the median stock in our universe. So, things are starting to get cheaper, but they certainly are not at the point where equities, broadly speaking, look very undervalued.

Benz: The median price to fair value for all of the companies in our coverage universe is obviously a broad brush. When you dig below the surface, do you notice any pockets of the market that appear to be cheap right now, even as some others may be relatively more expensive?

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Glaser: We have seen a divergence, much more so than we've seen in recent history. Sectors like utilities or consumer defensive are basically trading at fair value right now; we don't think there's any discount there. But you move over to financial services, and there's a 25% discount. A lot of that is due to the weakness that financial services stocks have seen due to some of those energy-related fears. Our analysts, for the most part, think those fears are overblown. I think that really has created a value pocket there.

But that being said, it's important to continue to be very careful and look at opportunities on a security-by-security basis. Really do your research. Make sure you understand why those shares have been beaten up so much. Make sure you have a constructive thought about why this is overblown before diving in. We just aren't seeing the kind of discounts anywhere yet where you can just--if you'll excuse the analogy--"back up the truck" and buy everything.

Benz: Let's talk about some specific names that our analysts do think represent a pretty a good value at this point in time.

Glaser: This is a great time to look at those wide-moat stocks that we talk about a lot. We talk about them because they have the ability to continue to earn economic profits for decades into the future. Even if we do hit some economic road bumps in the next couple of years, these are great franchises that are going to continue to earn economic profits for a long, long time, and are going to be around for a long time. If you can get an attractive entry point, a wide-moat stock could be a long-term core holding. It's a great time to look at firms like that.

Like we mentioned, financials are beaten down. We do see some more defensive names there that we like, such as Wells Fargo and PNC. There are some others like Citigroup and Bank of America that we think are undervalued and that have their energy exposure priced in, but those names are not quite as defensive.

You can look across a lot of other areas. We have over 75 5-star stocks that either have a narrow or wide moat right now, which is one of the biggest lists that we've seen for quite some time, including names such as Walt Disney, Express Scripts (which is a pharmacy benefits manager), and Monsanto. Across sectors, there are some good ideas out there. If you're looking to upgrade the quality of your portfolio, now could be a good time to look at some of these "moaty" stocks.

Benz: So, the market as a whole is not exactly cheap, but there may be bargains here and there if you're willing to look.

You say, however, if you are delving into some of these unloved pockets of the market, make sure that you understand the uncertainty that is hanging over these market segments.

Glaser: Uncertainty is a really important concept that sometimes is overlooked. If you look at some of our analyst ratings, maybe you focus on the fair value estimate or maybe on the star rating, or the moat. But "fair value uncertainty" is really just as important, because it is an indicator of how confident the analysts are in their cash flow projections and how confident they are that the company is going to be able to perform in the way that they expect over the next five to 10 years, or beyond.

That could be crucial, because if you have a stock that looks cheap, but it has a "very high" fair value uncertainty rating, that means the range of outcomes is very wide. If you have a wide range of outcomes, you need to demand a big margin of safety from what you think the shares are probably worth. That way, if something does go wrong, if things do end up on the lower side of where our expectations are, you're not going to be totally out of luck, because you had that cushion, you have something to fall back on because you bought the stock at such an unbelievably cheap price. So maybe it won't work out as well as you were hoping, but it's not going to be something where you're facing serious capital losses.

Uncertainty is really important to focus on, particularly today. The world is always uncertain, but it seems even more so right now. There are a lot of question marks. Looking for those firms that have lower uncertainty ratings--in the "low" and "medium" range--could be more fruitful, and you'd be able to accept slightly lower margins of safety, and those margins of safety are being offered in many cases, so it's important to key in on uncertainty.

Benz: Another key takeaway is that patience pays. Let's talk about that. Why do investors, if they are looking around for opportunities or managing any sort of stock portfolio, need to make sure they have a nice long holding period in mind.

Glaser: Patience is important because timing the market is so difficult. Trying to figure out, "This is going to be exactly the low, and it's only going to go up from here, and I'm going to get out when it hits the next high" is a game that most people aren't going to be able to win, and it probably isn't worth trying to play in the first place.

That does mean you have to be prepared for, potentially, the market to go down even further from here. A lot of the concerns that we mentioned at the top of this video are still very much live issues, and there's no clear sense of when they're going to be resolved. We're not going to get a clear picture of what global growth is going to look like tomorrow.

But I think it's important to remember that there's always a reason not to invest. You can always look out into the world and say, "There's this scary thing coming. I'm concerned about this. I'm concerned about that." You can always come up with reasons to talk yourself out of the market. But if you do that, and you're never invested, you're never going to get the gains of being in the market for that long period of time that's going to give you those good returns, which you probably need to meet your goals, be it retirement or whatever you're saving money for. You need to remember that being in the stock market means that you're taking on this risk; that's what you're getting rewarded for over time. It's part-and-parcel with taking on equity risk: You're going to have corrections, you're going to have big moves, and you're going to need the stomach to stick with it.

I think it's important to potentially look for opportunities now, and maybe this is a chance to put some money to work that you've had on the sidelines. But there could be even better opportunities down the road, or things could just go up from here. We just don't know what's going to happen in the short term, but we do think over the long term, investors are going to be rewarded for taking on this risk.

It's important to stay invested and not talk yourself out of it. … Stick to your plan, stick to what you think your asset allocation should be, and be thoughtful about any big moves that you're making in and out.

Benz: The last of your five takeaways is that it's not unreasonable to take some constructive steps to improve your portfolio. I've been writing about this on Morningstar.com as well, talking about things like tax-loss selling and converting traditional IRAs to Roth IRAs. What do you think are some constructive steps that investors can take to improve their portfolios and try to make a save of what has been a really challenging market environment?

Glaser: We did just talk about how it's important to stay invested [and stick to] your long-term plan. But that doesn't mean you should do absolutely nothing or should feel like your hands are tied.

If you own securities that you've held for a long time, and you look at the business and see that your thesis for buying it really has changed--that you really do see a diminishing of its competitive advantages and you don't think it's going to be able to earn an economic profit over time--it's OK to sell out of those stocks.

One of the concerns we heard when valuations were so high is, "If I sell out, what am I going to do with this money? I don't know where to put it." Well, there are other options now. There are some wide-moat stocks that are trading at big discounts. You have a place for that money to go. So this could be a good time to exit from those positions that you're not excited about. Even if those names have not quite reached their fair value, if you're buying something that's even cheaper, that's still an upgrade to your portfolio. That's something that could help your long-term returns. I think that's worth considering.

So think about trying to upgrade your portfolio a little bit, doing a lot of the portfolio-level things you've talked about, those are great ways to make the best of a correction like this, and make sure that you're well positioned for when stocks do eventually turn around.

Benz: It's been a challenging environment, but thank you for being here to share your insights.

Glaser: You're welcome, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.