Little Margin of Safety in Today's Markets

Note: This video is part of Morningstar.com's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Tim Strauts. He's a senior market research analyst at Morningstar. We're going to look at what our quantitative ratings are saying about parts of the market that are expensive and what parts look a little bit cheaper. Tim, thanks for joining me.

Tim Strauts: Thanks for having me.

Glaser: So, first off, what exactly is this equity quantitative model? What kinds of outputs does it have?

Strauts: So, the quantitative model allows us to get price/fair value ratios on a broad set of stocks around the globe, just by having the equity data, using about 12 factors. So, it's a nice way to get price/fair values that you can aggregate up to the country level or the fund level to make comparisons across the globe.

Glaser: Let's take a look at what this model is saying about the market in a couple of different ways--the first being the Morningstar Style Box. Does it see any big differences between growth and value and amongst different-sized companies?

Strauts: Right now, the market is a little over 1.1% overvalued. And looking at the style box, the value side of the style box offers the best opportunity right now. Value is about 2.7% undervalued, whereas growth is a little over 3% overvalued. So, there is about a 5% deviation between value and growth right now.

Glaser: How about small cap to large cap?

Strauts: Small caps are actually the most attractive, but there is not a large separation between the two. And then, one other thing I'd note is that wide-moat stocks--which are traditionally stocks that we think offer safer, better values in most markets--are actually a little bit more overvalued than no-moat stocks. I think what's going on there is, in general, market participants don't feel like there are a lot of great values out there, so they try to find safety in wide-moat stocks.

Glaser: How about by sector? Are there parts of the market where there are big differences or are valuations pretty even across sectors?

Strauts: We are seeing that the utility sector is a little bit overvalued, and that's primarily due to utilities being very correlated with the 10-year Treasury yield. As fixed-income interest rates fall, utilities tend to do very well. Over the last year, interest rates have fallen and utilities have had a nice run. So, utilities are a little overvalued. On the undervalued side is energy, and that's mainly due to declining oil prices.

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Glaser: Then, looking across the globe, are there regions or countries that seem like they are a little bit cheaper or are valuations pretty high across the entire world?

Strauts: I'll tell you there are no great opportunities, but there are some cheap valuations out there. The cheapest country out there right now is Russia, which is undervalued by 10%. And obviously, that's for a reason. There is a question of rule of law in Russia and whether your money is actually going to be safe there. Another country that is undervalued is Brazil, being 8% undervalued. Not a question of rule of law there, but they have some of their own issues. So, I would say, in general, emerging markets are the most undervalued, and Europe has also gotten cheap in the last quarter. But no great values right now.

Glaser: And the U.S. looks like it's one of the more expensive markets?

Strauts: It's only slightly overvalued. Like I said before, it's a little over 1% overvalued. There are countries that are higher than that, but there is really nothing that's extremely overvalued globally.

Glaser: So, it sounds like at least in the equity space there are a few little pockets here and there, but there aren't a ton of values. Let's take a look at fixed income, then, moving away from that quantitative model. When you look at fixed income, are you seeing any areas of opportunity there? Do corporate bonds still look like an opportunity or have credit spreads become too tight there?

Strauts: Well, credit spreads are really tight. And I would say, in general, that corporate bonds are not the value they were 18 to 24 months ago. So, I'd say there is nothing wrong with owning corporate bonds right now; they still offer a little additional yield over Treasuries. But you are not really getting a great value right now.

Glaser: Now, in terms of fund flows, we have seen a lot of money move out of those core fixed-income funds into other parts of the fixed-income market. What's your take on that? Do you think investors are getting complacent about the risks that they are taking outside of these core bond funds?

Strauts: Obviously, investors are stretched for yield, and so one of the things they have been doing is moving out of core bond funds, which have yields of, say, 2% to 4%, and moving to noncore strategies--things like bank loans, high yield, emerging-market debt, which all have yields over 4%--looking for that higher yield. But what we find is that when you do that, you are taking on additional risks. Because if you look at the correlations of emerging-market debt and high yield and bank loan to equities, they actually have a much higher correlation to equities than they do to actual bonds. So, investors may be thinking that they are reducing risk by going to these areas, but they are just exchanging one risk for the other.

Glaser: So, looking at fixed income and equity together, then, how would you characterize the investing landscape right now?

Strauts: I would say it's a fully valued market. Stocks and bonds, neither of them looks very attractive. So, that just means you still have to maintain your asset allocation and own stocks and bonds together.

Glaser: Tim, thanks for your thoughts today.

Strauts: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.