Lower Valuations, But Still Many Risks as Market Sells Off
For investors who demand more certainty in their stock picks, the market is offering few bargains today, even despite recent losses.
Jason Stipp: I'm Jason Stipp for Morningstar. Markets are selling off again on Friday following a spate of volatility. Here to discuss is Morningstar markets editor Jeremy Glaser. Jeremy, thanks for being here.
Jeremy Glaser: You're welcome.
Stipp: Markets are upset again on Friday. The proximate cause seems to be increasing weakness in crude oil. However, we are seeing weakness across the board. It's not just energy stocks that are selling off. So why is it that energy weakness is potentially causing upset across the market?
Glaser: It's broad based, but the real pain is being felt in energy and basic materials. That's where you're seeing a lot of the big declines. And that is because of lower oil prices, as you mentioned. Oil prices keep falling because of the supply-demand imbalance. This is not a new story; we continue to see evidence that there's a gap between the amount of oil that the world needs right now, given slowing economies across a lot of different areas, and the amount of supply that's still being put out there both on conventional oil--OPEC has not cut production and they keep sticking by their current production targets--and then the prospect of things like Iranian oil coming on the market. It makes people think this imbalance could last for quite some time. That's bringing prices down. We really haven't seen that point yet where the low prices are creating enough demand to bring the market back to a stabilized point.
I think it's also important to think about the Fed right now. I'm not someone who thinks that every single market move is driven by what's happening in the Federal Reserve or people talking about the Federal Reserve. But with the Fed set to raise rates next week, I think that's certainly on a lot of investors' minds. Even if a rate increase seems pretty much baked in, what is that path of increases going to look like? What's going to happen to the yield curve? There's still a lot of question marks out there. And I think that uncertainty could be weighing as well.
It's also important to point out that high-yield bonds are selling off considerably today as well. Again, some of that's energy related. Energy has an outsized position in high yield, as these companies have been issuing a lot of corporate debt in order to fund some of their expansion projects. And also the liquidation of the Third Avenue Fund--something that many people didn't see coming--is raising concerns about liquidity in the high-yield market and liquidity in a bunch of different spaces, and that's weighing on the marketplace today as well.
Stipp: You mentioned that energy is taking the brunt of the hit in the market. Within energy, though, what's getting hammered right now?
Glaser: MLPs and midstream continue to be hurt. The Alerian MLP ETF is down over 7% at midday, so we're seeing a lot of pressure there--even larger declines in some individual names.
The E&P, the exploration and production, companies are also getting hurt. They're a little bit more variable, but we're seeing some mid-single-digit declines or 10% declines in some of those names.
Generally speaking, integrated oil is holding up better. Exxon is down actually less than 2%, a relatively modest fall. BP is off 3%, Chevron about 2.5%. So some of these larger oil majors are holding up a little bit better than some of the midstream names and also some of those E&P names.
Stipp: When value investors see sell-offs like this, sometimes bargain-hunters will get interested. Are we starting to see any bargains in energy? Or is the future in that sector still really unclear?
Glaser: On the whole, energy is trading at a discount to our value estimate. We think the whole sector is trading at about an 11% discount. That's versus a 6% discount for the entire market. I should mention that these numbers are before today's sell-off. So both of those will go down a little bit depending on where we close.
You have to remember that this data doesn't take into account uncertainty yet. So, yes, we do think that many of the energy names are undervalued, but there's also a high degree of uncertainty about what is going to happen, given that we don't know how low oil prices will go and how long they're going to stay low. That could have a big impact on earnings and valuations.
With that uncertainty out there, investors need to demand a pretty big margin of safety. They have to buy at a cheap enough price that they know a ton can go wrong, and they're still going to be protected given how low of a price they paid, so they can still have a chance of getting a good return over time. I think we're not at a point where we're seeing that margin of safety for the sector as a whole to get super interested.
So investors who maybe see this sell-off as an opportunity, as Josh Peters put it this week in talking about the energy sector, maybe it's time to nibble a little bit more than swing for the fences. This is not a time where you really want to vastly change your sector weightings, vastly change your asset allocation. I don't think we're there yet.
Stipp: You mentioned that the market was already 6% undervalued before today's sell-off; depending on where we end up, it might be even more undervalued. So broadly speaking, if I don't have the stomach for energy, should I go bargain-hunting in other areas of the market? Are we seeing a cheap market now?
Glaser: Well, the entire market is certainly cheaper than it was, but it's far from cheap on any kind of historical basis. I think one way to look at it is cutting our ratings in a slightly different way. We often talk about buying shares of companies that have strong competitive advantages, what we call "economic moats," that have medium or low uncertainty. That's a sign that our analysts think that we have a pretty good idea of what this company is going to do. There's not that much uncertainty surrounding it. We think that can be important. And you also want to buy at a discount, get that margin of safety, for something trading with a 5-star rating.
When you screen against our universe for narrow- and wide-moat companies that have medium or low uncertainty that are 5 stars, you only get eight companies that come out of that screen, which is hardly an incredible number of options to buy right now. I think it is a sign that there still is room for valuations to come in a little bit before you'd start getting excited and start picking up a lot of great companies to hold for a long time at great prices.
I think it's important to remain patient. I know we've talked about this before, and it's not the most exciting advice in the world: Really stick to your plan. Make sure you know why you're holding equities, how long your time horizon is. Think about your sector weightings, make sure that nothing's totally out of whack--that you're not overexposed to energy or any other sector at the moment, unless you have a really compelling reason to do so, and are doing so very deliberately. I think sticking to that plan is what makes sense right now. There just isn't an incredible number of values in the market.
Stipp: And lastly, you mentioned the Fed at the open. The Fed obviously is having a very important meeting next week. Most people expect that they will raise interest rates. But if we see a lot of volatility in these next few days leading up to that meeting, might it change the Fed's mind, and they'll hold off yet one more time?
Glaser: It could, but it doesn't seem likely. Some of it will depend on what happens in the coming days, of course. I think a little bit of volatility like this is unlikely to derail the Fed at this point. When they did, in the past, not raise rates citing market turmoil, mainly due to worries about China, that was really a new set of worries that a lot of the market hadn't anticipated before. Low oil prices, again, are nothing new. Over the past year or so, we've been seeing falling oil prices, seeing the impact of it. It doesn't seem like the Fed is going to all of a sudden flag this as a problem.
Also, the Fed really is focused on inflation and they're focused on employment. That is their mandate, and they need to be looking at them. If they start adding other criteria and say that, "We need to have inflation heading toward our target, being close to full employment, and the market has to be smooth, and all of these other things must happen," then they're never going to raise rates. I think it's unlikely for them to add another condition at the last minute. So is it possible that this will derail? I suppose so. But I think most people are still betting that we're going to see a rate increase on Wednesday.
Stipp: Great insights on what has been a rocky market, Jeremy. Thanks for joining me.
Glaser: You're welcome, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.