After a successful January, stock markets have entered February in a lousy mood. On Monday, the Dow Jones Industrial Average printed a new record, a 1,175-point decline, which is the most substantial one-day decline in history.
It should be noted, however, the decline, while substantial, does not matter in a broader context. Indeed, a 1,100-point decline does not even count as one of the top 20 percentage declines of all time. We are going to need much more selling before for this market becomes attractive to value investors.
Indeed, even after these declines, almost none of the stocks on my watch list have fallen back into territory I would consider attractive. Some have fallen near levels I consider attractive in the broader scope of tax cuts and improving economic fundamentals, but overall the market still looks relatively unattractive.
The margin of safety
Alpine Capital Research published a research article earlier this week that tried to answer a critical question most value investors, at one point or another, will have had asked themselves.
The question: "What is a margin of safety?"
This is an interesting idea to consider for several reasons. First of all, the margin of safety has different meanings to different investors and, in my opinion, at least, has no definitive description.
That being said, some famous investors have tried to describe what the margin of safety is in the past. One was the "father of value investing" Benjamin Graham, who opined in 1949: "In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds."
Graham defined earnings power as an earnings yield, which is the inverse of a price-earnings multiple. This makes the margin of safety principle reasonably easy to understand: The yield on stocks must be higher than the rate on bonds to compensate for the higher risk of owning stocks compared to bonds.
At the time the report was published (the markets are moving quickly), the S&P 500 earnings yield was 3.13% while the current real yield on the 20-year U.S. Treasury bond was 0.48%, implying that despite equities' generally overbought situation, they still offer a margin of safety.
Many would argue this is not the case. Most equities look expensive considering historical valuations and compared to current earnings power. Does this mean Graham's initial understanding of the margin of safety is now defunct?
I would argue there is a strong case to be made that it is. Over the past five decades, markets have changed considerably. Globalization, along with technological developments and the world's love of cheap debt have all worked together to help push down long-term real interest rates, so it is unlikely we will ever see the sort of environment that prevailed during the first half of the last century. High single-digit or double-digit government bond yields are unlikely ever to return -- if they did, it would cause untold fiscal chaos for countries around the world. Therefore, risk-free asset yields (U.S. Treasuries) are more than likely to remain depressed for the foreseeable future. Indeed, analysts at Capital Economics believe it is unlikely yields will ever rise above 4% or 5% again.
If such an environment does persist, then we can draw two conclusions. Either Graham's definition of the margin of safety is now out of date and should no longer be used, or equities deserve to trade at a higher multiple today than their long-term historical averages.
I would argue that a bit of both are valid. The idea of a margin of safety has changed substantially over the years, and now calculations are based more on cash flows than asset values or relations to treasury yields. What's more, with more investors having access to better technology and a better understanding of intrinsic value, stocks deserve a higher valuation than they have in the past.
