The following is an excerpt of a recent market comment that first appeared at The Felder Report Premium[1].
What is the opposite of a margin of safety? That is a question this market has had me asking myself for some time now. A margin of safety is a discount to intrinsic value that provides a safety net in the result of an error in analysis or unforeseen negative developments. The opposite of a margin of safety then is a premium to intrinsic value than can vanish even if your analysis is correct or things go unexpectedly in your favor. There are times when a security reaches a valuation such that even if everything goes right you’re unlikely to profit. The price has already discounted a perfect outcome. This “priced for perfection[2]” scenario is the opposite of a margin of safety and this is currently where the stock market finds itself today.
So what exactly is this perfection that is currently built into stock market valuations? First, equity valuations have risen in recent years to their record heights[3] at present as a result of investors making a classic mistake. Whether consciously or unconsciously, they have essentially lowered the discount rate in their valuation models without also lowering the assumed growth rate of earnings. As Cliff Asness demonstrated years ago in his paper “Fight The Fed Model[4],” this is clearly irrational behavior. Because interest rates and earnings growth are so highly correlated one cannot be modified without the other in a discounted cash flow model. In other words, falling interest rates do no justify higher equity valuations. This doesn’t, however, stop investors from believing this very thing[5].
Furthermore, for this decision to...