Domestic equity markets posted mixed results in March, with certain indices extending February’s gains, while others  wavered. Geopolitical tensions were a key factor impacting performance, with Russia’s annexation of Crimea and the Russian army’s subsequent massing along the Ukraine border causing concern throughout Europe and Washington. Economic data remained rather sluggish, with the extraordinarily severe winter weather causing short-term distortions that extended into March. Employment gains in March were 192,000, slightly below expectations, but strong enough to indicate a further acceleration may be in the offing. The unemployment rate remained at 6.7%, even with additional workers reentering the workforce. Estimates of gross domestic product (GDP) growth in the fourth quarter were increased somewhat, to 2.6% from the prior estimate of 2.4%. Within this landscape, stocks had difficulty establishing a trend. The S&P 500 rose +0.8% for the month, and the Dow Jones Industrials gained +0.9%. However, the tech-heavy Nasdaq Composite Index struggled, declining -2.5%. The Russell 1000 Index of large cap stocks and Russell 2000 Index of small cap stocks diverged somewhat during the month, posting returns of +0.6% and -0.7%, respectively. Value stocks strongly outperformed growth stocks. In terms of sector performance, telecommunications services was the strongest performer on a relative basis, gaining +4.8%, while consumer discretionary was the poorest performer, posting a decline of -2.8%.

International equity markets also generated varied results in March. The MSCI World ex-U.S. Index declined -0.4% for the month. After a long stretch of underperformance, emerging markets finally found solid ground, and performed quite well relative to developed markets. Investors believed the adverse effects of the Federal Reserve’s tapering had been fully discounted, using low perceived valuations as a buying opportunity. The MSCI Emerging Markets Index gained +3.1% for the month. In contrast, the MSCI EAFE Index, which measures developed markets performance, dropped -0.6% for the month, with a primary reason being the aforementioned Russia-Ukraine tensions. Regionally, Latin America and Pacific ex-Japan were the best performers on a relative basis, with the MSCI EM Latin  America Index and the MSCI Pacific ex-Japan Index gaining +8.8% and +2.4%, respectively. Eastern Europe and China were among the poorest performers, with results of -2.1% and -1.7%, respectively.

Fixed-income markets generally trailed off in March, as investors digested mixed economic data and statements from Janet Yellen, the Fed chairman. The Fed continued its tapering of its asset purchase program during the month, reducing purchases by an additional $10 billion. As stated above, economic data during the month was mixed, and investors strived to determine just how much weather was to blame. In this environment, the benchmark 10-year U.S. Treasury yield ended the month at 2.72%, up slightly from the 2.66% the level of February 28th. Broad-based fixed-income indices posted slightly negative results in March, with the Barclays U.S. Aggregate Bond Index easing -0.2% for the month. Global fixed-income markets were essentially unchanged, with the Barclays Global Aggregate ex-U.S. Index inching down -0.01% for the month. Intermediate-term corporate bonds were soft, as the Barclays U.S. Corporate 5-10 Year Index fell -0.1%. The Barclays U.S. Corporate High Yield Index posted a gain of +0.2% for the month. Municipals also performed relatively well, advancing +0.2%.

By Prateek Mehrotra, CIO

$1.3 billion

The sum raised by prescription-data provider IMS Health Holdings, based on its IPO pricing at $20 a share, making it the second-largest initial public offering in the U.S. this year.

(Source: Wall Street Journal)

7.6

The latest estimate of the magnitude of an earthquake that hit northern Chile Wednesday, according to the U.S. Geological Society, following an 8.2 quake that struck off the coast of the country the day before.

(Source: Wall Street Journal)

The Reserve Bank of India left its key interest rate unchanged at 8% on Monday, the first pause by Governor Raghurum Rajan after hiking rates 75bps since September. Rajan certainly appears to be living up to the considerable hype since taking the job last year. In addition to introducing much needed reforms, Rajan has corralled CPI inflation to a two-year low of 8.1% Y/Y and stabilized India’s currency. The Rupee was one of the worst performing EM currencies through the first three quarters of 2013 but has since rallied and even outperformed the JPMorgan EM Currency Index since January 1. Higher real interest rates obviously make the Rupee more attractive but Rajan’s steady-hand is giving confidence to foreigners investing in India.

Indian Rupee / US Dollar (white)

–
JPMorgan EM Currency Index (orange)

(Source: Bloomberg, GBI)

The strong performance of stocks in 2013 has many commentators describing the current market as being in a bubble. And often they cite the Shiller P/E [price-to-earnings] ratio, a measure developed by Yale economist and Nobel Prize winner Robert Shiller.

As of March 19, 2014, the Shiller P/E stood at 25.4, much higher than the historical average of 16.5. If a value of 16.5 indicates that the market is fairly valued, as some commentators believe, then the current market is more than 50% overvalued. (See Chart below)

The Shiller P/E is a twist on the traditional P/E. It takes the previous 10 years’ earnings on the S&P 500^® Index, adjusts them to current dollars, averages them, and then divides this result into the S&P 500’s current market capitalization. By relying on 10 years of earnings, the Shiller P/E mitigates the earnings volatility that can distort the traditional market P/E.

One problem with this measure, however, is that it may be used in a way that is too restrictive. If a reading of over 16.5 means that the market is “overvalued,” then stocks have been “overvalued” for most of the past two decades. Since January 1991, the Shiller P/E has been above average for 268 of the past 278 months.

Yet, during that time, the S&P 500 has more than quintupled, rising from 326.4 (on January 2, 1991) to more than 1,860 (as of March 19, 2014). Including dividends, this amounts to a compound annual return of 10.1%. Clearly, investors using the Shiller P/E in order to avoid an “overvalued” market would have missed out on significant gains.

The Shiller P/E is not, however, without its critics. Wharton professor Jeremy Siegel, for example, has pointed out that the metric may be biased upward because of accounting rule changes made in the late 1990s. These changes require that assets be written down when they lose value and then charged against income. Increases in asset prices, however, are not recorded unless the assets are sold.

These changes create a downward bias in reported GAAP earnings, says Siegel, resulting in an upward bias in the Shiller P/E. Siegel also believes these accounting changes make comparisons of today’s earnings with those reported before the changes invalid. He recommends that for an apples-to-apples comparison with today’s market, only the last 15 years of Shiller P/Es be used. The average over this period (December 1998 to December 2013) is 26.5, further suggesting that current valuations may not be as unreasonable as many suggest.

Those arguing for a market bubble also cite corporate profit margins, which are near record highs and which some believe are likely to return to more normal levels soon. But many factors are behind the higher profitability, including low interest rates and favorable tax rates in international markets, neither of which is likely to change soon.

Operating leverage is also responsible for the improved profits, according to Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist. “The capital intensity of U.S. business enhances productivity, but it also raises fixed costs relative to total costs, and these fixed costs don’t go away during an economic downturn the way employee costs do,” said Ezrati. “Fixed costs must be covered even when revenues decline, so when sales fall, earnings may drop precipitously,” he added. “But when revenues rise, much of the increase goes right to the bottom line, as the fixed costs are covered.”

This positive effect may persist for a while, according to Ezrati. The economy is still using only 78.5% of its existing capacity, according to the Federal Reserve, suggesting that firms still have more equipment to bring online, which would allow even more revenues to flow to the bottom line.

(Source: Lord Abbett)