The ACM Journal 2014 Q1

Capital Markets Review

 

The first quarter of 2014 was generally solid for most segments of the capital markets. Domestic stock returns were positive, but not stellar. This is not too surprising, given their massive run in 2013. Interestingly, mid-cap stocks provided the strongest returns among the domestic stock group. Small-caps were the worst, but they have been on quite a run for most of the past decade. We remain concerned about the valuation levels of midcap and smallcap stocks, but so far they have held firm.

International stock returns were not as strong, again. Stagnant economies in Europe, slowing economic growth in the emerging markets, and of course, the situation with Russia and Ukraine have all weighed on international stock market returns. Still, we really like the longer-term outlook for international stocks, particularly the emerging markets. The valuation disparity between U.S. stocks and stocks in the rest of the world is significant. While the price/earnings ratio for U.S. stocks is around 17, it is only around 14 for developed world international stocks and 11 for the emerging markets. This seems like a bargain for those willing to ride out short-term volatility.

Interest rate sensitive investments, such as bonds and real estate performed quite well during the first quarter. Real estate investment trusts (REITs) rose 8.8%, which is a huge gain for a single quarter. REITs have lagged significantly the last year or two, so some of this may just be a “catch up” rally. We also continue to worry about the valuations for REITs, which have been extended, in our view. Investing for income has been in vogue the past few years, and REITs have generally benefited. We believe they, and all high-dividend-paying stocks benefited too much, resulting in overvaluation. We have consequently been underweighted in REITs recently. This worked against us in the quarter, but has been the right move over the past year. Bonds also rebounded somewhat after a lousy 2013. A gain of 1.8% might not seem inspiring, but considering that bonds typically only earn around 5.0% in an average year, their gain in the first quarter is quite strong. We have been conservative with regard to bonds during the past year. In many portfolios, we’ve had significant amounts of cash, rather than investing in bonds. This was based on our belief that the opportunity cost for being out of bonds was not that high. In fact, we’ve

Bonds also rebounded somewhat after a lousy 2013. A gain of 1.8% might not seem inspiring, but considering that bonds typically only earn around 5.0% in an average year, their gain in the first quarter is quite strong. We have been conservative with regard to bonds during the past year. In many portfolios, we’ve had significant amounts of cash, rather than investing in bonds. This was based on our belief that the opportunity cost for being out of bonds was not that high. In fact, we’ve

Bonds also rebounded somewhat after a lousy 2013. A gain of 1.8% might not seem inspiring, but considering that bonds typically only earn around 5.0% in an average year, their gain in the first quarter is quite strong. We have been conservative with regard to bonds during the past year. In many portfolios, we’ve had significant amounts of cash, rather than investing in bonds. This was based on our belief that the opportunity cost for being out of bonds was not that high. In fact, we’ve sidestepped some losses, and only recently missed out on a little bit of gain. However, we may be changing our view.

This is not in reaction to anything that is happening in the market, but rather to new research. A recent study in the Financial Analysts Journal, shows that rising interest rates historically have not been a problem for bond investors with a longer horizon. Typically, rising interest rates hurt the value of bonds, resulting in losses for bond investors.

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