As you know, Ariel Investments focuses on small-caps, mid-caps, large-caps as well as international stocks. The indexes above represent these broad investment universes.
As you can see, international stocks had a great month, with the MSCI EAFE rising nearly 3% to close out a strong first quarter. Meanwhile, U.S. stocks were flat across large -, mid-, and small-caps in March. Despite the soft finish to the quarter, it was a good one for domestic shares—albeit much better for large- and mid-caps than for small-caps.
The key event this month may not directly explain the big international gains, but it suggests why U.S. stocks lagged. On March 15, the United States Federal Reserve raised the federal funds rate by 0.25% to the 0.75% to 1.00% range. This move was the third such hike from the Fed in the past 15 months. As you know, interest rates tend to pull down equity returns, usually causing stocks to decelerate but not go into reverse. So while foreign markets continued to charge ahead in March, domestic stocks took a pause.
Turning to the intermediate term, it has been a fantastic 12-month period for equities. The table below shows our investment universes, breaking them down by style.
Clearly it has been a great year for equities—some indexes doubled their long-term average returns. U.S. stocks topped international shares by a wide margin. And across the board value benchmarks outperformed core indexes, which in turn beat their growth counterparts. Recall that in 2015 it was growth stocks that were outperforming.
As noted previously, we are somewhat concerned about the valuation of U.S. equities. Using BNY Mellon data going back to 1993, we calculate the forward P/E ratio for the S&P 500 Index to be 17.1X on average; the most recent figure was 18.2X. Moreover, the valuation distance between value and core indexes is unusually narrow in some market cap bands. For instance, over the last two decades, the Russell Midcap Value Index’s 15.0X forward P/E ratio has been more than two points cheaper than the corresponding core index’s 17.2X average. Currently, those figures are 17.8X and 19.1X, respectively. These figures are by no means alarming; we remain quite far from what we would call “bubble” valuations.
We do think such elevated prices are likely to pressure short- and intermediate-term returns. After a long, strong run, especially given above-average valuation levels, lower-than-average returns are to be expected and a correction would not be a big surprise. Note this stance has no impact on our long-term view that equities are a strong investment: in line with our turtle mascot, we remain resolutely patient investors and do not believe timing the market to be a recipe for success. Moreover, although the indexes have heightened valuations, our portfolios are in line with history. That is, we continue to ply our craft of buying and holding underpriced fare; so for the domestic portfolios, our P/E ratios are well below those of their value benchmarks. As value investors, we believe buying cheap securities is always a good idea. We think it is especially helpful to have a portfolio of stocks with low valuations when the market appears pricey; our philosophy holds that expensive stocks are likely to see prices come down more than shares that are already cheap.
The opinions expressed are current as of the date of this commentary but are subject to change. The details offered in this commentary do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
