Despite the market’s subdued first-quarter performance, annualized total returns for the major indexes remained in double-digit territory for the one-, three-, and five-year periods ended March 31, 2014. President, Director of Investments, and Portfolio Manager Chuck Royce offers his thoughts on the market’s behavior during the first quarter and why he thinks investors can expect a major correction within the next twelve months.
What did you make of the market’s behavior during the first quarter?
Chuck Royce: The market finished a little better than flat—with the small-cap Russell 2000 (INDEXRUSSELL:RUT) Index up 1.1% and the large-cap S&P 500 (INDEXSP:.INX) Index up 1.8% in the first quarter.
It often felt like a more volatile period, particularly during January and the last two weeks of March. Yet there was no “bump in the night;” that is, we didn’t see anything like a true correction.
The Russell 2000 finished the quarter -2.8% off its most recent high on March 4, 2014. So even having just finished a pretty nondescript quarter, annualized total returns for the major indexes remained very high for the one-, three-, and five-year periods ended March 31, 2014.
I think what we saw in the first quarter, then, was simply the market quieting down, which seemed perfectly normal and expected considering, at times, the feverish pace of returns over the last two years. This was a positive development in that it showed just how resilient the market has been.
Going back to the low on March 9, 2009, we saw a substantial decline of 29.1% for small-caps (as measured by the Russell 2000) from the end of April through early October in 2011 and a smaller decline of 8.4% from mid-September through mid-November of 2012.
That makes 16 full months since the last correction of 7.5% or more, and almost two-and-a-half years since a significantly bearish period. That’s an incredible run.
What was your take on small-cap leadership in the first quarter?
Chuck Royce: Riskier stocks were out in front and led small-caps until the last few weeks of March, when there was a pullback and steep correction for certain biotech and social media companies.
In any case, biotech stocks really dominated small-cap returns in the first quarter. So while leadership in the first quarter was top-heavy and led mostly by a single industry, it was also consistent with much of what we saw in 2012 and 2013—investors continued to flock to fast-growing companies.
Again, there were signs of a shift in March, but a few weeks is too short a period for me to make a call about a change in leadership with any conviction. But I am hopeful.
I think what we saw in the first quarter, then, was simply the market quieting down, which seemed perfectly normal and expected considering, at times, the feverish pace of returns over the last two years.
Why do you think investors favored more speculative and fast-growing companies in the first quarter at the expense of more fundamentally sound businesses?
Chuck Royce: I think it was a case of sticking with what’s worked. It was a story of investment momentum remaining squarely centered on great growth stories, and not on much else.
With rates falling again through much of the first quarter, there was little impetus for investors to focus more on the fundamental characteristics that attract our attention.
Many of the first quarter’s best-performing biotech companies, for example, are not yet profitable. But investors were drawn to the double-digit top-line growth rates of many small-cap biotech businesses rather than the slow and steady growers that constitute the bulk of our portfolios’ success stories.
The Fed is continuing to taper while also keeping interest rates low. What are the implications of these policies for cyclical and quality stocks?
Chuck Royce: It’s going to be very interesting. While the Fed is determined to keep short-term rates close to zero, the 10-year Treasury rate almost has to rise because it’s largest buyer—the Fed—is pledging that it will buy fewer and fewer of them.
This looks like good news for those of us who’ve been trailing the indexes over the last few years because it’s another in a series of signs that the Fed believes in the underlying strength of the U.S. economy.
We’re big believers in our economy as well, and we anticipate that GDP will continue to pick up as this long, slow recovery gathers more momentum over the next several months.
Do you think a correction of 10% or greater is likely in the next year since we haven’t seen one in more than two years?
Chuck Royce: I think it’s more than likely that we see a correction on that scale within the next twelve months.
As anomalous and frustrating as the last few years have been for many of our portfolios, I have no doubt that certain realities of equity investing remain valid, even in the age of ZIRP (zero interest rate policies) and QE. It is a basic truth that markets are cyclical. There is no stasis—things are always changing.
So while our patience has been tested and we’ve seen a number of strange things since the advent of the 2008 crisis, we still have an unshakeable conviction that investing in companies with terrific fundamentals trading at attractive valuations to their intrinsic worth is among the best ways to build wealth over the long term.
That’s one thing that doesn’t change.