Chuck Royce: Is the Improving Economy a Good Sign for Active Managers? by Royce Funds
There are still enough opportunities out there to keep returns in positive territory through the end of 2014. This could make the market’s next act a very happy one for active small-cap managers.
Whatever other opinions we may all hold about the stock market’s behavior over the last six years, we think everyone can agree that it has certainly been dramatic.
The action began in earnest in the fall of 2008, although it is important to recall that small-cap stock prices had actually been falling for more than a year prior to that—the peak for the Russell 2000 Index having been established on July 13, 2007.
Yet the full effects of the bear were unleashed by the events of the Financial Crisis, which keyed the dangerously precipitous nosedive of share prices in the fall of 2008. The tumult lasted until small-caps finally hit a bottom on March 9, 2009.
The fear and anxiety the descent created, however, reached into the next several years. The feeling of extraordinary fragility that characterized the early days of the recovery in the spring of 2009 did not magically evaporate when markets began to find their feet again.
In fact, one could argue that these emotions dominated the behavior of investors at least until the end of 2012.
The three years from 2010 through 2012 were eventful, even if the stress and excitement they generated did not equal that of the first six months of 2009.
In fact, much of the market’s most extreme moves in that entire four-year span (2009-2012) took place in the first six months of those years, driven in large part by events both actual and potential.
The recession in the U.S., debt issues in Europe, and slow growth in China were all very real, while a double-dip recession here at home, default in Europe, and implosion in China fortunately failed to materialize.
By the end of 2012, with the stock market climbing and the economy expanding, investors seemed to recognize that, in spite of high volatility and political uncertainty, equity returns had been solidly positive since the March 2009 bottom. This improved confidence helped to spur a different kind of dramatic arc.
The long, slow recovery entered a new phase in 2013—a heady, and virtually correction-free, bull run in which returns for each of the major domestic stock indexes topped 30%.
The curtain opened on 2014, then, on the heels of one of the better calendar-year performances in the history of domestic equities, which followed four consecutive years of mostly rising stock prices in an uncertain economy.
So the question now is, what is the next act for equities?
Some argue that the economy is not strong enough to really take flight. They worry about the rich valuations sported by large numbers of stocks.
Others see the relative absence of volatility as a sign of complacency and fret that stocks are about to enter a destructive bear phase.
There are those who point to increasingly unsettled international situations, such as in Ukraine, Syria, and Iraq, and argue that the market cannot continue to pretend that events in these nations take place far offstage, not in an increasingly intertwined global economy.
We, however, are in accord with the more widespread consensus that sees the U.S. economy as gradually normalizing.
As evidence we would point to the following: The deficit continues to fall, the Fed continues to wind down the rate of its monthly bond purchases, and interest rates, though they remain close to zero, look likely to rise again in the near future as they did last year between May and December.
Inflation is tame, commodity prices stable. Volatility, as measured by the VIX, finished the first half of 2014 at low levels not seen since 2007. Add an increasingly robust M&A market, and it seems to us that the recipe for ongoing growth—and bullishness, however mild, at least compared to last year—seems almost complete.
And this process of normalization looks likely to accelerate as the Fed’s role recedes further and further into the background, setting the stage for a more dynamic pace of growth.
So while there remain voices who insist that stocks are overvalued, we think the case for additional gains, which could include a correction along the way, remains persuasive.
It seems to us that the relatively lower returns of the first half of 2014 indicate not an end to a bull phase, but a chance for the market to catch its breath and assess its surroundings.
It may be that investors need a break from all the drama, a respite from the unrelenting pace of the last six years. So the desire to stand back for a moment and evaluate what is happening seems eminently reasonable.
How many investors have enjoyed more than a few moments of true calm since before the recession began back in 2007? Ultimately, we suspect that both the expanding economy and slower pace of returns will result in more fundamentally focused investors.
Indeed, the indications that the strength of companies and the businesses they manage are beginning to matter more than indexes and the macro events that move them go back to the spring of 2012, when quality stocks—those with high returns on invested capital—enjoyed a brief run of outperformance.
This nascent phenomenon re-started—again, briefly—in May 2013 when the 10-year Treasury rate reached a bottom. Quality companies, particularly those in our chosen small-cap space, have not yet emerged as leaders, but they have inched closer over the last two years. Correlation levels throughout the market are falling.
These are excellent conditions, in our view, for disciplined active management approaches, especially those with a long-term investment horizon.
No Direction Home
U.S. stocks turned in a respectable performance in the first half of 2014. If results were not as lofty as they were in the first half of 2013 (and they were not), they were achieved in a more tranquil domestic environment than in the first halves of 2010, 2011, or 2012.
One consequence of the more relaxed atmosphere of the first half was that stocks did not seem to know quite what to do with themselves. While the overvalued/not-quite-overvalued-yet argument goes on, the market has not established a clear direction so far in 2014.
The year began on a more moderate note following a red-hot second half of 2013. The bull has so far remained in place during the current cycle; he simply slowed his run to a