Chuck Royce on 3Q14: Is Volatility Ushering in a New Market Phase? by Royce Funds
Volatility shook the markets in the last three months, halting the bullish—and placid—pace of returns in a market that has not seen a significant correction since 2011.
Chief Executive Officer Chuck Royce talks about market events from the third quarter, the growing disparity between small-cap and large-cap performance, the continuing strength of the economy, the prospects for higher interest rates, the current case for small-cap quality, and more.
Were you surprised by the higher levels of volatility in the market during the third quarter?
Chuck Royce: Not entirely. The market had been so placid—very bullish but placid—for about 18 months prior to the beginning of the third quarter that a spike in volatility felt inevitable.
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And the quarter was definitely a volatile period—with a pronounced downward bias. It began in early July right at the bell, as it were, that opened the quarter. Share prices fell pretty consistently through most of July before the markets rebounded in August.
September then turned out to be an extremely rocky month that undid much of the previous month’s gains. There were days in September that were as bearish as any in July. So far, all of this looks to me like part of a historically normal corrective process as the market enters a new phase.
I’m not sure we’re in a new cycle yet, but the amount of recent volatility is a convincing sign that we’ve shifted away from the uneventfully bullish period that lasted from the beginning of 2013 through the first half of this year.
Looking back, there have been a number of very bearish autumn days—in 1987, 1997, 2001, 2008, and 2011. At the end of the day, I think we’re looking at a correction in the 10-12% range.
Do you anticipate that large-cap stocks will continue to outperform small-caps through the end of the year or possibly longer?
Chuck Royce: I think it’s likely. The dominance of large-cap so far in 2014 has been the most striking development to me.
What’s been especially notable has been the outperformance of large-cap versus small-cap during recent down phases. For example, the small-cap Russell 2000 Index fell hard in July (-6.1%) while the large-cap Russell 1000 Index suffered a far more modest loss (-1.6%).
These kinds of corrections are a normal part of every market cycle, but the growing disparity between asset class performance is not something that’s necessarily a part of every major market phase.
While many quality small-caps have done well in the years since the March 2009 small-cap bottom, many have failed to keep pace with more defensive or high-growth areas. But none of this has changed our belief that fundamentally strong companies trading at discounts to their private worth can outperform over the long term, often with lower volatility.
Are you concerned about a small-cap bubble?
Chuck Royce: I’m not. We’ve seen some mini bubbles within small-cap. There have been fairly significant corrections for biotech and some social media and related technology companies.
But none of this suggests—to me, anyway—that small-cap stocks as a group are in danger of a major correction along the lines of the Tech bubble in 2000 or the long down phase from July 2007 through March 2009 that was driven by the twin engines of the recession and the financial crisis.
Most of the companies that we’ve been talking to continue to have a positive long-term outlook. In fact, in the next cycle I fully expect that small-cap will do better on the upside than large-cap.
Do you think the U.S. economy will continue to gain momentum?
Chuck Royce: Yes, I still think the economy is gathering strength, and there are no signs that any significant slowdown is on the way.
Those whose job it is to think about large-scale macro issues—that is, not us—point to some valid concerns: there hasn’t been enough inflation, the enormous amount of liquidity the Fed has injected into the economy hasn’t had a proportional effect on lending, and we still haven’t seen a major CAPEX (capital expenditure) cycle.
However, the economy keeps ticking upward. The M&A market has been very strong, which has often been a prelude to a dynamic CAPEX cycle. In addition, the recent rally for the U.S. dollar indicates how strong the economy looks relative to the rest of the developed world.
I think things are likely to keep improving as the Fed continues to disengage itself more and more fully from the economy.
What is the current case for small-cap quality?
Chuck Royce: We hitched our wagon to quality in the small-cap area many years before the financial crisis, and that’s not going to change.
Our challenge has been that, while many quality small-caps have done well in the years since the March 2009 small-cap bottom, many have failed to keep pace with more defensive or high-growth areas.
But none of this has changed our belief that fundamentally strong companies trading at discounts to their private worth can outperform over the long term, often with lower volatility. These remain core investment principles for us.
I also think that, based on three- to five-year prospects, there are a number of quality small-caps that look underpriced compared to their small-cap peers and to other investment alternatives.
They may not look cheap on an absolute basis, but at the end of the third quarter I saw companies that looked attractively priced to me relative to the rest of equities.
When do you expect the Fed to increase interest rates?
Chuck Royce: Certainly the consensus is that the Fed is committed to keeping liquidity levels high and interest rates low for the intermediate term.
Predicting interest rates—or anything else—is not our specialty, but I think that a robust amount of economic improvement could result in increases sooner than many seem to think, with the 10-year Treasury rising to 3% or more, which would still be low on an absolute basis.
In any case, I think an increase in rates will ultimately be a healthy event for both the economy and the market.