Commentary

Chuck Royce

Certain observers of both the economy and the financial markets have recently stated that the events of the past year—particularly the housing crisis, the credit crunch and the slowing economy—signal the end to an era of low interest rates and low-to-moderate inflation. Do you agree with this assessment?

I think there’s no question that we’ve entered a period that will be characterized by higher inflation and rising interest rates. One likely consequence will be an end to the nearly 25-year bull market for bonds. However, I also think there are equally, if not more, significant elements to the story that haven’t received as much attention, namely, the shift in the status of the U.S. in the global economy. We’ve gone from being by far the most dominant force, perhaps the only truly dominant force, to being first among a small group of leading players, which includes the European Union, China, Japan and India. The first sign of this change can be traced back to late 2000, when the U.S. dollar first began to decline versus the Euro, a decline that has lasted more than seven years and counting. Other factors also contributed—the bursting Internet bubble, the events of 9/11, a war that has made the U.S. unpopular abroad and our own recent struggles with housing, credit and an overall stalled economy. Each is a piece of a larger puzzle that shows the global economy undergoing major changes, and I believe that the shifting role of the U.S. within this system is the critical event.

Do you think that the short-term upswing that followed the March market lows and lasted through much of the second quarter was based on genuine optimism about stocks or was it more akin to a bear-market rally?

I think the optimism was genuine. However, it seems to have been based on short-term factors in most cases, which to me makes it closer to a short-term rally within the current cycle. Right now, there’s too much uncertainty about the economy for the equity markets to settle down and establish a consistent, forward-looking perspective. Although there have been plenty of pleasant surprises, I don’t think the profit picture is strong enough to outweigh the anxiety that so many investors are feeling, especially about inflation. I see the next year or so being a very volatile period as the market continues to sort out the effects of the housing and credit bubbles and adjusts to a more inflationary environment. However, I think that three to five years from now, investors will be mostly pleased with returns because I expect the economy to recover and I think the market will see it coming first.

Do you still think that small-cap is likely to lead the market during any rally?

Yes, though I expect most of the rallies over the next year to eighteen months will be fairly brief. Low returns and a lot of volatility should be the order of the day. I anticipate that investors will therefore be looking for lower risk in the form of company quality, especially if the bond markets begin to struggle as many people seem to expect. We see the next year or two as a time to prepare and position our portfolios for a market and economic rebound that looks at least a year or two away. So while smaller companies should be all right in the short term, I suspect that the real action lies further ahead. In any case, we keep doing what we always do—buy what we think are high-quality smaller companies trading at attractive prices.

Are you still seeing promising opportunities in smaller stocks, both here in the U.S. and internationally?

Absolutely. A volatile stock market has historically been a boon to value investors, and the current period is no exception. Certain areas continue to offer what look to us like compelling bargains, both here and abroad. In addition, some industries have been doing very well, so we’ve been taking gains in some cases, holding in others and even building positions in companies that are managing their growth most effectively. Wide divergence in sector performance is something that I think will be with us for a while, so we see ample opportunity out there.