Commentary

Chuck Royce

What are your thoughts on another eventful and tumultuous quarter in 2008?

Since the summer of 2007, we've seen an unprecedented series of interconnected events, starting with the subprime mortgage implosion and moving through global credit contraction and the demise of Bear Stearns. This year's third quarter then saw an amazing, concentrated series of occurrences: the takeover of A.I.G., the fall of Lehman Brothers, the rescue of Washington Mutual, the sale of Wachovia's banking business and, most important, the federal government's plan to bail out troubled financial institutions. These events were the culmination of a whole host of factors, including the low-interest-rate environment, changes to the securitization process, deregulation, the proliferation of non-bank mortgage lending and the growing popularity of adjustable rate mortgages. The list could go on and on. However, what's more interesting in the present is that any one of the seismic events of the past 15 months would be remarkable on its own. The fact that they all took place within a little more than a year means that we're part of a once-in-a-century kind of phenomenon, one that will thoroughly recast our financial landscape. And it will do so in ways that none of us can clearly see right now.

Do you think that the bailout plan is likely to succeed, if only in loosening credit and restoring liquidity to the markets?

I think everyone was hopeful that the plan Congress passed would be effective. However, the first 10 trading days of October did not create the thawing effect on a frozen credit market that the plan was designed to produce. Too much remains unresolved in a period that makes any previous market woes—the bear market in 1973-4, Black Monday in 1987, the Asian currency crisis in 1997 and the bursting tech bubble early in this decade—pale in comparison. The dilemma goes beyond the record-high number of foreclosures and falling house prices to the problem of how to accurately fix a value to mortgage securities and restore the flow of short-term credit.. My most optimistic scenario is that a coordinated global effort restores liquidity in the short-term and ultimately works out profitably for both taxpayers and financial institutions.

Do you still feel confident in the long-term prospects for smaller stocks?

I do, even in the midst of all of our current difficulties. Of course, my optimism about the long-term prospects for smaller stocks is predicated on the bailout allowing the smooth functioning of the short-term credit market. I also think that if we see an end to negative news from the larger financial companies, such as Goldman-Sachs, JP Morgan Chase, Morgan Stanley and Bank of America, it will go a long way in restoring confidence both in the economy and the stock market. Most important to us is how attractive conservatively capitalized, high-quality companies, especially those not in immediate need of cash, will look to investors as we battle through the current crisis. In spite of the turmoil and volatility that rocked the markets during early October, we believe that equity prices will eventually stabilize and return to more historically normal economic circumstances, which increases our confidence in the long-term prospects for our asset class.

Do you expect highly volatile sector rotation to be the norm for a while?

Yes, though I expect all kinds of volatility to rule the market in the near term. For example, during the third quarter there were 23 trading days in which the Russell 2000 moved up or down by at least 2% intra-day from the previous day's close, and 12 trading days in which the index moved up or down more than 3%. I would expect comparable numbers in the fourth quarter. As for sector volatility, we saw commodity-based stocks dominate performance in the first half of 2008, then anxiety about a global recession took hold early in July, causing many of these stocks to make a sharp u-turn. Other sectors, such as smaller financial services companies, did the opposite, rebounding in the third quarter after suffering in the first half of the year. Those of us here at Royce who have exposure to oil, energy and mining stocks think that those commodities are in a long-term secular bullish cycle, so we saw a lot of interesting opportunities as stock prices fluctuated dramatically in the third quarter. It was another instance of volatility being a friend to cautious, long-term value investors.