Co-CIO Market Update: Keeping Our Focus in the Bear Market

Whitney George and Chuck Royce

What is your take on the stock market's dramatic plunge over the last few days?

Chuck: Both the federal government's game of chicken regarding raising the debt ceiling and the more recent downgrade of the U.S. Government's credit rating from AAA to AA+ by Standard & Poor's sent shockwaves through the market. So while the economy—and the equity markets—have been growing since the 2008 financial crisis, these recoveries are fragile in nature. We saw just how fragile in the market's reaction to these events beginning on August 4th. Investors are understandably anxious about the government's inability to compromise and the effect that this has had on our country's credit rating. However, they're also nervous about a host of other economic issues both here and abroad, such as global debt, unemployment, and the rate of growth in developed economies and housing. So the catalyst for the sell-off may have been the S&P downgrade, but other, arguably more valid, concerns also came into play.

Whitney: It seemed as though the market waited until a lot of people were away on vacation to react to many well-known issues that have been out there in the economy for a long time now. Although the downgrade was a trigger, there have been a number of other significant developments that did not lead to similar declines. So possibly it was the Tea Party's willingness to hold the debt ceiling hostage or possibly it was S&P, looking to restore some credibility in the wake of the mortgage crisis, downgrading the country's credit rating. Certainly when companies began reporting second-quarter earnings in July, the strong results from several companies were tempered by managements sounding a note of caution about how the rest of the year would play out. That caution is understandable considering what was coming out of Washington at the time of those earnings announcements, considering the quantity of new regulations that will affect healthcare and financial companies, and considering how much uncertainty remains in the economy. On top of a very cautious corporate outlook, we had politicians failing to show leadership and brokering a deal that almost no one found satisfactory.

How is Royce dealing with the decline?

Whitney: As always, we use declines as an opportunity to refresh our portfolios. The indiscriminate selling is allowing us to re-enter some of our highest-quality names at absolute valuations that we are very comfortable with. Ideally, these purchases help to lay the groundwork for performance over the next two or three years. As we have always done during these kinds of difficult periods, we are adding risk as the market is removing it by reducing valuations. Especially in the micro-cap space, companies that we think possess high quality saw their stock prices cut in half, which presents a great buying opportunity for us. Our investment horizon is strictly long term, so we try to stay calm and keep looking for strong companies trading at what we think are compelling valuations. We're seeing great bargains in areas such as technology, energy, agriculture, precious metals and asset managers, businesses that we like because they're well-positioned to benefit from higher-growth areas of the globe.

Do you think an extended bear market or a second recession is likely?

Whitney: With the Russell 2000 Index losing more than 20% from its April 29 high, I'd say we're in a bear market, though I can't say for sure how much longer it will last. I would say the same about the recession. I think that an extended bear market could help lead to a recession because of the negative effect it would have on consumer confidence. However, I don't know if that will be the case. We will continue to make every effort to use it to our long-term advantage.

How much recovery is possible for the market before the end of the year?

Chuck: I think a ragged recovery, with a lot of up and down days, is possible. I expect the market to take the next several weeks to re-gain its balance. From that point through the end of the year, I think low, positive returns are a possibility. Our overall, long-term take remains mostly unchanged—we are still modestly bullish and cautiously optimistic as we look out over the next few years.