Chuck Royce on First Quarter 2011

Chuck Royce

Were you surprised that the stock market was so placid amidst all of the world's tumult and tragedy during the first quarter?

I was very surprised that the markets were so placid. Stocks performed well in the first quarter in spite of some extraordinary events in the world, starting with Tunisia and Egypt and moving on through the devastation in Japan and more unrest in Libya and other countries in the Middle East. The super-sized headlines were almost disorienting, following on one another so quickly. Yet all of these dramatic and significant events had almost no major impact on the markets. Looking at both the Russell 2000 and the S&P 500, there were a total of five declines of more than 2% per day through the quarter, four for the Russell 2000 and one for the S&P 500. Two of the small-cap index's declines were in January and the S&P 500's was in February.

The market has shown an almost disturbing tendency to look at the bright side of things. At Royce, we've certainly been in the more optimistic camp since the financial crisis in the fall of 2008, but now we're concerned that the market seems to see everything that happens in the world in such a positive light. You can see this most clearly in the market's decidedly bearish reactions last spring to the BP disaster, the European debt crisis and the threat of a double-dip recession versus the far more bullish response to this year's events. I was definitely expecting a downturn somewhere in the neighborhood of at least 7%, but the market didn't even come close to that. It may have something to do with the fact that what's happening in Japan is a great human tragedy, but not a great financial tragedy, at least as of right now. The financial crisis in 2008 was a systemic threat, and therefore very scary for the markets in a way that natural disasters, for all their devastation, are not.

Do you think that recent events are likely to impede the pace of the economic recovery?

In the short run I think we'll see some interruptions, especially as Japan struggles to get back on its feet. It's a major force in the global economy, and we've seen attempts at measuring what the near-term impact will be on manufacturing and global supply chains. However, I think that Japan will recover and that the effects of its woes on the global economy should be relatively short lived. I also believe that the stock market's momentum will slow as the economy continues to gain strength. This may seem counter-intuitive until one remembers that the market, especially as measured by small-cap stocks, has enjoyed a terrific rally both from the bottom in March 2009 and from July 2010's interim low. From July 6, 2010 through March 31, 2011, the Russell 2000 gained 44.2%. So a slackening of that feverish pace should not be surprising, even in the context of a growing economy.

Do you still believe that quality stocks, regardless of market cap, are likely to lead the market?

Yes, and I think it may have already begun. Funds that focus on quality stocks, which we define as those with great balance sheets, high returns on invested capital and the ability to generate free cash flow, were among our top performers in the first quarter. It seems overdue because my initial expectation was that the financial crisis would make investors far more discriminating and wary of risk, yet the rally that began in March 2009 was dominated in its early stages by lower-quality, higher-risk stocks. More recently, however, I've been seeing more and more quality businesses enjoy the kind of interest from investors that I thought I'd see two years ago.

Are you still optimistic about the long-term prospects for equities?

Absolutely. I am still expecting that longer-term average annual returns are more likely to fall in the upper single to low double digits, especially for the decade as a whole. I believe that small-cap stocks should fully participate, even in what I anticipate will be a highly cyclical market characterized by frequent rotations in leadership. I also think that investors will continue to move back to equities, which will obviously help to boost returns.