article 03-25-2015

Signs of a Normalizing Market

In the wake of the 2008 financial crisis, the Fed's monetary stimulus programs had the unintended effect of suspending the historically typical functioning of capital markets in terms of the productive and destructive uses of capital. Today, the fiscal climate is beginning to change. President and Co-Chief Investment Officer Chris Clark takes a look at what's happening in the current market and talks about why our discipline could be rewarded in the foreseeable future.

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Strange things happen every day in the capital markets. Consider the recent fortunes for the 10-year Treasury, which hit a low of 1.68% on 1/30/15. (It reached an all-time low of 1.38% on 7/24/12.) Its yield then rose to 2.13% on 2/20/15—a nearly 27% increase in yield in three weeks. (The rate finished February at 2.00%, remaining volatile through the rest of that month.)

It's very interesting to us that the 10-year Treasury, a "risk-free asset," has been trading like a penny stock. What does that mean for other asset pricing? How does one assess risk in this environment? These are just a couple of the relevant questions many investors are asking at what we suspect is the tail end of one of the oddest periods in the history of the financial markets.

By now, it's no secret that active management approaches have faced numerous challenges throughout most of this period, in particular from 2011-2014, which led to relative underperformance for many of our portfolios in recent years.

The current, more volatile, less certain period seems to us to be a good time to heed the saying, "Past performance is no guarantee of future results." What has worked over the past few years, a period dominated by QE and ZIRP (zero interest-rate policy), will almost certainly not work in the next cycle.

Our decisions over the past several years defined both our absolute and relative portfolio performance over that period. We actively avoided highly levered, lower quality, and richly valued companies. We remained mostly overweight in cyclical sectors such as Industrials, Energy, Information Technology, and Materials while being underweight in Health Care, Financials, Consumer Staples, and Utilities.

These were intentional decisions based on our ongoing analyses of valuation, company quality, and long-term risk/reward scenarios. On a relative basis recent results for several of our portfolios fell short of expectations.

Most Funds underperformed the higher-than-average returns for the small-cap Russell 2000 Index and, in some cases, the performance of our peer group as well for the one-, three-, and five-year periods ended 12/31/14. (View returns for The Royce Funds)

Many of these same Funds, however, also posted strong absolute results, earning average annual total returns for the three- and five-year periods ended 12/31/14 that were well above both their own and their respective benchmarks' historical rolling three- and five-year averages.

More recently, through the first seven weeks of 2015, the performance of many of our portfolios has been correlated to the often violent spikes in the 10-year Treasury, as we would expect. In fact, it has been consistent with our experience of previous sharp rate increases in the post-financial crisis era.

The current, more volatile, less certain period seems to us to be a good time to heed the saying, "Past performance is no guarantee of future results." What has worked over the past few years, a period dominated by QE and ZIRP (zero interest-rate policy), will almost certainly not work in the next cycle.

The years from 2011-2014 were dominated by defensive and high-growth areas. Investors flocked to high-yielding equities such as REITs, Utilities, and MLPs while also buying heavily into industries such as biotech and social media. In addition, non-earning companies were also popular, in large part for the asset protection that was artificially provided to them via QE.

It's worth emphasizing how far out of favor risk management was during this period. Aggressive monetary policies had the unintended effect of suspending the historically typical functioning of capital markets in terms of the productive and destructive uses of capital. 

Aggressive monetary policies had the unintended effect of suspending the historically typical functioning of capital markets in terms of the productive and destructive uses of capital.

But the rear view mirror can be a hypnotic and potentially deceptive instrument—look too long and you may miss what's right in front of you. As prudent investors, we would not construct a portfolio that resembles the Russell 2000 today—with a third of its constituents being loss-making companies and its large weightings in areas such as biotech, REITs, and social media that sport indefensible valuations.

And the monetary climate is assuredly beginning to change. QE as we have known it in the U.S. has ended. One striking early indication of a return to what we would call normal can be seen in the rapidly widening high-yield spreads that are driving up the cost of capital.  Other encouraging signs include:

  • Accelerated M&A activity
  • Capital allocation transitioning from dividends and buybacks to capital expenditures and employment
  • The lack of a January effect in 2015
  • The earnings yield of the Russell 2000 looking compelling compared to the 10-year Treasury yield
  • The 12-month forward P/E of the Russell 2000 at a somewhat elevated 18.0x
  • The IPO calendar picking up, which could impact liquidity

In this context we think it's time for a rebound for active management. More specifically, we see the potential for disciplined, risk-conscious approaches that seek the kind of fundamentally strong, attractively priced businesses that we expect to lead in the next cycle.

We think this is similar to what happened in the wake of the late '90s tech bubble bursting. During that period, we maintained our discipline even after being told on numerous occasions that we were missing something and needed to accept the new realities of investing. We chose instead to stick with what we know best, and the period following the tech bubble was one of the strongest for both absolute and relative performance in our firm's history.

This did not happen because we did things differently—it happened because we remained faithful to our disciplined approaches, methodologies that we accept will go in and out of favor, sometimes severely, but in the end should prove their worth over full market cycles. This has worked over most of the last 40-plus years, and we believe strongly that it can work as we move forward.

Important Disclosure Information

The thoughts in this piece concerning the stock and bond markets are solely those of the person speaking and, of course, there can be no assurance with regard to future market movements.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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