Do you think the current rally can last?
Yes, I think it can. One of the larger worries in the second quarter was the possibility of a second
recession, just as it was in 2010 and 2011. However, I think that concern has largely passed. While the economy continues to move along in its current slow-growth phase, it seems that there have been enough positive developments to quell any concerns about another
recession, at least for the intermediate term. I definitely get the sense that the more optimistic news that we've been hearing from companies over the last few years has begun to penetrate to some degree while the more pessimistic headline items have receded a bit.
Are you surprised that the market has been rallying just prior to a particularly contentious election?
I'm not too surprised, though I admit that my view on this may be a little unconventional. For me, it relates to why we're seeing a pick-up in investor confidence. Regardless of the outcome, I firmly believe that both candidates are committed to fiscal reform one way or the other. We're not hearing a lot of specifics, but I think it's very clear to politicians in both parties that something needs to be done. So while we're currently in the war of words that marks any presidential election, especially the late stages, I think the market is betting on fiscal and tax reform in 2013. I also think that as we get closer to Election Day, people—including investors and the people who manage companies, of course—become prepared for what they think is coming next, which detracts from the uncertainty surrounding the markets. Each of these factors is playing a role in the current bullish phase.
While the market has been strong, trading volumes have been fairly low. What do you think has to happen to reignite interest in equities?
It's undeniable that equities have had some very difficult years. Even allowing for the current upswing, five-year returns for many stocks, indexes, and funds were lackluster through the end of September, while 10-year returns are just starting to look better. So it's not surprising that many investors are not rushing back into equities. What I suspect will create a shift in that behavior is not just an ongoing bull run for stocks, but also a pullback in bond returns. Once we see the confluence of these two events, I think we'll see more movement into stocks. Right now, with so many investors on the sidelines, the rally looks like a classic instance of the old adage that the market climbs a wall of worry. I've even seen articles questioning higher stock prices, saying that the markets simply shouldn't be advancing, which as a contrarian gives me some confidence going forward.
Do think bonds could be approaching a bubble?
I think the word bubble is much too strong. However, I do think that bonds could be entering a bearish phase because in certain areas of the fixed-income market, we're seeing too many investors chasing yield or looking for safety. The junk bond market, for example, looks far too risky to me currently, as do certain high-yielding areas of the stock market where people don't seem aware of the risk they are taking to achieve a desired yield. In those places, I do think there's a scenario where bondholders may begin losing principal, which could create a swing back to equities. However, in the more standard fixed income world, there are institutional needs that are not likely to change.
With the market in a bullish phase, where are you finding value?
We're still doing in essence what we've always done, which is to look for that combination of high quality and attractive valuation. Amid all of the challenges and difficulties of the last few years, we've continued to invest the same way. This has meant looking at a lot of what we think are high-quality, cyclical businesses, including a number of industrial companies that in our view can benefit from the ongoing recovery of the global economy and the need for infrastructure creation in the developing world and upgrades in more developed countries.
Chuck Royce is the president and co-chief investment officer of The Royce Funds. This commentary originally appeared on the firm's website.
