Royce Funds Commentary - Are Investors Missing the Bull Market?
Certainly the steep declines experienced during the unwinding of the tech bubble in the early 2000s followed by the near-collapse of the capital markets during the financial crisis that began in 2007 were traumatic events.
One somewhat contradictory observation, however, is that while investors experienced steep markdowns in the values of their portfolios at those difficult moments—many exited stocks during these periods—the overall performance of the market during the past 10 years was actually quite good.
In fact, for the large-cap S&P 500 Index the average annual total return for the 10-year period as of March 31, 2013 stood at 8.5%—a pretty solid result given all the issues the markets faced over that time period.
We highlight this result partly because it resonates with us as long-term investors, but perhaps more importantly, because it is also largely at odds with conventional wisdom of late about the performance of stocks. Investors have allocated enormous amounts of capital to other asset categories over the last 10 years—most notably to cash and fixed-income investments—although hard assets such as gold have also garnered favor until very recently.
Bonds in particular have been the asset class of choice for going on three decades, but now sit at price levels that make replicating past performance nearly mathematically impossible. And indeed, it appears that stocks are now in the process of regaining some of their lost luster.
We have talked at length about the mounting risks of loss in both purchasing power and principal in this widely loved segment of the market. However, a recent Wall Street Journal article highlighted a milestone that has further reinforced our cautious view toward the fixed-income markets.
Investors’ voracious hunger for yield has pushed average junk bond yields below 5% to record lows as measured by the Barclays U.S. Corporate High Yield Index. Commensurately, issuance in the high-yield market hit a record in 2012 and is on pace to surpass that elevated level in 2013.
Despite continued economic weakness, most below-investment-grade issuers are easily able to fend off the liquidity issues normally associated with an environment of tepid sales growth and poor visibility. While not an issue now, we worry about what will happen when interest rates normalize and the traditional capitalist cleansing system is once again allowed to distinguish between companies with durable business models compared to those whose profitability is rooted in financial engineering.
Investors are making a dangerous wager that rates will remain near zero for a long time. As you might imagine, we disagree. While not a fashionable position in the current environment, we think strong balance sheets matter and may matter even more when the rate structure normalizes, which we believe it inevitably will.
So how have stocks racked up such impressive gains over the past decade? A combination of factors have contributed. Simple mean reversion has certainly been one of them. It is important to remember that as recently as September 30, 2010, trailing 10-year average annual total returns were actually negative for many stocks.
In fact, 10-year rolling returns were negative for 23 consecutive months from November 30, 2008 through September 30, 2010, the worst streak on record, even surpassing results recorded over the course of the Great Depression.
Ultimately the product of two crushing bear markets following the tech bubble in 2000 and the housing bubble in 2007, stocks were abandoned for the perceived safety of bonds. What was perhaps forgotten through all the equity market volatility in the first decade of the 21st century was the notion that many companies are actually durable and adaptable franchises with intrinsic business values that can actually be far less volatile than the market value investors place on them at any given moment in time.
Such companies have a unique ability to manage their cost structures, exploit competitive advantages and market positions, rationalize their business models, drive pricing power, and respond to economic fluctuations.
Unlike fixed income and commodity investments, stocks are dynamic entities that can behave both reactively and proactively to changing economic conditions. Perhaps that is why, as of March 31, 2013, U.S. equities are once again performing quite well in absolute terms on both a trailing one-year basis and, even more importantly, over the trailing 10-year period.
Important Disclosure Information
Chris Clark is a portfolio manager and principal of Royce & Associates, LLC. Mr. Clark's thoughts in this essay concerning the stock and bond markets are solely his own and, of course, there can be no assurance with regard to future market movements.
The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The Barclays U.S. Corporate High Yield Index is an index of fixed-rate, publicly issued, non-investment grade debt. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.