While there was a brief shift towards higher quality from April through mid-May, low quality reasserted itself in June to mark a fairly muted—and mixed—second-quarter performance for small-caps. Forty-plus-year industry veteranCharlie Dreifus discusses the market's behavior during this period, as well as the U.S. economy and stock market.
What did you make of the market's behavior in the second quarter?
We haven't yet seen the great rotation out of bonds into equities as well as the expected rise in interest rates, so things are a little strange—the market seems to be refusing to follow a script.
Equities have remained remarkably resilient in the face of all that has been thrown their way over the last couple of years.
In June, we saw a return to low quality, after a very short—too short—movement towards higher quality. Non-dividend-paying stocks with higher betas were favored in June.
We also had an unfortunate small-cap trifecta: They were among the poorest-performing equity asset classes, the weakest sector was Consumer Discretionary (led by retailers), and low quality dominated.
On the large-cap side, I hold a number of what I believe are very high-quality retailers that other investors do not currently find attractive. But until I see evidence that the thesis is wrong, I'm sticking to these names.
Dividend growers continue to be attractive to us. They are not yield substitutes and therefore should not be as exposed to rising rates, yet they may offer growing dividends and relatively low volatility. Perhaps there is no perfect asset class for the current economic environment, and thus investors are looking for a middle ground.
How do you see the U.S. economy and stock market right now?
An economic outcome that I increasingly believe in resembles Bill Gross's "new neutral"— slower but more consistent growth than we've seen in the past with resulting lower-than-expected inflation and interest rates. This is a variation of the "Goldilocks" outcome—not too hot or too cold.
If this is indeed the case, multiples not only could maintain themselves, but could also actually increase.
China continues to flounder. It has a housing market bubble, industrial overcapacity, a shadow banking crisis, high pollution, an aging population, and widespread corruption.
This all translates to continued weaker growth in China, which creates a tailwind for U.S. equities in the form of lower-commodity inflation.
Until third- and fourth-quarter GDP figures become available, there will be doubters regarding the ongoing strength in the economy given the big decline in first-quarter GDP, which was largely due to bad weather and the likely noise surrounding the second-quarter figures.
I still think the economy is slowly, steadily expanding. The expansion seems to have tighter self-regulatory tendencies.
When growth accelerates, bond yields and oil prices tend to increase, slowing growth. Then when growth slows, bond yields and oil prices tend to decline.
Still, the monetary policy of the Fed, the European Central Bank, and the Bank of Japan are significantly more stimulative today than they were in 2009 when the world economy was on the brink of a meltdown.
What is your outlook for stocks going forward?
The old saying is that the market has predicted nine of the past three recessions—it can give false negatives. However, in the postwar period it's hard to find false positives.
The market could be signaling, as I have hypothesized, much stronger-than-consensus future earnings as a result of slow but steady improvement in the economy and the incremental profit potential we see.
It's interesting, however, that there is virtually no retail participation in the market. Many individual investors have yet to express irrational exuberance, which is usually a sign of the top.
No one seems happy or really believes in the market. Money normally follows performance and thus equities should be more popular.
If the U.S. is truly experiencing manufacturing and energy renaissances, which I firmly believe it is, then the capital spending cycle is likely to be long and solid.
If the dollar appreciates as many (myself included) believe it will due to falling trade and budget deficits, the currently much-disliked Consumer Discretionary sector would be a clear winner.
Do you see any evidence of a looming correction?
I think the most likely catalyst for a correction in the coming months is an inflation scare.
However, the decline in the velocity of money and abundance of low and unskilled labor (leading to lesser wage pressures) suggest to me that any signs of inflation are likely to be temporary.
When one considers inflation, inflationary expectations, and long-term interest rates, it does not appear that equities are at a highly risky valuation.
While there are some pockets—some tech and biotech—overall overvaluation in the market appears to be far less prevalent today than in past periods of irrational exuberance.
Important Disclosure Information
Charlie Dreifus is the Portfolio Manager of Royce Special Equity Fund and Royce Special Equity Multi-Cap Fund. Mr. Dreifus's thoughts and opinions in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. No assurance can be given that the past performance trends as outlined above will continue in the future. There can be no assurance that companies that currently pay a dividend will continue to do so in the future. This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money.