Chuck discusses the fourth quarter and recaps the full year in stocks.

 

Chuck Royce

 

Why did the stock market have such a good year in 2010 amid the perception of so much economic trouble and uncertainty?

 

It does remind me of the old adage that the market climbs a wall of worry or the idea that the market is almost always looking ahead a few years. You could make a case that each of those clichés defines what happened in 2010 pretty well. Looking more closely, I think what happened is that the media focused on a narrow set of economic news, namely housing and unemployment, and missed much of what was going on elsewhere in the economy. For months, it seems that we heard about nothing but foreclosures and jobless claims. It's not that these aren't significant problems; it's that they're very narrow lenses through which to view our economy. Our own work was showing many pockets of strength in the economy that were accelerating, industries that were benefiting from the decline of the dollar, and increased activity in many different parts of the economy. So the market's strength through much of 2010 was not a surprise to us.

 

Why do you think that small-caps across the globe outpaced large-cap stocks so decisively this past year, especially in the fourth quarter?

 

It's always hard to say exactly why any asset class beat another during short-term periods. However, it does look as though people began to grow more comfortable with equities as the year went on, especially once the Greek debt crisis subsided and the BP oil spill got under control. The logical extension of that increasing comfort with equities is a willingness to take on more risk. There is a perception on the part of certain investors—a perception that we do not share—that small-cap is where one goes to find more risky investments. So this may account not only for small-cap's performance advantage in 2010, but also for its greater relative strength later in the year when equity markets looked more stable to many investors. Another reason might be the historical advantage that small-caps have enjoyed coming out of recessions. They're often thought of as being more nimble and thus more responsive to economic events, and I think that 2010 represents the latest phase in the post-recession recovery for stocks that began after the market low in March 2009.

 

Considering the performance edge small-cap stocks are enjoying, do you still see frequent leadership rotation between small-cap and large-cap stocks?

 

The world seems to have been waiting for a while now for large-cap to make a move and post a very pronounced gain in performance at the expense of small-cap. This grand anticipation for large-cap leadership has so far not come to pass, and I don't really see it coming soon. In fact, I think characteristics such as quality and dividends are more likely to determine leadership than market capitalization. So while I think that large-cap will have periods of outperformance in the months to come, I don't expect the spread to be significant. I believe that the days of wide divergence between small-cap and large-cap, such as we saw in the '90s, are over, at least for the intermediate term.

 

Are you concerned that recent returns have limited the number of opportunities in micro-cap, small-cap and mid-cap stocks?

 

Return opportunities are not what they were two years ago. However, that was also a crisis moment when the markets were in tatters and prices were plummeting. Clearly, we have to work a little harder and search more thoroughly for attractive bargains than we did in the period between late 2008 and early 2009 and even in the early months of the recovery. However, there are always companies whose stock prices are being punished disproportionately to their value as a business. We're seeing them both here in the U.S. and in other parts of the globe, but more on a stock by stock basis. Looking ahead to the next three to five years, we do not see the kind of returns on an annualized basis that we saw in 2010. There will be corrections in the 10-15% range, which should create opportunities. So while we think that returns will remain positive, volatility will be a presence that we seek to use to our advantage.

 

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