How would you describe the economy and the markets over the last year-to-18 months?

Words cannot begin to adequately describe what we have witnessed. The current cycle is anything but classic, though it is already historic. There are few givens. We need the rules and policies to be consistent so that no one, including consumers, corporations and sovereign wealth funds, holds back from acting in a positive manner due to uncertainty. We cannot afford a vacuum in leadership. Actions and leadership need to be visible. We hope that we are correct in thinking that confidence will soon be moving in the right direction. As a signal of improved confidence, perhaps short-term Treasury bills need to yield more than the near-zero yield they currently offer. Investors are investing merely for a return of capital rather than a return on capital.

It looks like the U.S. and others will continue to add liquidity until the threat of deflation ends and lending works again. With rates near zero, it is possible that the Federal Reserve will further expand the assets it is willing to purchase, in order to unfreeze the markets. Mark-to-market of assets at financial institutions is still an issue. The new Citibank initiatives show how committed our government is to reducing further stress to our financial system. Of course one could argue the government’s guarantee of some of Citibank’s assets, rather than purchasing them, is merely semantics, should those assets result in losses.

Do you believe that our government's responses have been appropriate?

Not initially, but things have improved. As the casino-like derivatives market, which I daresay few fully understood (myself included), began to take its toll, the world had to wait too long for the various governments to take control of the situation. We all needed to believe that our leaders were on top of the situation. Confidence eroded because of delayed actions.

As a result of the Lehman collapse, we saw incredible tightening as fears of counter-party risk increased. Until recently, there was little global coordination. The magnitude of the responses around the world, while reassuring, do bring us into uncharted waters. Further, our government's actions were initially ad hoc—seemingly addressing the symptoms and not the disease. It appears that we may have now at least caught up to the curve rather than lagging behind it. In retrospect, the Lehman decision looks like a costly error. Yet our difficult situation would have been a lot worse if the dollar had been declining, though our ever-mounting debt and deficits ultimately pose a challenge concerning the dollar. Many books will ultimately result from what we have witnessed recently. A good title might be "What Were They Thinking?"

How do you expect the market will respond to the government's interventions?

The market has to come to grips with record government budget deficits and a Federal Reserve that is debasing its balance sheet with less creditworthy assets. When will the foreign buyers of our debt increase their diversification and/or ask for higher rates? For now, we need to see an improved outlook: the various yield spreads have to decline, we need to see further global easing and effective policy responses. The commodity inflation that caused some foreign central banks to hesitate cutting rates is behind us. Inflation tends to be a process rather than an event. Right now, the concern is over deflation as demand declines because of the expectation of lower prices. However, in time, we will need to reign in the excess liquidity that has been created to curb inflation. Will we, or can we do it? Once inflation becomes a real issue, and given the size of our debt, one would expect to be able to notice the changes imposed by the bond vigilantes and/or foreign investors.

Nothing that has been done will spare us the severe pain we are likely to see, but we needed action to set the economy on the path to recovery, as well as to avoid serious deflation. Longer term, as already mentioned, deficits and debt pose inflationary concerns. The actions taken by our government will increase the budget deficit as a percentage of GDP. Tax increases are inevitable, as are changes in expenditures or spending proposals. Our government will have a much larger and riskier balance sheet. Also looming in the not-too-distant future are the costs of baby boomer retirement to Social Security and Medicare. It would not be at all surprising to see an increase in payroll taxes passed in order to "save" Social Security.

What are the key concerns going forward?

We need to focus on the economy and the markets. However, we must also ponder and ultimately address the status of our free-market legacy and the credibility of the Federal Reserve and the Treasury. Our government's actions raise questions about inflation over time, though it is not currently a problem. The output gap—real GDP versus potential GDP—is expected to be the largest since the early 1980's, with the expected result of lower inflation. Inflation also looks less likely due to reduced material requirements from the emerging markets, as they are significantly slowing. With the net worth of the American consumer on track for a record decline in the fourth quarter of 2008, it is not surprising that consumers are paying off mortgage and other debt for the first time in 10 years.

How long will it take for consumer confidence to stabilize?

Despite the decline in oil prices, potential additional rebates and other fiscal stimulus plans, such as infrastructure spending and aid to state and local governments, we should not expect a quick turnaround in consumer attitudes. Times are likely to continue to be painful. Looking ahead to the middle of next year, it looks as though real consumer spending will be at its weakest level in 30 years. With consumption coming off a 70-year high relative to GDP, this will not be pleasant. The decline in the price of energy, while certainly helpful, has taken a back seat to the declines in net worth resulting from housing and the stock market, and fear about job security.

There will be long lags and an L-shaped environment is still more likely. Consumers will need a long time to recover and build their balance sheets and net worth. Perhaps part of the strength in the U.S. dollar stems from a belief that the U.S. taxpayers will ultimately fund the bailout. That argument is enhanced when one views the relative expected growth in the working age population from now to 2050, for the U.S. compared to other developed nations, as well as to China.

Has recent volatility been good news in some ways?

Extremely high levels of volatility—what we might call "volatile volatility"—is not a good thing. During the week of October 6th the Dow and S&P 500 each declined 18%, their worst week ever. On Friday October 10th, the spread between the high and the low on the Dow was over 1000 points (about 11%), its first-ever four-digit swing. Yet during the final week in October, the Russell 2000 rose more than 14%, its biggest weekly advance ever, albeit from an oversold market. This year, the difference between the daily high and low for small caps was greater than 1% on 96% of the days and greater than 2% on 50% of the days. No question that hedge fund and other liquidations have taken their toll on the market.

The elimination of the uptick rule in 2007 for short sales clearly had some effect, allowing for bear raids on issues. As the ramifications and adjustments due to the deleveraging of the system continue, we are likely to see more of these wide market swings. Rallies cannot be definitive until the market more clearly sees an economic recovery. Given decade-long poor investment results, compounded by the current year, one should not be surprised by the depressing effects of higher pension costs that are likely to surface. The good news is that we are near to reverting to the long-term market (Dow Jones Industrials) total return, after roughly 20 years of being above it.

Until the dramatic late-November rallies off of the November 20th low, the lower prices only reinforced the buyers' hesitation. As of the close on November 20th, the S&P 500 had declined to an 11-year low. Had the year ended then, we would have experienced the worst year since 1872. We were clearly oversold. The combined gain for the two days post November 20, for the S&P 500 was the largest since the gains that followed the October 1987 crash.

Why have dividends become such a topic of renewed interest?

The increased importance of dividends seems obvious to us. Companies that generate excess cash so that they can initiate or increase dividends will win investors' favor. Not surprising or temporary in our opinion, was the performance of dividend payers in the third calendar quarter versus non-payers in the Russell 2000. Dividend-payers rose 6.1%, while non-payers declined 6.4%.

For many companies (generally not those we hold in Royce Special Equity Fund (RSE), we believe), the years ahead will include the need to raise capital by selling equity. Until we have sufficiently gone through that process, one should not expect strong market results. Some of our holdings, and some notable, large and well-financed companies, are likely to be alone in their buyback activities.

Market Outlook

The outlook for earnings and the multiple to apply to those earnings remain elusive. We believe that further dramatic downward earnings revisions will occur. This is particularly true of multinationals that had benefited from the stronger growth outside of the United States as well as the weaker dollar. Domestic revenue generation is being favored by the market over global revenues. While Royce has some exposure to foreign revenues also, we believe that RSE's is far more limited. Cash flow in general, and dividends in particular, take on greater significance. Total return investing has returned.

The market's overall valuation is not attractive enough to expect much performance beyond earnings and dividends for some time. A sideway move in P/E ratios is possible. The market is not inexpensive despite relatively low P/E's for the energy sector. This seems right, as the energy sector of the S&P 500 accounts for more than 25% of the index's income before extraordinary items. If energy profits decline, the S&P 500's multiple moves higher, perhaps by a considerable amount, depending on the severity of the earnings decline. The crucial question remains, how much of the bad news and earnings are priced into the market compared to what is yet to be reported.

What is your outlook for your conservative value approach?

To some degree, at least relative to much of the past, we have witnessed a slow motion crash. Thus, we have been trying to strike a balance between buying too heavily and being opportunistic. We have found several new opportunities. The common denominator to all of our problems was the bubble in risk taking. Investors are increasingly embracing our more risk-averse approach, which we believe should benefit our holdings. We have seen that capital and liquidity were the two most sought-after items. Many of our holdings have an abundance of both—too much equity in the form of cash in many cases.

An Obama Administration and a Democratic Congress make higher taxes on dividends and capital gains all but certain. This suggests to us more transactional activity in advance of whatever or whenever the effective date of these increases. We believe that this type of activity will be seen in our portfolio because of its financial characteristics, as well as the high level of family and/or insider ownership of many holdings. The market is favoring companies with dominant families, expecting that the tax changes will motivate them to some kind of transactional activity. We have recently seen three of our holdings declare "special" dividends.

While, as mentioned, our overall market outlook remains subdued, we remain positive regarding Royce Special Equity Fund. What investors can, and indeed should, expect is adherence to our disciplined methodology, which strives to invest in inexpensive, well financed, quality companies. We are working harder than ever in our attempt to continue to provide that which we believe brought investors to the Fund.