July 18, 2017

“Well, this is a bull market, you know.”

-Old Turkey, as quoted in Reminiscences of a Stock Operator

For a long time I used to read Reminiscences of a Stock Operator, the putative market observations of Jesse Livermore, the legendary trader who was active in the first four decades of the 20th century. Having let that habit lapse for nearly a decade, I decided to revisit the book a few months ago. It is a work that any serious investor should read and probably re-read every so often. Way before anyone ever heard of behavioral finance, those reflections are a near-perfect compendium of how market activity and individual psychology combine to create an ever-changing array of ways to make investing mistakes and to (presumably) learn from them.

At a recent investor dinner, I was asked for some macro comments and thoughts on the market. What is expected, of course, is an economic outlook replete with expected GDP growth rates, the outlook for earnings, interest rates, inflation, Fed policy, global forces that may impact the U.S. market, followed by what that means for the stock market. Rather than go through that drill, I just quoted the line above from Old Turkey.

One does not have to squint to see the unmistakable direction of the market, whether the time horizon is year-to-date 2017, the past year, the past three years, the past five years. We are over nine years into a bull market that has taken the S&P from around 660 to 2425. Quite remarkably, this has occurred while investors have persistently taken money out of equities and put that money into bonds (with a few brief exceptions, notably during the so-called taper tantrum of 2013), even as interest rates continued to decline to a level not seen in 5000 years. People seemed quite comfortable buying fixed income securities at the highest valuations in history while shunning stocks. The reason, of course, is that bonds are “safe” while stocks are “risky.”

Bond yields peaked in October of 1981 and have been declining, on average, for over 35 years, an entire investing lifetime for most people, providing both income and capital gains in an instrument with greater contractual safety and far less volatility than stocks. That is all in the process of changing, as is becoming increasingly clear.

The Fed has begun a tightening cycle, which is currently benign, but history would suggest that will eventually give way to something more ominous. The ECB is still engaged in its massive QE program, but Mario Draghi has begun to signal that may be about to change as the European economy continues to strengthen. Eurozone short rates at -0.40% are likely be a thing of the past before too long.

Several of the finest investors of their generation — Ray Dalio, Bill Gross, Jeffrey Gundlach — have all begun to warn about a changing secular environment for bonds, a view with which I concur. As I have written previously, I believe the great bond bull market that began in 1981 ended in 2016 when rates fell below 1.4% on the 10-year. The bond bear market began quietly, but in the past few weeks benchmark yields in both the U.S. and Europe have moved sharply higher. In Germany, yields have more than doubled, albeit to still remarkably low levels below 60 basis points. I think developed-country yields are headed much higher in the next few years.

If yields at the short and long end do go steadily higher in the next year or two, and investors in bonds start to lose money in earnest, what does that mean for stocks? As long as the curve shifts up as the Fed tightening cycle proceeds and it does not invert (which I think unlikely), then the bear market in bonds is likely to provide support to stocks as money moves from money-losing bonds to still-rising stocks. We saw this in 2013 once yields got to the 3% range and money began to move to stocks from bonds. The stock market was up over 30% in 2013.

All of this comes with the usual caveats: it assumes the economy and earnings continue to grow, that inflation remains subdued, that the Fed doesn’t surprise the markets (I do expect the Fed to begin to reduce their QE-swollen balance sheet later this year by not reinvesting the proceeds from maturing securities), that some geopolitical event does not disrupt the market, and so on.

The market’s price/earnings ratio is moderately elevated versus its long-term average, but that average includes the very low p/e ratio of the high-inflation 1970’s, which brings the averages down. More importantly, all asset classes compete with each other for investors’ money, so looking at p/e ratios in isolation is incomplete if one wants to draw any reasonable conclusion about valuation. Neither cash nor bonds offer any serious competition to stocks at present levels. I think yields on the 10-year would have to be north of 4% before they do, which would imply short rates above 2%, levels the market thinks are years away.

Jesse Livermore used to note that stock prices follow what he called “the path of least resistance” and that investors should always trade in line with the path of least resistance. Since March of 2009 that path has been higher, and it looks to remain so.

This is a bull market, you know.


The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of publication, the date of the call. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

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