January 10, 2017
Warren Buffett once remarked that the only value of stock forecasters was to make fortune tellers look good. Despite the evident good sense of his comment, it has had no discernible deterrent effect on the recurring yearly ritual of market forecasts that are offered as the calendar flips to a new year. Every economist is expected to forecast the economy, every strategist the market and corporate earnings, every industry analyst the outlook for their industry and their forecast of which stocks will beat the market. Portfolio managers are not exempt from this mostly fruitless activity, as this letter attests. The good news is all these forecasts are mostly harmless, unless one is tempted to act on them.
I think that instead of trying to forecast what WILL happen, it is more useful to try to understand what IS happening and to go from there. So here goes: it is clear we are in a long running bull market in equities that began amidst deep pessimism in March 2009. That bull market grew from the high 600’s in the S&P 500 to an intraday record on January 6 of 2282.10. For most of the past nearly 8 years, the market advance has been greeted with skepticism, recalling to mind Sir John Templeton’s remark that “bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria”. The rally that greeted the election of Donald Trump seems to have erased much of that skepticism, at least in the short run, and we may be entering the maturing phase characterized by optimism, if the forecasts of most market strategists are representative of the overall view.
The sense of optimism is not misplaced, in my opinion, unless the views of some of President-elect Trump’s mercantilist and protectionist advisors become reality. Trump is about deals, not details, which suggests that the details of individual and corporate tax reform will be left to Paul Ryan and Mitch McConnell to hammer out. It appears highly likely we will get substantial individual and corporate tax relief, and a move to the standard territorial tax system adopted by most other countries, which will lead to repatriation of perhaps more than a trillion dollars of cash “trapped” overseas. Substantial regulatory relief also looks to be on the way. Fiscal stimulus may also be in the offing. Much of the hope about friendlier policies toward business has found its way into stock prices since the election, but to the extent that these policies are actually forthcoming, there is still room for the market to move higher, perhaps substantially so.
The situation with bonds, though, is far different, and more ominous. The great bond bull market which began in October 1981 looks to have ended in July 2016. Treasuries began that period yielding 15.83%1, the highest in US history, and ended it yielding 1.35%, the lowest in US history. Put differently, they began it the cheapest they had ever been, and ended it the most expensive they had ever been. Risk-free treasuries beat risky stocks for a generation, something financial theory would find highly improbable if not nigh impossible. Of course, they also completely trounced stocks on a risk-adjusted basis. Remarkably, most of the skepticism about the market since 2009 has been about stocks and the potential stock bubble or coming stock collapse. Very little was heard about a bond bubble, even as the valuation of bonds was far in excess of stocks and remains so. Therein lies the trouble.
If the consensus is roughly right that US growth will pick up in 2017 and 2018 due to the stimulative effect of the anticipated change in economic and tax policy, then rates are headed higher at both the short and long end of the curve, especially if inflation begins to stir, as the most recent wage reports show is happening. That means losses for bondholders, and bondholders hate losses in their “safe” assets. We have already seen redemptions in bond funds and flows into equity funds for only the second time since 2009. The first time was during the so called “taper tantrum” in 2013 when 10-year yields soared to over 3% from under 2% from the spring to late summer. The flows into equities coming from bonds were sufficient to drive the stock market up over 30% that year.
I think one of the more neglected risks of 2017 and 2018 is the “risk” that the stock market is too strong; that Templeton’s optimism phase drives stocks considerably higher, pushing valuations to levels that become excessive and which lead to little margin for error in fiscal or monetary policy. I don’t believe we are there yet with the market’s median multiple at around 18x. Bonds are still way too expensive, in my opinion, at 2.41%, to provide much competition for stocks. I believe it would take 10-year yields pushing 4% before they would have much impact on stock prices, especially as that would likely be occurring in a strong economy with rising stock prices. The great bull market of the 1990’s happened when the 10-year averaged 6%. It took yields over 9% to finally crack the 1987 bull market.
The stock market is not as cheap as it used to be, but is also not as expensive as it is likely to get, in my opinion. Stocks appear to be trading in the range of fair value, meaning the future rates of return are likely to be in the 5% to 7% area, which is the sum of earnings and dividend growth with no multiple expansion. Bonds look to have entered a long bear market whose only bright spot is that it is likely to be a benign bear market, at least to start. Fund flows from bonds to equities will likely underpin stock prices in the near-to-intermediate term, just as we have seen since the election.
The path of least resistance for stocks, to use Jesse Livermore’s phrase, has been and looks to continue to be, higher. The current bull market will end, as all bull markets do, when prices are so high relative to the returns on other assets that future returns become subpar. Undoubtedly, at the peak things will be great and the outlook will be for more of the same. I do not think we are there yet, and this bull could have several more years to run. Even so, bull markets are not linear, and we will undoubtedly have periods of decline, even serious decline. The 1982 to 1999 bull market saw a crash greater than 1929 in 1987, a banking collapse and recession in 1990, and numerous corrections.
A stock market trading at fair value usually contains a mix of cheap stocks, fairly priced stocks, and expensive stocks. This market is no exception, and should provide enough opportunity for the enterprising investor to have a good 2017. We think homebuilders, airlines, selected technology and financials all offer worthwhile opportunities. The battered heath care sector particularly has many companies selling at attractive valuations.
Best wishes for a prosperous 2017.
Bill Miller, CFA
S&P 500 2276.98
Jan 7, 2017
1The 10-year hit 15.83% on 9/30/1981. Source: Bloomberg
The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date published. Any views are subject to change at any time based on market or other conditions, and LMM 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.
©2017 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.