Bill Miller Letters Archive

1991 Q2 – Market Commentary

Stocks spent the last 90 days going nowhere, ending the quarter fractionally lower than where they began. The S&P 500 fell .23%, including reinvested dividends, while the Value Trust rose .82%. The momentum and enthusiasm so evident in the fist quarter has now dissipated, and the market has taken on the characteristics of Dr. Dolittle’s pushmi- pullyu, the quadruped with a head at each end who couldn’t make up his mind(s) about which direction he wanted to go.

After a listless quarter, the market remains up over 14% for the 6 months. But those gains just undo the damage done in the previous six months by the invasion of Kuwait and the recession. At the end of the second quarter of 1990, the Dow was slightly over 2900; today it is less than 2% above that level. Twelve months ago long-term interest rates were 8.6%; today they are 8.5%. Earnings for the S&P 500 were $21.26 for the twelve months ended June 30, 1990. For the twelve months just ended, earnings were $20.97. Since neither earnings nor interest rates have gone anywhere in the past year, it should be no surprise that the market has not budged much from last year’s level.

The recession is over, according the Fed Chairman Greenspan, which means earnings should begin trending up. If that occurs without a concomitant rise in long-term interest rates, stocks should enjoy further gains. Bulls argue that since inflation is low and commodities prices are well behaved, there is room for long rates to recede to 8% or even lower by the end of the year. Bears counter that rates have never declined as the economy climbs out of recession. They maintain that slow money supply growth coupled with an expanding economy will drain liquidity from financial markets, putting upward pressure on rates and downward pressure on stocks. Rising rates could short circuit the nascent recovery and tip the economy back into recession.

These arguments have countless iterations and counter-arguments that would be both tedious and unproductive to wade through. Looking at the cash positions of investors (low) and the valuation of the stock market – nearly 18x earnings, with a 3% dividend yield – most people seem to have bet with the bulls. A glance at the Value Trust’s cash, note, and bond positions might suggest we are in the bear camp since our non-equity holdings are higher than normal and now total about 26% of assets. That inference, though, would be wrong.

Long term we are bulls, since equities go up on average 66% of the time, have outperformed all other asset classes, and we believe, will outperform other asset classes through complete market cycles. (A market cycle typically would be measured from the trough of one recession to the trough of the next recession.) Near term we are market agnostics, believing that the short-term direction of the market is unknowable. We are more heavily invested than usual in cash and bonds because these instruments represent better value than usual. This will perhaps be clearer if we consider equities as a special kind of bond.

Equities can usefully be thought of as bonds whose coupons vary and are only partially paid out. The par value of the bond compares with the book value of a stock, the coupon (e.g., 8.5% on current long treasuries) on the bond with the return on equity of the stock. Bonds have stated maturities, while equities are perpetual. A growth stock paying no dividend is like a perpetual zero coupon bond. If it earns – or is expected to earn – a high return on equity, it will be valued very highly by the market, as would such a bond with a coupon that was high and believed to be secure.

The long-term average return on equity of American business is about 13%. Bonds with perpetual 13% coupons in the current 8.5% rate environment would trade at a significant premium to par value. Stocks, thus not surprisingly, now trade at a big premium to book value. One major difference, though, is that bonds are contractually required to pay out their coupon or go bankrupt, while companies typically pay out only a portion of their “coupon” to shareholders as dividends, retaining the rest. Turning the analogy around, a bond is like a stock that pays all of its earnings out to shareholders each year of its existence.

If the S&P 500 were thought of as one company, it would have earnings of about $21.00 per share and would trade at 377, the current level of the index. The price earnings ratio would be 18. The $3.08 paid out as dividends last quarter comes to an annualized yield of 3.3%. If the S&P were a bond, paying out the full $21.00, the coupon yield would be 5.6%. We can do that well in treasury bills, which lack the risk of market fluctuations. By moving out the yield curve we can pick up additional return. Although this introduces some volatility, the amount is still less than that of the equity market.

This perhaps makes clearer the value in credit instruments relative to the equity market. Our above average non-equity holdings have nothing to do with either being bearish or with timing the market. We much prefer finding great equity investments to holding cash or bonds, and we are continually searching for new ideas. No matter what the level of the market, we will make a new commitment if we develop conviction in a company. Finding those ideas, though, is considerably harder at present valuation levels.

This has been an unusually long and narrow trading range. By mid-February the war rally had carried us to 2934 on the Dow. The intra-day high on the last trading day of June was also 2934. Usually the best course when the market meanders is patience. Whatever the market’s course over the balance of the year, we will continue to look for bargains. Like Mr. Micawber, we are confident something will turn up.

As always, we appreciate your support and welcome your comments.