Bill Miller Letters Archive

1991 Q3 – Market Commentary

Stocks and bonds rose broadly over the summer, extending the recovery that began a year ago from the recession and war-induced declines of 1990. Your fund continued to do very well.

These results have been achieved while holding substantial cash reserves, thereby assuming considerably below-average portfolio risk. Our recent returns, although gratifying, are not sustainable longer term. Equities have, since 1925, averaged about 10.5% compounded annual returns. From current levels (Dow 3000), equity returns more in line with historic norms should be achievable. Low double-digit equity returns may note seem all that exciting, but they are 2.5x the returns available from cash, and 50% more than is available from government bonds. We believe the returns from stocks will be among the highest real returns available from any source in the 1990s.

The 1980s saw exceptional returns from bonds, as interest rates fell steadily; from stocks, as the economy had the longest peacetime expansion in history; from cash, which provided high real returns as inflation fell faster than deposit and money market rates; from art and assorted collectibles; from real estate, and even from junk bonds for most of that period.

Entering the early 1990s, a different investment climate prevails. Hard assets, such as precious metals, oil and gas, collectibles, and most importantly real estate, are either stagnating or in decline. Bond yields have fallen to levels seen only a few times in the past twenty years, and cash in banks and money markets is yielding about 5%, also a 20- year low. Retired people, accustomed to rolling over their bank CDs at attractive rates while assuming almost no risk, now face a potentially serious shortage of income at today’s low interest rates.

The current slow-growth, low-inflation economy promises to be with us for quite some time. With most of the baby boomers now assimilated into the workplace, the relative dearth of new entrants into the labor force will mean slower growth in demand. An aging population, the quickening pace of technological change, and the sharp slowdown in the service sector, should mean enhanced productivity growth. Modest demand and increasing productivity, along with ample supplies of commodities and central bank discipline, are a prescription for low inflation.

Low inflation means low interest rates, and we believe the rush to preserve yield and income levels has just begun. For most of the past twenty years, investors have been able to park assets in short-term instruments and achieve two separate objectives: liquidity and real growth. The need for liquidity, for cash on demand without suffering market

risk, has been the historic function of bank deposits and, beginning in the 1970s, money market funds. But cash typically has had a drawback: it provided no real rate of return. One’s purchasing power was preserved, and safety was achieved, but because there was no risk, no volatility of principal, cash did not provide positive real rates of return. In order to build capital it was necessary to extend maturities and endure risk: that is, buy bonds and stocks.

That changed about 15 years ago when inflation accelerated and savings rates fell. Cash provided a haven from inflation, as yields quickly adjusted upward. Investors became accustomed first to higher riskless returns, then to real riskless returns, as accelerated borrowing and the fear of inflation combined to generate high real interest rates. The 1980s were one of the rare periods in history when investors could earn high real returns in short-term investments and take no risk. That period is now over perhaps never to return.

Investors have responded to this new low-rate environment by beginning a massive shift in portfolios, one that has profound long-term implications. In order to preserve income and achieve some real returns, people are beginning to extend maturities. The potential magnitude of this shift is staggering. Household financial assets are about $11 trillion. There are only about $250 billion of government bonds outstanding with maturities greater than 10 years. Since the beginning of the year, the amount of money in bank time deposits has declined, while bond mutual fund accumulation is annualized at $75 billion, a record. This compares to $35 billion of accumulation last year.

Stocks are a major beneficiary of this portfolio shift. Equity mutual fund accumulation is running at twice 1990s rate: $34 billion versus $15 billion. Individuals have only about 20% of household assets invested in equities, not far from record lows. A 1% shift in asset preference to stocks implies purchases of over $100 billion, more than twice the amount of net accumulation by all institutional investors in any single year. At the end of the last period of sustained low inflation, the late 1960s, individuals had nearly 50% of their assets in stocks.

We believe these trends are powerful, positive, and just beginning. It may seem remarkable, but the 1980s bull market was not primarily one of equities, despite the 17.5% average annual advance of the S&P 500. The bull market was in bonds. Twenty- year zero coupon bonds averaged over 20% per year for the decade. It was this bond bull market that propelled stocks higher.

With interest rates settling at lower levels, we believe investors will increasingly be attracted to the advantages of equities. Just as the decade of the 1980s belonged to bonds, the 1990s should belong to stocks. Although the trends appear to be firmly in place, the path to financial nirvana will not be linear. Political and economic events are unpredictable and markets will be volatile. We will continue to focus your fund’s assets on value and positive fundamentals.

We have added some additional features to this report that we thought might be interesting to you. There is a table listing the stocks in the portfolio that went up or down the most in the quarter. We have also provided a summary of new stocks purchased and those eliminated from the portfolio in the quarter.

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