Bill Miller Letters Archive

1992 Q3 – Market Commentary

The Stock Market

It was Scottish botanist Robert Brown who gave his name to the random movement of molecules bouncing off each other that we call Brownian motion, a term evoked by the aimless meandering of the market so far this year. The popular averages ended the third quarter marginally higher for the year, although the Dow fell 1.4%, before dividends, over the summer. Your fund ended the nine months with a total return of 2.17%, after rising 1.98% in the September quarter.

October has begun with its usual sinking spell, erasing the modest gains we have achieved, leaving us just about even for the year. Weakness has also been evident in the indices. The Dow began the year at 3176, rallied to 3413 on June 1st, touched that closing high again on an intra-day basis August 3rd, and closed October 9th at 3136, its low for the year. The S&P 500 and the Value Line Index show similar patterns, with total returns for both indices hovering around zero.

This is an unusually tight range for the market to operate in over a nine-month period. Salomon Brothers has calculated that market volatility in 1992 has been the lowest ever recorded, a fitting and not coincidental analogue to an economic environment likewise characterized by no growth.

Governor Clinton has promised change and to get America moving again. With income growth stagnant and job creation anemic, his message is being embraced by those with the will to believe. If the problem with the economy is that government spending is too low, and taxes are not high enough, then prosperity is right around the corner if the Clinton/Gore ticket is elected.

We believe that the malaise afflicting the economy is structural, not cyclical, and that it is not amenable to pump priming or any other handy metaphor the candidates are likely to espouse. Excessive debt at the individual, corporate and governmental levels has left each of these economic agents unable or unwilling to take on enough additional debt to provide an economic acceleration comparable to past recoveries.

These structural factors are what has vitiated monetary policy, thwarting the effects of 24 cuts in interest rates since 1990. With short-term rates the lowest in 30 years, and long- term rates the lowest in 6 years – and headed lower in our opinion – neither the economy nor the stock market is constrained by rates. Since a stimulative monetary policy has been ineffective in boosting the economy, it is no surprise that the idea of having the government spend our way to prosperity (through “investing” in infrastructure and education and the environment) has gained a new respectability among idea merchants. We believe that any such program of targeted investments, tax credits for R&D, tax increases for the rich, and cuts for the rest, will be unable to produce a higher growth path for the economy than 1.5-2.0%. Debt and demographics will see to that.

The budget accord that resulted from President Bush’s broken no-new-taxes pledge specifies that new spending initiatives must be accompanied by either tax increases or spending cuts of equal magnitude. This was an anemic attempt to rein in government spending and prevent a growing deficit spiral. Although demonstrably ineffective as a deficit reduction measure, the budget deal virtually guarantees that new spending programs will be too feeble to provide real stimulus to the economy, even if one believes in a crude, Keynesian demand model.

If President Clinton were to break this accord and usher in a wave of aggressive spending, we believe the reaction of capital markets would be swift and decisive, with interest rates rising and stocks falling sufficiently to offset the excessive stimulation. Just as the markets broke the Maastricht agreement in Europe, we think they will discipline the policies of any new administration. The likely result of a new administration running economic policy: some change at the margin, but policies not dramatically different from today.

If this is right, then in 1993 corporate profits are likely to continue their modest trajectory higher, interest rates and inflation should remain low, and the path of least resistance for the stock market should be up. We think the market can rise about 10% in the next 12 months, handily beating cash and moderately outpacing long bonds.

If the Bundesbank begins easing in earnest in Germany, as the economic situation warrants (there is price deflation at the wholesale level, retail sales are falling, and lay- offs are an everyday occurrence) our stock market could go substantially higher. Lower rates in Germany would usher in lower rates throughout Europe, take pressure off the dollar, and make our financial assets much more attractive to overseas investors, who remain woefully underweighted in our market.

The picture for equity investors looks to us reasonably bright over the next year. We see the main risks as two: silly economic policies that frighten the markets, or a triple dip recession brought on by those policies or by economic anemia made worse by excessively restrictive central bank policies abroad. On balance, the odds tilt in favor of higher stock prices.

Portfolio Activity

During the quarter, we eliminated three stocks from the portfolio: American Express, IBM, and GTE. The latter had been an excellent performer and reached our price target. We determined that the first two companies, despite depressed valuations, faced competitive pressures such that they would be unlikely to earn adequate returns for the foreseeable future. Subsequent to our sales, both companies reported poor results and the stocks have declined.

We bought two new companies in the quarter: Bristol-Myers and Schering-Plough. They have sold off sharply this year, in line with a weak health care group. We think the fears relating to a new attempt to control health care costs are already reflected in these

companies’ stock prices. An aging population, new drug development, and the cost effectiveness of pharmaceuticals relative to other treatment methods, should combine to drive low teens growth in earnings and dividends for the next several years for both companies. We also bought RJR common stock in the quarter. This is not really a new position, since we have RJR PERCS, a hybrid preferred stock convertible to RJR common. RJR is the best value, in our opinion, in the food/tobacco industry, trading at less than 8x free cash flow after taxes and capital expenditures. We think reported earnings will grow well above 20% per year for several more years.

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