Bill Miller Letters Archive

1994 Q3 – Market Commentary

This is an easy market to analyze and a hard one in which to make much money. Rising interest rates have devastated bonds, leading to the worst twelve-month period for bond investors in history. Stocks, buoyed by strong profits reports, have so far proven resistant to rate increases, with most of the major market indices posting small gains for the nine months ended September 30.

The Value Trust is up 2.45% so far this year and is up 7.83% over the past twelve months. Both figures are ahead of the market; the latter figure is more than twice the 3.68% return of the S&P 500 over the same twelve-month period. Long bonds, in contrast, are down over 20% in the past year.

We believe the divergent paths of stocks and bonds cannot continue for long. Bond valuations have gone from expensive a year ago to cheap today. Unless bonds can rally, or at least stabilize, we think the path of least resistance for stocks will change from sideways to down. If you are bullish on stocks, you have to be bullish on bonds.

In October 1993, investors were sanguine enough about the long-term outlook to accept under 6% for 30-year obligations. Now they are so worried they demand 6% for one- year treasuries. The sell-off has been brutal and has spilled over into stocks that act like bonds. Those stocks most sensitive to interest rates – utilities, home builders, mortgage bankers and insurance companies – are also down 20-25% in the past year.

It is not inflation that is causing all this devastation, it is inflation expectations. Inflation is quiescent. Wages are rising at the slowest rate since 1981. The third quarter GDP report showed strong growth of 3.4% coexisting with an implicit price deflator rising only 1.6%, down from the second quarter’s 2.9%.

The bears say those numbers are irrelevant; they merely report the past. It is future inflation the market needs to be worried about. With growth strong, unemployment low, capacity utilization high, commodities prices surging, bank loans growing, and precious metals stirring, considerably higher inflation is imminent, they believe, unless the economy slows. Hence the repeated calls for the Fed to tighten again, to raise rates high enough to brake (or break) the economy.

The Fed needs to do more, the inflation hawks say, and unless it acts decisively – raising short-term rates 50 basis points just after the election and 50 more around the first of the year – inflation will work its way into wage rates and then even more pain will be forthcoming. Henry Kaufman, whose gloomy forecasts in the late 1970s were legendary, recently said bond yields were headed to 9 or 10%. If you believe that, you should be prepared for a very difficult stock market.

We do not believe it. One year ago investors were piling into long bonds at under 6% because, accustomed to capital gains as yields fell, and eager not to leave money on the table, they believed the daily drumbeat of commentary that yields were headed still lower. Now, reeling after the worst twelve months of losses in bond market history, and fearful of losing still more, the same investors who bought so confidently at higher prices are selling after and because prices are lower.

The papers are still full of analysts such as Dr. Kaufman who believe rates have more to rise because the Fed has not done enough. Maybe so. But we believe those same analysts will soon be worrying about whether the Fed has done too much and then 8% yields will look very attractive.

Economic theory, like stock market chart patterns, has little predictive value. It often functions like a financial Rorschach test, or an I Ching interpretation, telling a lot about what’s on one’s mind, but very little about the future. Those who are confident rates are headed much higher are able to lay that bet off in financial markets and, if they are right, will profit marvelously. Donald McCloskey, an economist skeptical of the knowledge claims of his profession, has a column in the November Scientific American discussing this issue.

Our own Rorschach reading sees the first signs of a slowing economy: consumer confidence is down four months in a row, the Business Week production index has dipped, and the Conference Board’s Help Wanted Index has downticked. As adjustable rate mortgages adjust upward over the next year, more disposable income will be diverted to service housing debt. In 1992 and 1993 the economy was struggling although theory said it should be surging. The culprit was consumer confidence. Once it spurted, the economy accelerated. We think the recent decline in consumer confidence presages a slowing in the economy.

One year ago we sold out 30-year treasuries because we could find very little value in the fixed income market. We had bought those bonds just prior to the election in the bond market panic about the prospects of a Democrat in the White House. That panic likewise took yields to 8%.

This letter has been mostly about bonds, not stocks. With the bond market debacle in the past year, bonds have gone from being expensive and unattractive relative to equities, to being cheap compared to stocks. If the bond bears are right, and long rates are headed a good deal higher (we will concede that short rates are going up at least once more), the next year for equity investors could be as difficult as the last year has been for fixed income investors.

We think the bears are wrong and that long rates are in the process of peaking. Corporate profits, though, are still growing and we expect them to be up about 10% in 1995. If we are right, the combination of falling long-term rates and rising profits should lead to a good year for stocks.

The source of the error bond investors made last year, and that stock investors made in 1987, was myopia, focusing on the near-term outlook and trend while ignoring long-term value. We try to avoid the short-term volatility inherent in stocks as investors react to the recent items on the tape and in the newspapers. Long term, as the results of the fund have demonstrated over the years, a disciplined approach to buying value has proven rewarding. We expect it will continue to do so.

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