Bill Miller Letters Archive

1994 Q4 – Market Commentary

Last year, for the first time since 1974, investors lost money in both stocks and bonds. The average growth fund was down 2.2% in 1994, while bond investors had their worst year in history by some measures. Your fund performed reasonably well in that difficult environment, rising 1.39%, outpacing most growth funds and the S&P 500.

The story in 1994 was rising interest rates, beginning with the first Fed tightening on February 4 and culminating in the 75 basis points (100 basis points = 1.00%) move in late November. Because those rate increases were driven by the strength of the economy, equities held up fairly well as earnings growth exceeded expectations. Fixed income instruments, which have no such offset, declined sharply all across the yield curve.

Most investors in stocks anticipated some increase in rates; it was the magnitude of the rate rise that caught everyone by surprise. Investors are, of course, surprised every year by events. The world is in constant flux and the path of economic, political, and social change is unpredictable. Successful investing does not require that one predict anything precisely. Having a reasonable eye for value and trying to insure that your inevitable errors are not too costly will usually enable you to achieve your investment objectives, provided one has the patience and discipline to stay the course.

Interest rates have continued to preoccupy people as the new year unfolds. The debate involves whether the Federal Reserve Board will increase rates again, a question that will be settled by the time you read this. Current thinking is that it will, because manufacturing capacity utilization is bumping up against record highs, unemployment is thought to be at levels below which inflation may creep into labor contracts, economic growth is described as robust, and many commodity prices are at multi-year highs. The Federal Reserve has said many times they would prefer to err on the side of being too tight rather than too easy.

A substantial minority of analysts believes rates are high enough and that the economy has already begun to slow down. We are in this camp. Most of the indicators of strong growth cited are lagging indicators that turn down well after the forward edge of the economy has already rolled over. Many of the leading indicators of the economy’s strength are pointing to much slower growth as the new year progresses.

Housing has clearly peaked, consumer credit growth has reached levels usually associated with downturn, the most recent retail sales numbers were well below expectations, showing a decline in December, and the auto companies are starting to cut production and to offer rebates on selected models. Most importantly, the yield curve has flattened and money growth is virtually non-existent. It is useful to spend some time on this last item, whatever the outcome of the current wrangle about Fed policy, because we believe it holds important clues about this year’s economic environment. We promise to keep this short and non-technical.

Twelve months ago, the narrowest measure of the money supply, called M-1, consisting mostly of currency and money in checking accounts, was growing rapidly. Strict monetarists, analysts who place a heavy emphasis on monetary policy as an explanatory tool, warned that this would inevitably lead to accelerating economic growth and rising inflation. Growth in M-1 is thought to lead growth in the economy because growth in spendable, non-interest bearing cash usually soon translates into spending. The Fed, trying to control inflationary expectations, began its tightening as M-1 was growing at a low teens rate.

Some monetarists place more emphasis on much broader measures of money supply, those that encompass general credit availability. They dismissed the inflation threat, noting that these measures were growing slowly, indicating no generalized pattern of increased credit growth that could fuel inflation.

Back in the late 1970s, investors waited eagerly every week for the new money supply numbers, believing them to hold the key to future inflation, economic growth, and Fed policy. As Fed governors have adopted more eclectic and broad-based indicators to guide their activities, watching the Ms has fallen out of favor just as the explanatory and predictive value of this exercise is increasing.

The rapid growth of M-1 in late 1993 and early 1994 accurately foretold the acceleration in the economy that became evident as the year wore on. Consumers began to spend more rapidly, housing and auto sales jumped, and the economy responded. The slow growth in the broader gauges of the money supply indicated no broader credit acceleration that would signal inflationary pressures, and inflation ended 1994 at a lower rate than it began the year.

After six increases in the Federal Funds rate and three increases in the discount rate, the Federal Reserve has succeeded not only in driving borrowing costs higher, but has also slowed the growth of M-1 to 1.7%. As rates on short-term funds increase, saving becomes more attractive than spending, and spendable cash growth slows. Broader credit measures remain quite subdued. We think this dramatic fall in M-1 presages a sharp slowdown in the economy this year, and that by the second half of the year worries will begin to surface that the Fed’s tightening went too far.

All the attention in the past year has been on rising interest rates; very little press ink or investor thought has been spent on when the Fed will start to cut rates. In March of 1989, Fed Chairman Greenspan pronounced himself very worried about inflation when the Fed raised rates. Only three months later he cut rates as the economy began to slow. We think one of the surprises of 1995 could be that short-term rates end the year lower than where they began it.

We have long believed that the current investment environment resembles the 1983-84 period more than it does 1987 or 1990. That is, it is a growth scare characterized by the fear that rapid economic growth will lead to rising inflation. It is not, like 1987, a time of gross stock overvaluation, or like 1990, the beginning of a recession. Despite being a poor year for investors, 1994 did not see the declines in the popular averages that characterized all those prior periods. That may yet lie ahead, if investors fear a recession is about to begin, whether or not they are right.

We believe a major decline, one of more than 15%, is unlikely, but it is certainly possible. Investors in funds such as this should be aware of and prepared for such an event. We do not attempt to guess stock market moves and do not intend to disturb long- term investment positions because we think the market may decline.

The Value Trust’s portfolio continues to be tightly focused. With assets of nearly a billion dollars, we hold only 42 common stocks, well below the typical number of names in a fund this size. The portfolio is well-diversified with holdings across a broad array of industries, including technology, health care, food and beverages, telecommunications, transportation, retail, and financial services, which remains a major theme due to low valuations and excellent long-term prospects. The fund has a modest position in two Mexican stocks, which hurt our results in the fourth quarter when Mexico unexpectedly devalued its currency. We did not believe devaluation was necessary and regard that decision as an epic error based on a tired and obsolete economic theory. Prior to the devaluation, the government forecast 1995 growth of 4%, with inflation of around 5%. The new, post devaluation forecast is growth of 1%, inflation of 15-20%, falling wages, and falling profits. It is important to remember that devaluation was supposed to make things better for Mexico, not create an economic crisis requiring international assistance. We have not sold our Mexican stocks, since selling into a selling panic has not historically been a profitable investment strategy. We may be buyers or sellers depending on how events unfold.

We only bought one stock in the fourth quarter, Chrysler, while selling seven holdings. Chrysler replaced General Motors in the fund, and we made it a major position due to its exceptional profitability, strong finances, and demonstrated willingness to put some of its excess cash to work for shareholders by buying back stock and sharply increasing the dividend.

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