Bill Miller Letters Archive

1996 Q2 – Market Commentary

Your fund rose 3.64% in the second quarter, bringing our six month increase to 11.05%. The quarter’s return slightly trailed the increase in the S&P 500, which advanced 4.49%, and the average growth fund which rose 4.45%, as measured by Lipper Analytical Services, Inc. Our year-to-date advance remains ahead of both benchmarks.

The second quarter saw what may be the high water mark in speculation for this cycle. Strong money flows into aggressive growth funds fueled the advance of many small, speculative companies, whose valuations often reached breathtaking levels. At the sale time, interest rates continued to rise during the quarter, and moved past 7% for the 30-year Treasury bond.

At the end of June, the results for bond and stock investors differed dramatically. Those who bought long-term Treasuries at about 6% in January had lost almost 10% of their money in six months, while equity investors were up by about the same amount. The more venturesome small stock investors had average returns in their mutual funds of over 15%. Bond and stock returns usually don’t diverge for very long. By the end of the second quarter the valuation gap between stocks and bonds had widened such that we believed – and still believe – that to be bullish on stocks you have to be bullish on bonds. In this kind of environment, the best stocks should be those that look like bonds: banks, insurance companies, credit card companies, thrifts. We are loaded with these. Despite the fund’s strong performance in the first half, our financial stocks have turned in only a so-so performance. We think they are very attractively valued and will perform well in the second half.

The current situation is roughly the opposite of that prevailing at the beginning of the year when bonds yielded under 6%. Then stocks were attractively priced relative to bonds. But the sharp divergence in their performance has changed all that, and the market has already begun to exact its toll on overly complacent or enthusiastic stock investors. In just the first few weeks of the third quarter, a swift correction has engulfed the stock market. The major stock indices are down more than 8%, while the frothier over the counter market is off over 15% from highs reached just recently. On most days when the stock market has declined, which at this writing is most of them since the 114 point drop on July 5, the bond market has rallied. This has begun to redress the valuation imbalance, but has not yet rectified it.

The correction was kicked off by a jobs report which indicated continuing strong demand for labor at a time of already low unemployment. More disturbing to the market, real wages grew at the fastest rate in thirty years, which rekindled fears of higher inflation. Although bonds fell sharply the day of the report, they have rallied steadily since, indicating that 7% yields have already discounted some upward movement in inflation.
Whatever the portent of the employment report, its effect on economists and investors was immediate. The economic seers raised their forecasts for second quarter growth to 4% or more and also increased their estimates of third quarter growth from an average of 2-2.5% to 3-3.5%. At its present size, the economy will generate an extra $60 billion of output in the next 90 days, if those forecasts can be believed. A strong consensus has also emerged that the Federal Reserve Board will raise rates at its August meeting, if not before.

Labor cost inflation is more problematic than the commodity price increases that led to inflation fears earlier this year. Labor costs make up about two-thirds of the cost of production. The supply of labor is relatively fixed and when demand for labor passes a point called the non-accelerating inflation rate of unemployment (abbreviated as NAIRU), theory says that labor costs may fuel higher inflation as companies bid for other companies’ workers.

Stock investors may be hurt in at least two different ways if wage inflation takes hold. First, since pricing power is minimal, wage increases cannot easily be passed along to customers. This raises concerns about profit margins (and profits) getting squeezed. Pressure on profits means pressure on stock prices, other things equal. Second, the Fed is known to be especially sensitive to wage inflation, since it is difficult to halt once started. They are much more likely to aggressively raise interest rates at signs of wage inflation than if only commodity prices are rising. Rising interest rates hurt stocks directly at these relative valuation levels, and also increase the chances of recession, another bad outcome if you own stocks (but not high-quality bonds).

We do not believe the recent uptick in real wages signals the beginning of a rise in core inflation. Real wages can (and should) rise when worker productivity rises. In the first quarter, productivity shot ahead at more than a 4% rate, leading to a fall in unit labor costs. It should be no surprise that after five years of economic expansion, real wages would move upward with continued productivity growth. It may be that rising wage growth is signaling continued gains in productivity, not increased inflation. Whatever the cost pressures, if monetary policy does not accommodate them through more rapid money growth, then inflation will not be able to take hold. We think rising wage growth heralds solid productivity growth, especially when one views it in the context of the other factors of production.

Core producer price index (PPI) numbers show a twelve month rate of growth of 1.6%, but a three and six month growth rate of only 1%. Total PPI growth has been inflated by the commodity surge of a few months ago, which has now abated. Reported PPI data are beginning to move to the recent core rate of 1%. Consumer prices have historically averaged about .5% above the core rate, so this indicator is pointing toward inflation of under 2%. With commodity prices falling, core PPI falling, and most cyclical stocks – which are barometers of economic strength – falling, there is little evidence of inflation pressure outside the wage data. That makes it unlikely, in our view, that wage increases alone will fuel higher inflation.

It is the prospect of wage inflation that sent stock investors into a panic. In a classic turn of phrase, one rattled analyst, observing the selling frenzy, said, “we are watching the lemmings fly out the window.”

The change in investor psychology occasioned by a little selling is always fascinating to behold. The major stock indices are off by 8%. In the past 30 years, half the days the market has been open it has been trading at 5% or more from the peak. Over the past 95 years, there have been 54 corrections of 10% or more, the most recent occurring intraday on July 16. For long-term investors, sell-offs provide an opportunity. For speculators, they provide a lesson.

We think, though, that it will be tough for stocks to beat bonds in the second half. Valuation and trend are in bonds’ favor. With inflation running at 3% – or less – bond yields in the 7% range provide real returns well above historical norms. The trend in many sensitive inflation indicators, such as gold, oil, and industrial commodities prices, has been down from peaks reached a few months ago. A more subtle feature of the favorable bond outlook is the trend in the economy’s growth rate. Even those economists who just raised their growth rate for this quarter believe the second quarter will be the peak in economic momentum. Bond prices tend to be coincident indicators of economic momentum. Prices often rise as the economy slows, as happened in the second half of last year, and fall when economic growth is accelerating, as in the first half of this year.

We agree with the consensus (for a change) that economic growth will decelerate in the second half of this year. If so, that would tend to underpin bond prices. We disagree, though, that the Fed will be forced to raise rates in August. On that point, we are agnostic, except to note that when the Fed voted to hold policy steady at its last meeting on July 3, the vote was unanimous. Inflation worries were then largely absent.

Since the stock market has so quickly swung from enthusiasm to despair, we think if the Fed does not raise rates in August a nice rally may ensue. Perhaps perversely, the worse the market acts from now to then may play a role in the Fed’s decision. At the July meeting, they noted that a market correction may provide clues about the economy’s prospects. The worse stocks act, the more the Fed will think the economy is cooling off without the need for a rate hike.

We mention all this macroeconomic stuff not because we try to predict the economy or the market. We don’t. We do try to understand the economic forces operating at any given time and what the valuation of various asset classes is implying about the future.

Our stock selection, though, is one by one, valuation driven, and long-term oriented. Quarterly transactions remain at a low level. We have reduced our Nike position significantly. The company is terrific, we have big gains in it over the past few years, but it is no longer a bargain at 25x earnings. This is now one for the growth and momentum crowd.

We took a moderate position in MGM Grand, a company whose controlling shareholder – Kirk Kerkorian – and management we have long admired. MGM is embarked on a significant expansion both in Las Vegas and in Atlantic City. We think cash flow, earnings, and the stock could double in the next five years, with minimal long-term risk.

A significant portion of our research time is being dedicated to technology, a sector that has been through a spectacular decline in the past nine months. Many stocks are down 60 or 70% from their peaks. Two of the group’s bellwethers, Motorola and Hewlett Packard, reported poor results and suffered sharp falls in their stock prices a few weeks ago. The best companies are usually the last to decline, and we think bargains have begun to appear in this group.

The best bargain we already own is IBM, which we think is absurdly underpriced in the low $90 range. IBM will probably also report weak results for the just-ended quarter, but we are quite optimistic about its prospects. At 8x earnings and 4x cash flow, not much has to go right for it to do quite well for us.

We have also begun to build a position in Seagate Technology, the leading producer of disk drives for computers. The disk drive industry, while fiercely competitive, has consolidated from 55 manufacturers in 1989 to 12 at the end of June to 11 today. Hewlett Packard announced they were dropping out of the business when they announced their earnings. We think Seagate can earn $6.00 in the next twelve months, and earn double that amount in four years. At under 7x earnings, down over 25 points from its high, it looks like a bargain.

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