Bill Miller Letters Archive

1996 Q3 – Market Commentary

With the indices hovering at record round numbers, 6000 on the Dow and 700 on the S&P, the fears that engulfed the market during the correction in July have become a distant memory. As we indicated in our last letter, we believe that those fears – which related to incipient wage inflation – were misplaced and that the Federal Reserve had no need to raise interest rates. When the Fed left rates unchanged at its August and September meetings, those fears receded and stocks rallied.

Most economists still appear to expect a rate increase, only now they expect it after the election. They believe the economy is operating so close to capacity that the risk of inflation remains high, and that the Fed should raise rates to insure the economy does not overheat. We continue to disagree. We think the economy is slowing, and that the risk to stocks is not an overheating economy and rising inflation, but an economy that weakens unexpectedly. This is not an outcome we expect, but we believe it more likely than the alternative.

The number and variety of quality companies having earnings difficulties, such as AT&T, Motorola, Kellogg, Hewlett Packard, Whirlpool, Albertson’s (the list could be expanded but you get the drift), presages, we think, broader difficulty in achieving profitable growth. Most companies have gone through the downsizing and restructuring that has been so much in the news. Cost cutting, coupled with solid economic growth, has resulted in strong profit increases, high returns on equity, and record cash generation for the S&P 500.

Going forward, however, we think growth for many companies will be much harder to achieve. It will have to be fueled by new products and volume growth, not cost cutting and certainly not price increases. The consequences of a low inflation, low nominal growth environment will become evident as the ability to further wring out costs becomes more difficult.

Consumer spending makes up two thirds of GDP and is the primary driver of economic growth. With unemployment low and consumer confidence high, many economists think the consumer will continue to fuel above trend growth. Demographics and debt augur otherwise. The number of people turning 25 years old drops sharply next year and for several years thereafter. This demographic group is closely correlated with household formations and spending on consumer durables. Moreover, personal consumption expenditures’ growth has outstripped income growth for most of the past 4 years, leaving the average consumer with near record debt. Reported bankruptcies are up sharply, and credit card delinquencies were also rising before declining in the second quarter.

The 76 million baby boomers are now mostly in their 40s and have begun to reduce their spending and increase their savings for retirement. We think these factors will lead to subdued consumer spending, sluggish growth, and increasing earnings difficulties over the next year or so. We do not expect an end to the expansion, just a deceleration from above trend to below trend growth.

Earnings have been the elan vital of this bull market since the lows in October 1990. Whenever earnings have flagged, interest rates have dropped, simultaneously providing valuation support to the market and raising expectations about future earnings. There is still considerable room for short rates to decline if the economy begins to sag, and some room for long rates to come down. But the bulk of the interest rate driven moves we have periodically experienced since the secular peak in rates in 1981 have about run their course.

The slow growth, low inflation environment of the past 6 years has been accompanied by a little noticed, but extremely important trend: decline in the volatility of most economic data. Volatility is important because it is associated with risk. Many academics believe that it is the same thing as risk, at least insofar as stock prices are concerned. (Risk is the subject of Peter Bernstein’s wonderful new book, Against the Gods: The Remarkable Story of Risk.)

The generation of investors who entered the markets after the late 1960s grew up with volatility. Interest rates soared then crashed, inflation went from 3% to double digits and back to 3%. Stocks collapsed in the ‘70s, soared in the ‘80s, crashing in ’87 and now have moved back to record highs. Farmland prices, oil, Latin debt and currencies, all have exhibited high volatility over the years. That began to change this decade. One of the reasons we went 6 years without a 10% correction in stocks was because the economy grew steadily with low volatility. Stock price volatility in this decade has been among the lowest on record.
Recent U.S. inflation volatility has been only one-quarter of that which existed in the late 1980s and one-third that of the early 1990s. The volatility of inflation is now at 30 year lows. Changes in commodity price volatility have led to changes in inflation volatility consistently since 1971. Commodity price volatility is at 27 year lows and remains in a downward trend. Inflation volatility is thus not likely to reverse soon.

The low volatility of inflation has led to record low volatility in short-term interest rates. We think it will soon extend to long rates, much to the consternation of bond traders, for whom volatility provides a livelihood.

Most importantly for equity investors, the volatility of economic growth has declined. For all the ink spilled about its direction and growth rate, the U.S. economy has had only 8 months of recession since 1982. This is in sharp contrast to the familiar boom and bust pattern usually coinciding with the Presidential election cycle. The economy now appears to be on a path of moderate, sustained growth. This has important implications for stock selection.

Many investors think about investing in relation to the economic cycles. Retailers, apparel, and autos are so-called early cycle stocks, while paper, chemical, chemicals, and steels are late cycle companies. Food, beverages, and drug stocks are defensive names; you are supposed to own them when the economy is on the brink of recession. If the economy is becoming much less cyclical, as we believe, all this rotation from one stock group to another becomes much less effective, even counterproductive.

We think the move to low economic volatility will be with us for some time. Careful attention to valuation and stock selection will be keys to above average results.

With only 8 months of recession in 15 years, unemployment down, inflation at 30 year lows, and the deficit half what it was 4 years ago, the population should be basking in prosperity’s glow. Growth has been the exception throughout most of recorded human history, as the Nobel laureate Douglas North has pointed out. One would think people would notice when the economy has been performing unusually well. But not so.

In a fine article called “A Nation that Poor Mouths Its Own Boom,” the Washington Post (October 13, 1996) reported the following:
“The average American thinks the number of jobless is four times higher than it actually is. Nearly 1 in 4 believes the current unemployment rate tops 25% – the proportion of Americans…out of work at the worst of the Great Depression. They believe prices are rising four times faster than they really are and that the federal budget deficit is higher, not lower, than it was five years ago. And 7 in 10 say there are fewer jobs than there were five years ago.”

It may be that this cognitive dissonance accounts for the pessimism that habitually surrounds the stock market, at least among the pundits quoted so often in the press. If people really have the beliefs the Post describes, they must surely be surprised when the market does well. They would probably believe that the market is significantly overvalued and that a bear market is imminent.

Bear markets happen when things go wrong in the economy: profits decline, inflation increases, interest rates rise, etc. If these things happen, stocks will undoubtedly come under pressure. There is little evidence that the economy is on other than a moderate growth trajectory. If that is so, then stocks should continue to provide acceptable returns.

We think, though, that after nearly two years of dramatically above trend results, stock returns will moderate over the next year or so. Profits look to be up in the single digits next year and we think it likely stock returns will track profits growth. Reasonable expectations for the market are for returns of 8-10%, including dividends. If this is right, 78 we would hope to do somewhat better, since the companies in our portfolio trade at large discounts to the market, while having what we believe to be above average profit growth potential.

Portfolio activity was light in the quarter. We continued to build our position in Seagate Technology that we mentioned in last quarter’s letter. The shares were purchased at under 7x our estimate of 1997 earnings for the largest, most profitable company in an industry experiencing strong demand. The stock has already moved up nicely, but we continue to expect it to perform well over the next few years. We sold duPont, which reached our target price, and Digital Equipment, which has seen its business come under renewed pressure. We had a nice gain in DEC and redeployed the funds into Seagate.

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