Bill Miller Letters Archive

1991 Q1 – Market Commentary

“Lest men suspect your tale untrue. Keep probability in view” -John Gay

The Value Trust had a good first quarter. Our 13.01% rise was the tenth double-digit increase since the fund started in early 1982. Twice the fund has fallen by double digits, in the third quarter of 1990 and in the fourth quarter of 1987. Despite carrying a large cash position, we did better than the Dow, which rose 11.61%. We were slightly behind the S&P 500, which gained 14.51%. The broad Value Line index rose 22% for the quarter, exceeding its previous best quarter in the past ten years set in late 1982 as the bull market was just getting underway.

For most of the past ten years the Value Line index has lagged the S&P 500. The Value Trust has beaten the S&P just over half the time since 1982, and bettered the Value Line nearly 70% of the time. In the past three years, a tough time for value investing, we have done better than the S&P one third of the time, yet we beat the Value Line 75% of the time.

We entered 1990 with a cautious outlook. That worked well for about two weeks, until the market exploded on January 16th. All the major indices peaked on April 17th and have since been consolidating. Our cash position hindered our results in the quarter, since it only contributed 1.5% to our returns, but has helped recently. Since our cash will return about 4.5% for the rest of the year, the Dow would have to end 1991 at nearly 3100 to provide an equivalent return. At this writing, the fund has moved ahead of the S&P and has remained ahead of the Dow for the year.

While thinking about the first quarter, I was reminded of two books, quite different from each other, but both germane to what transpired in the past 90 days, and to what may ensue. Adam Smith’s The Money Game was first published in 1967, at the height and end of the great bull market that began in the late 1940s. It is an entertaining, sophisticated, and accurate look at the Wall Street environment at the peak of enthusiasm. The Eudaemonic Pie, by Thomas Bass, which came out in 1986, is an account of a quirky group of physicists and computer scientists who tried to break the bank in Las Vegas by building into a shoe a computer that used statistical mechanics to predict the probable landing point of a roulette ball on the spinning wheel.

Early in The Money Game, Adam Smith quotes Keynes about the “game of professional investment” being boring unless one is possessed of “ the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.” It used to be that investment management consisted of buying and holding stocks and bonds of investment grade, as determined by some statistical rating service. Performance was measured, if at all, over long periods of time, and little thought was given to predicting the vagaries of the market.

Investing was serious business, not a game. “Playing the market” was used to describe those whose investment purposes were not entirely serious, were perhaps even a bit frivolous. Dabbling in stocks was a pastime, not a profession for markets “players”. The great stock market characters of the late nineteenth and early twentieth century – Jesse Livermore, “Bet a Million” Gates, Arthur Cutten, the Fisher Brothers – were the market’s equivalent of professional gamblers like Amarillo Slim and Johnny Moss. There was a clear social and moral distinction between them and the stolid bankers who managed money.

That distinction became blurred, as Adam Smith recounts, in the late 1960s when the cult of performance first took hold. Just as Nixon declared in 1971, “we are all Keynesians now”, portfolio managers are all performance driven now, since investable funds chase past performance records, and a portfolio manager without funds to manage is just expensive overhead.

As the players in the money game have shortened their time horizons due to the emphasis on short-term performance, their behavior has sometimes come to resemble that of the casino gambler more than that of a rational, long-term investor. Getting the near-term direction of the market right, being in the stocks that are now outperforming and anticipating the next move are what investors seem to want from their advisors. The Wall Street Journal recently reported that a major investment firm fired its strategist because he was too cautious in a rapidly rising market. If the time horizon of strategy is now a few months, tactics must be a daily phenomenon.

The gamblers in Thomas Bass’ book were not strategists or money managers trying to predict the market, they were scientists trying to predict roulette. Being quantitatively oriented, they knew that betting red or black had an expected loss of 5.3 cents for every dollar bet per spin of the wheel. The longer one stays at the wheel, the greater the probability of total loss. The optimal roulette strategy under normal odds for one who is actually trying to make money is to bet the entire roll on one spin.

The Eudaemons devised a methodology that optimized their chances of long-term gains. Factoring in the tilt of the wheel, the speed of the ball, its angle of descent, and numerous other considerations, the computers concealed in their shoes were able to shift the odds from 5.3% against to 40% in their favor.

The success of their strategy was based on not betting on improbable outcomes. The computer was able to eliminate about eight numbers per spin from the 36 a priori possibilities. But the 40% advantage they had over the house only existed in the long run. In the short run, statistical fluctuations could appear that would deplete or eliminate their capital. Such fluctuations could also lead to large gains accruing to those with clearly sub-optimal or even irrational systems. Success was virtually assured, but only over the long term, and only by making bets with a high probability of success.

The rewards of consistently beating the house at the casino or of regularly beating the market are substantial. It is perhaps not surprising that some members of the Eudaemons have moved from the game of roulette to the money game. Doyne Farmer, who led the group, now heads the theoretical division at Los Alamos National Laboratory. He and a group of mathematicians, economists, and computer scientists have been trying to understand the market as a prelude to predicting it. There is good news and bad news so far. The good news is the market seems to exhibit certain patterns consistent with what is called deterministic chaos. The bad news is the patterns are not predictable.

We have learned over the years that predicting the market is futile; understanding it is challenging enough. Right now the players in the game are betting on an economic recovery that will begin sometime this summer or fall and carry into 1992. Investors who were cautious or nervous last October are now increasingly bullish. The percentage of investment advisors who are bearish, 23.1%, is the lowest level since September 1987. At current prices, stocks appear to be discounting S&P 500 earnings of about $26.00, compared to 1991 estimates of $21.75.

If the recovery arrives on schedule and interest rates do not rise, the market would appear to be fairly priced at present levels. Sustainable advances will likely depend on some combination of lower interest rates or better than expected earnings. If the recovery is delayed, or rates move up, the market could give back some of the gains we saw this quarter. Like the gambler who bets with the craps player because he’s on a roll, many investors are betting with the market because it’s on a roll. Such a strategy is not likely to lead to any better results in the market than it does in the casino.

In any case, our long-term strategy will remain consistent. We will not attempt to predict the market, except to note that the odds on its being higher in any 12 month period are about 66% since 1926. In the past 50 years, the odds are better, nearly 75%. The house advantage for investors in stocks has been 10.1% per year since 1926. In order to maximize the probabilities of long-term success, we intend, like the Eudaemons, to avoid betting on improbable outcomes. We will continue to look for sound companies whose shares can be purchased at discounts to what our analyses indicate they are worth, managed by people we can trust.

As we do each quarter, we would like to thank shareholders for their support and we welcome your comments and suggestions.