It is no surprise to me to see that Bill Miller, the long serving manager of the Legg Mason Value Trust, has been outperforming the market since the current rally began. Nobody’s performance has fallen further since the market cracked in 2007 – but good managers don’t become bad overnight, and he was bound to bounce back strongly.
In his latest quarterly letter to shareholders he remains strongly bullish on the outlook for the stock market. Here is an extract:
“Where does that leave us? The exogenous risks — geopolitical upheaval, terrorism, pandemics — are always with us. The others, rapidly rising interest rates or commodity prices, or serious policy errors, look to have fairly low probabilities attached to them and do not presently pose a threat to the economy or to a continued rise in the market.
“I have not said anything about the risk of inflation, in part because it is remote over the next few years. But it is a common worry, and a constant topic of discussion. The issue arises because of the massive deficits being run now and for the next couple of years, and the inexorable growth of entitlements programs, which will drive debt-to-GDP ratios north of 100%, from the current level of around 65%, for the first time since World War II. Many believe we will have no choice but to inflate our way out of those obligations.
“I disagree and think the major threat remains deflation, not inflation. The U.S. government ran large deficits in the 1930s and even larger ones during World War II reaching nearly 40% of GDP. Yet except for a one-time rise in prices after wage and price controls were lifted when the war ended, there was almost no inflation for 30 years. Japan’s debt-to-GDP ratio is 170% now, and its problem is deflation, not inflation.
“Inflation can only arise if labor or business, or both, have pricing power. Labor is still around 70% of the cost of doing business, and there won’t be any inflation there with unemployment at 9.5% and rising. Capacity utilization is 68%, among the lowest in the postwar period. Businesses will have no pricing power until that number is at least over 80%, a long way away. If the so-called new normal is growth of between 1 and 2%, there will be no inflation.
“What about the idea that politically we will be unable to do anything but inflate our way out of our debts? To believe that is going to happen, one has to believe the Federal Reserve will collectively repudiate its objective of price stability. Since the Fed that allowed inflation to devastate the economy in the 1970s is seen as having failed in its mission, while Paul Volcker, who sent the economy into what was until now the worst recession in postwar history by raising rates dramatically to kill inflation, is seen as a hero, it seems at best a stretch to think a future Fed will deliberately pursue inflationary policies.
“Could it happen? Sure. Do we need to be watchful for any signs of an incipient inflation? Absolutely. But the prospect of any kind of inflationary risk to the stock market over the next couple of years is vanishingly small.
“Bull markets typically begin when the following four conditions are present: the economy is bottoming, profits are bottoming, the Fed is stimulating, and valuations are low. That’s where we are now. The path of least resistance, as Jesse Livermore used to call it, is higher”.
History records that all the best value managers, from Warren Buffett down, suffer unduly during bear markets. The evidence, for those who doubt this, is in Robert Hagstrom’s books. As buy and hold investors with large indvidual positions and a concentrated portfolio, they are almost bound to do so. But that is also why they bounce back so strongly when markets rally.
You may think that Bill Miller’s current optimism is exaggerated, but it is on a par with the noises coming out from many other professionals with the same value bias. The odds that the market will go higher this year still look good to me. The fact that the economic news is still so bad does not contradict this thesis. It is a more a case of the brave reaping the highest rewards.
Jonathan Davis 