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Oct 14, 2020

Bill Miller 3Q 2020 Market Letter

Bill Miller

As we pass the three-quarter pole and head into the homestretch of this most unusual year, it is instructive (I think) to reflect on how we got here, and where “here” is as it pertains to the US stock market. As 2020 began, we, along with most equity investors, were optimistic about stocks. The Federal Reserve had clearly signaled it was on hold indefinitely with regard to raising rates, inflation was quiescent, bond yields provided no significant competition to stocks, corporate balance sheets were in good shape, and expectations were for a global synchronized economic expansion. Reflecting this, the S&P 500 Index reached a new all-time high in February. A little over four weeks later, stocks had fallen into a bear market and were down almost 40% from the highs only recently achieved. The cause, of course, was the novel coronavirus, which struck first in Wuhan, China but quickly spread throughout the world, and which soon turned a global expansion into a global recession, the worst since the 1930s. Bond yields collapsed as investors sought shelter, and equity investors suffered grievous losses as they sold stocks in search of ever-elusive safety.

As has been often noted but seldom heeded, selling during a selling panic is rarely an effective strategy. This time was no exception as those who sold in March did nothing but lock in losses. Stocks bottomed on March 23 and, as shocking as the decline had been, perhaps even more stunning was the recovery that then began even as the pandemic raged. From a bear market low in late March, the S&P 500 reached a new all-time in early September before beginning a 10% correction that hit the market’s leaders, mostly technology stocks, particularly hard.

The market’s recovery was fueled by very aggressive liquidity injections by the Fed and central banks around the world, coupled with record fiscal stimulus in the form of over $4 trillion of spending to partially offset income losses as unemployment soared to the highest levels since the Great Depression. These extraordinary measures stabilized short-term credit markets, underpinned stocks, and provided sufficient income support to allow the economy to begin what looks like a sustainable, though uneven, recovery.

As of this writing, 3 weeks ahead of the election, much needed additional stimulus is stalled as the two parties put their own short-term political interests, as usual, ahead of the country’s interest. The polls, so wrong in 2016, show Vice President Biden with a solid lead over President Trump and the Democrats favored to take the Senate. As markets contemplate this outcome, they are remarkably sanguine (some would say, “complacent”). The platform of the Democrats calls for higher taxes on individual and corporate income, as well as on dividends and capital gains, more regulations, particularly on unpopular industries such as fossil fuels, and massive new federal spending programs. Many are puzzled at how an economic program calling for higher taxes when unemployment is at 8% makes any sense and why stocks are acting well in the face of this.

An ever-present tendency during presidential election years is to try to ascertain how the market will behave depending on which party takes control of the apparatus of government. This is a pointless and fruitless exercise as there is no clear cut answer as one looks back at history. To take only the most recent case, the administrations of Presidents Obama and Trump, whose personalities and policies could hardly be more different. Stocks rose over 16% per year during Obama’s terms and about 15% during Trump’s. The best-performing groups during the Obama administration were technology and consumer. The same for Trump’s term. Energy was the worst in both administrations.

In my opinion, what is underpinning stocks now, and I think will continue to do until fundamentals are dramatically different, is the historic change in the Fed’s reaction function. Ever since the great recession in 2008 and 2009, the Fed has been focused on the “normalization” of interest rates from the historically low levels that prevailed in the past 10 years. After persistently overestimating economic growth and underestimating inflation for a decade, they have announced that interest rates would be pinned at zero until inflation exceeds 2% and full employment has been reached.

The markets are, of course, aware of this new policy, but to be aware of it and to have fully discounted it are two different things. I think the change in Fed policy is likely the most significant in over 40 years, and, if sustained, is likely to have dramatic consequences for asset prices. In 1979, in the face of rising and persistent inflation, Fed Chairman Paul Volcker began a policy of restricting the growth of the money supply to crush inflation. The result, ultimately successful, was to send rates on treasuries to historic highs of nearly 16% in 1981 and real rates to over 6%, a level of return consistent with that of equities over the previous 100 years. Stock prices declined for 2 years, bottoming in August of 1982, when the Fed started to ease rates, ushering in a long bull market in stocks.

The real action, though, was in bonds. “Risk-free” treasuries had been anything but for 35 years as interest rates rose gradually, then suddenly, wiping out vast amounts of wealth that had sought safety. Chairman Volker’s policy of controlling the money supply to eliminate inflation was stunningly successful. Inflation is non-existent and central bank authorities say deflation is the current threat. Now real interest rates globally in developed countries are negative for over $30 trillion of bonds and bonds have outperformed stocks for nearly 40 years.

The Fed’s new policy, its new reaction function, is the exact opposite of that pursued by Chairman Volcker. The Fed now wants inflation to rise. Deflation, not inflation, is the enemy and if one believes the Fed, it will do whatever it takes to get inflation over 2% and unemployment from its current level of 8% to 3% or less. Both are likely to take years. If they mean it, as I think they do, and if they are successful, as I think they will be, bonds will enter a long-term bear market and equity valuations, which appear extended to many, will become much more so, perhaps to levels not seen before, just as interest rates are now.

All of this is just beginning. And the Fed’s new policy may not achieve its goals if secular deflationary forces are as strong as many believe. The money supply, though, is now growing rapidly. Stocks are rising and valuations of the big growers are expanding dramatically. Ten-year Treasury yields are rising, albeit ever so slightly. In the near term, I think value stocks, whose valuations relative to growth stocks are at or near all-time lows, will do much better; indeed they are already starting to. Much maligned and neglected financials should also shine as the yield curve steepens and net interest margins increase. Gold should provide solid returns and bitcoin perhaps stellar ones.

I think this is just starting to happen. How long it will last is anybody’s guess. I don’t think the coming ascendancy of value over growth means the high growth market leaders such as Tesla, Apple, Amazon, Google, and Netflix will falter. I think they will do fine — they are ripping today — just less fine than the more lowly valued names that have lagged for the past decade. The implication is that the bull market will continue but will broaden to include many previous laggards.

It should be a good period for holders of equities, but much more problematic for fixed income investors who have prospered for so long.

Bill Miller, CFA
S&P 500 3525.68
October 12, 2020

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