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Apr 17, 2019

Some Reflections on the Bull at 10

Bill Miller

1Q 2019 Market Letter

The bull market that began in early March 2009 passed its 10th birthday last month, something no one expected when the S&P 500 bottomed at 666. The economic expansion that has accompanied it — as usual, the market led the beginning of the expansion by about 6 months — will become the longest in history when, as appears likely, it surpasses the previous record later this year. While this has generated the usual angst and fretting about when the inevitable recession, and concomitant bear market, will occur, it is worth noting that Australia is in its 28th year of continuous expansion.

What follows are some reflections occasioned by this long bull market. They are not meant to be systematic or complete, nor are they meant to suggest timeless principles that can be applied in the future. They reflect how we have navigated this period, and so perhaps may have some applicability to others who share our long-term, patient, contrarian (for the most part), value-driven philosophy. We have been fortunate that our strategy that has been available during that period has outperformed the S&P 500 by over 450 basis points per year.1 Luck surely has played a role over that period, but our views have been sufficiently different from the consensus to lead to that highly differentiated performance.

Fears of recession or of a bear market have been endemic since this bull market began. The financial crisis was so financially and emotionally devastating for so many that it left the typical investor, whether individual or institutional, risk and volatility phobic, determined to avoid a repeat of that catastrophe and subsequently doomed to leave a lot of money on the table in the search for safety. This is similar to the impact of the Great Depression of the 1930s on the public. That shock was so severe, following the long and often exuberant prosperity of the 1920s, that it induced a high degree of financial conservatism and desire for safety compared to what had gone before. Economic conditions change, but human psychology is pretty consistent in how it reacts to stress and loss.

We thought that one result of the financial crisis would be to create a persistent and long-lasting gap between perceived and real risk. The desire to avoid risk would magnify perceived risk so that the real risk would almost always be less. We systematically took advantage of that, believing it would create mispricing by undervaluing companies perceived as risky and vulnerable. If one could have made only one investment decision post the crisis, it would have been to be long high beta (volatility relative to the market). Put differently, the implied equity risk premium, the excess return required to own stocks over safe treasuries, has been persistently high for 10 years, relative to history, and remains so, indicating it is likely excess returns are still available due to the long-standing desire for safety. The equity risk premium is available on the website of Aswath Damodaran, one of the world’s experts on valuation and a professor at NYU’s business school.

Another exploitable behavior that has harmed investors’ results for the past decade is the attempt to forecast the twists and turns of the US or global economy, usually on a short-term basis, and to adjust portfolios accordingly. The motivation here is to try to avoid a recession and bear market. I agree with the remarks of Peter Lynch, Fidelity’s great portfolio manager, who said he did not spend 15 minutes a year trying to forecast the economy. He said he believed that more money was lost worrying about or preparing for recessions than was lost in the recessions themselves. This was particularly evident during the euro crisis of 2011, the so-called Taper Tantrum of 2013, the recession scare at the beginning of 2016, the sharp drop in the fourth quarter of 2018, and again in March of this year. In each case, the stock market sold off sharply because of macroeconomic fears, and in each case those fears proved erroneous. The market reversed course as soon as investors had adjusted their portfolios for what never happened. Trying to surf the market according to the flow of macro data added no value but did hurt performance.

The stock market, and capital markets generally, lead the economy and the macro data follow. Despite the quip by Nobel Prize-winning economist Paul Samuelson that the stock market had forecast 9 of the last 5 recessions, that record is far superior to that of the Federal Reserve or the Council of Economic Advisers, who have never forecast a recession. The problem with macro forecasting is that the market knows everything that anyone else knows. There may be forecasters who are very good, indeed better than almost anyone else, but they are not better than everyone taken together. That is precisely the same problem active equity managers face. It is not that active equity managers lack skill, it is that they are all skilled, but no one is so much more skilled than all the rest as to assure persistent outperformance over time.

An additional difficulty facing macro forecasters is that markets do not just reflect the current and expected path of the economy, they affect it. This is what George Soros calls reflexivity. It was fully evident in the Fed’s change in posture in response to the steep decline in stocks and the rally in bonds late in the fourth quarter as both market action and flow of data indicated a sharp global slowdown. The change in the Fed’s reaction function changed the market’s expectation about the probability of recession leading to a strong rally in stocks in January and February.

What has worked in this bull market if macro forecasting is a fruitless (for most) endeavor? An effective strategy, one that we have employed, is creative non-action, what Taoists call Wei Wu Wei, doing not doing. No one has privileged access to the future, a future which is largely unknowable, except in broad, probabilistic outlines. It is much easier to find companies where expectations are low, free cash flow yields are high, return on capital is solid or improving, which have a sustainable competitive advantage, and where management allocates capital effectively, than it is to forecast the economy and try to create a portfolio that will do well if that forecast is correct, which it mostly won’t be. Much better to focus on what is happening now and avoid trying to forecast the unknowable.

So what is going on now? The economy is in a long expansion which shows no signs of ending. The Fed is accommodative and has indicated it is in no hurry to raise rates. Inflation is low, interest rates provide no significant competition to stocks with bonds trading at 40x a cash stream that will not grow while stocks trade at 17x earnings and those should grow about 5%, or a bit more, long term. Dividends for the S&P 500 grew 9.9% for the four quarters ending March 31. There is plenty of room for dividends to grow faster than earnings since the current payout ratio is 35.5% compared to 52% on average since 2016. Buybacks are at record levels.

More generally, GDP is at an all-time high, corporate profits are at an all-time high, margins are at an all-time high, cash flows are at an all-time high, dividends are at an all-time high. Unemployment is at a 50-year low, initial claims for unemployment are at lowest level relative to the population in history, household net worth is at an all-time high, consumer balance sheets are fine, the savings rate at 6% is solid. There are more economic time series that are likewise in good shape, but the picture is clear. Usually when the economic data is that positive, stocks are at an all-time high, but they are not (yet). The surprise would be if they don’t surpass the September 2018 highs. Stocks are in a bull market and bonds in the US are in a benign bear market that began in 2016 with yields just under 1.4%.

My former Legg Mason colleague Ken Leech, chief investment officer of Legg Mason’s big bond subsidiary Western Asset, once described my investment outlook as varying between bullish and very bullish. It was a good line, although not entirely accurate, but accurate enough. Stocks have gone up on average about 70% of the years since World War II. If recessions or bear markets cannot be accurately forecast, then being bullish has a 70% probability of being correct unless valuations compared to returns available elsewhere are unattractive, which is certainly not the case now.

The path of least resistance for stocks remains higher.

Bill Miller, CFA

April 7, 2019
S&P 500 2892

1Performance for a representative Opportunity Equity account, net of fees, for the period from the market low on 3/9/09 to 3/31/19. Click here for performance data as of the quarter ending 3/31/19.  Click here for important performance information. Past performance is no guarantee of future results.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results. Content may not be reprinted, republished or used in any manner without written consent from Miller Value Partners.

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