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Aug 17, 2015

The Path of Least Resistance

Bill Miller

The stock market was roiled last week by the unexpected devaluation of the Chinese yuan. By establishing a crawling peg, the Chinese left room for further declines in the currency, something I expect over the next 6 months or so. There were several reasons for both the action and the timing. The Chinese economy has been sluggish and its export machine has been sputtering. Their currency had appreciated around 10% over the past year, in line with the dollar’s increase on a trade weighted basis, making things even more difficult for Chinese exporters. The Fed is expected to begin a gradual tightening process shortly, which was likely to put more upward pressure on the currency if it remained as tightly pegged to the dollar as before. The Chinese Premier visits the US in the fall, and the government likely wanted to put some distance between the devaluation, Fed tightening, and his visit. Perhaps most importantly, China wants its currency to eventually become a reserve currency, and it cannot do that without its floating reasonably freely against other currencies, something the IMF noted this week in an approving comment on the devaluation.

No matter how sensible the move economically, it rattled investors’ psychology, with a vocal minority proclaiming (wrongly) the beginning of a currency war. Stocks sliced through the 200 day moving average on the downside and tagged the 2050 area on the S&P 500 where it held and bounced, ending the week at 2091. The 2050 area has contained all declines in the market since late February, and the high of 2134 has held several attempts to break out higher. Volatility has likewise been subdued. The tight trading range has frustrated bulls and bears alike, although frustration with the market has hardly been a rare occurrence over the past 6 years.

My view remains that we are in a long lasting bull market and economic recovery that began in the spring of 2009 for the former and the fall of 2009 for the latter. Both have a reasonable shot at being the longest in our lifetime due to the severity of the financial crisis and the depth of the market’s previous decline. Good and bad news will come and go, precipitating rallies and corrections, but until the conditions that presage the end of the bull and the onset of the bear are present, being long US stocks is the way to invest.

Bull markets are a function of liquidity, valuation, and growth. All are currently positive, though not as positive as they have been for most of the time since the March 09 lows. None are problematic enough in my opinion to threaten this bull market, so I believe the path of least resistance for stocks continues to be higher. The end of the commodity super cycle and the resulting sharp decline in oil prices remain additional positives.

Within the US equity market, we think the most attractive areas are homebuilders, airlines, and financials. Builders are outperforming, but are still in the early stages of a multi-year period of double digit earnings growth yet trade at a below market multiple. Nothing that happens in China or with the US dollar will have much impact on the bright outlook for builders. The big airlines are all down this year because of what we believe are temporary factors that have already begun to dissipate (declining revenue per available seat mile, rising oil prices in the second quarter) and are among the cheapest stocks in the market. All are buying back large amounts of stock, as they should at these bargain valuations. (read: Game Time: Guess that Company) Financials have corrected in the past few weeks but remain among the biggest beneficiaries of the tightening cycle and are inexpensive in our opinion. Dividends and buybacks should both grow nicely over the next few years.

It’s important to stipulate that neither we nor anyone else has any idea of what the market will actually do, since no one has privileged access to the future. The probabilities, though, favor the optimists, or so we optimistically believe.

The views expressed are subject to change at any time. LMM disclaims any responsibility to update such views. The presentation 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, and there is no guarantee the views expressed will turn out to be correct.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.