Bill Miller: «Markets always tend to go from undervalued to overvalued. And we’re probably half way through that journey.»
From the top to the bottom and back up again: That’s the story of Bill Miller. The legendary Legg Mason money manager is famous for beating the S&P 500 fifteen years in a row. But then came the financial crisis and his portfolio went into free fall. He had bought up shares of AIG, Wachovia, Bear Stearns and Freddie Mac, all of which were nearly wiped out. In the last two years though he staged a spectacular comeback. His Opportunity Trust fund ranked among the very best in the mutual funds industry. «I’m quite optimistic about the year and I think the market will probably be up double digits», says Miller. No stranger to taking risks he is especially optimistic for stocks of U.S. homebuilders, airlines and Amazon.
Mr. Miller, the markets have become more volatile recently. What is your outlook for equities?
After the S&P 500 being up close to 50% in two years, some kind of pull back or flattening out for thirty, sixty, ninety days or even longer would not be unusual. In fact, it would be expected. But it looks as if people seem to have forgotten that virtually every single year the market has a correction. Also, this year there are midterm elections in Congress. And usually in an election year what you see is that the market starts off slowly and typically would go flat or down for a couple of quarters and then end up strongly as we get into the fourth quarter of the year. Who knows if that will happen, but that’s the pattern starting off.
So you’re not concerned that after five years the bull market is losing steam?
That’s unlikely. I’m quite optimistic about the year and I think the market will probably be up double digits. Usually bear markets are caused by some combination of three things: Namely a spike in oil prices, Fed tightening or a recession. Today, the opposite is the case. All the elements are in place for an ongoing bull market: There’s ample liquidity, solid economic growth and attractive valuations. If you have those three things you almost never have a bear market.
Is this really true? The Federal Reserve is expected to terminate its QE3 program sometime this fall. After that, the first interest rate hike doesn’t seem to be far away.
Despite of the tapering the Fed is still net injecting liquidity into the markets. Also, we have interest rates at near record lows. The Fed has been blindingly obvious for years that any kind of tightening is going to depend on the data. It’s pretty clear from their consistency of the statements, both Chairman Ben Bernanke’s and Chairman Janet Yellen’s: Just because you hit a 6,5% unemployment rate doesn’t mean that the Fed is going to be tightening any time soon after that. They are rightfully very concerned about a repeat of the 1937 experience when the Fed tightened too soon. That caused the stock market to collapse, the recovery to end and we didn’t recover again for two to three years.
Most economists are expecting the first rise in interest rates sometime in the middle of next year. Therefore, it would be no surprise if investors are starting to act nervous already several months earlier.
When the Fed starts putting up the Federal Funds Rate, whether that’s 2015 or 2016, based on history that could cause the market to go into a pretty significant correction. That’s because the market does not know how far the Fed is going to go and what exactly they are going to do. But what happens is that the Fed goes from being accommodative – like they are now – to being neutral. And based on history that has always been a good buying opportunity. The market gets only dangerous when the Fed moves from neutral to tight. When the Fed starts talking about imbalances and about rising inflation pressures that’s when you need to get defensive because they can influence the economy but they can’t control the outcomes.
There are virtually no signs of inflation so far. But there’s a lot of talk about overvaluations and too much optimism. Especially the U.S. stock market doesn’t look cheap any more.
Markets always tend to go from undervalued to overvalued. What you have now is this journey from undervaluation to overvaluation which began in 2009. And we’re probably half way through that. If this bull market follows the historical pattern, over the next two to three years we will move from a fair valuation to overvaluation and then back down again, once the Fed starts to tighten. Obviously, valuation is not as attractive as it used to be, but it’s still attractive based on historical standards. Right now, the valuation of the S&P 500 is about in the midrange of the long term averages of 15 to 16 times earnings. But if you adjust those earnings for interest rates and inflation, you see that the market is undervalued. Also, if you take a closer look at the top 25 names in the S&P 500, their P/E ratio is around 12,5 to 13 times. And these are very high quality companies like Exxon Mobil, IBM or Apple. So you are not looking at P/E ratios which are at all demanding for very high quality names.
What does that mean for investors?
A question we’re always asking is about the reasons why I would be more bullish today than I would be in a normal market, trading at 16 times earnings and gone up almost 150%. That would normally be a more dangerous signal than it is right now. The reason is that asset allocations are still indicating great conservatism. People are still pessimistic in general about stocks, even though corporate profits are on a record level, the stock market is close to a record level, margins are close to a record level, balance sheets are the best they’ve ever been, buy backs are at a record level, dividend yields are solid and dividend growth is in double digits. So all the things you want to look for as an underlying reality will tell you that this market is going higher. And the key one thing is that it’s married to a pessimistic psychology. I don’t mean looking at sentiment indicators. It’s not a question of what people are saying but what they’re doing. It’s said that everybody is bullish. But when everybody is bullish why is the asset allocation so negative? Why are investors still overweighting bonds? So people may talk bullish but they don’t behave bullish.
A reason for this pessimism is probably that there’s still a lot of slack in the economy. For instance, in the first quarter growth nearly stalled.
The first quarter was weaker but it looks like it was mostly weather related. What’s interesting is that you have to distinguish between what people’s hopes or believes are about the economy and what is good for investors. There’s a difference in view between Wall Street and Main Street. The stock market has been doing great. On the other hand, many people on Main Street still think we’re in a recession because they haven’t seen unemployment come down. So for investors it has been a very good recovery but for a person who is unemployed obviously it has been a very bad recovery. But I think that is about to change. The recovery has been subpar by broader standards mainly because housing continued to lag. Going in to the next couple of years housing is supposed to pick up again. Also, the last two job numbers were very solid and early indicators such as wage growth are picking up significantly, and commercial and industrial loan growth is very strong compared to last year. So I think all of those things indicate that the economy is probably going to be accelerating during the year.
But the homebuilder stocks have been lagging the broader market since last spring.
Our equity fund was the number one of all funds in 2012. The reason it did so well was largely due to the home builders which went up six or seven times in that one year period. So we actually sold a fair chunk of our homebuilder stocks into spring 2013 because they became expensive in a relatively short term. But we were not selling all of them, we just trimmed those positions back. Now we’ve got a good position in the homebuilder sector and I think stocks like PulteGroup, Taylor Morrison and KB Home are poised for another big move. In any business that is highly cyclical and where there is a long, multiyear cycle, the pattern is quite similar. If you think back to the last decade: What went up the most? Oil bottomed at 10 $ per barrel in 1999. At that point economists said it would go to down to $5, but then we had this big emerging markets boom and it went up to $147 until 2008. So if you look at the history of emerging markets, commodity prices and similar things they all followed the same pattern in that ten year cycle. The first year is huge, then comes a pull back for a while and then it continues to go up. That’s what we are going to see with homebuilders and we’ve got another three to four years at least in the homebuilder cycle.
You are also betting on airline stocks. What’s the story here?
In the airline sector there have also been cycles. But they went historically from airline stocks being the worst thing possible to own to being terrible to own. We believe that there has been a secular change in the airline sector for the better, and that is not completely reflected in stock prices. The huge move has already been made. But we think they still are going to do better than the market over the next several years. The main driver for that is consolidation. Three or four years ago, the number one market share of the domestic U.S. carriers was 12%. And now the top three carriers, AMR, Delta and United together control over 75% of the market. So they’ve doubled their market share and now it’s a much more stable industry. Delta made the first big move and has come the most far. So Delta is going to be fine, but United has even a greater runaway.
You also made a lot of money with red-hot internet stocks like Netflix or Pandora. How concerned are you about the severe correction in those so-called momentum stocks?
It has been very good that that cohort of stocks has sold out. We sold the chunk of our Netflix shares and we sold the chunk of our Pandora shares. They’re both at a level now where the risk reward is positive again. Take a look at how the market has valued Amazon for example as it has become larger and more mature over the last five years. The shares typically tended to bottom at about 1.5 to 1.6 times market capitalization relative to revenues. And that’s approximately the level where they are right now. So then you can ask: How much is Amazon going to grow over the next three years? We think Amazon is going to double roughly its current size – and that’s a conservative estimate!
For investments in stocks like Amazon, Netflix or Pandora you need to have strong nerves. What’s your investment philosophy when it comes to risk?
The financial crisis certainly changed my perception where the risks could come from in the overall market. At that time I was mainly concerned about overall valuation risks. But even if the market was at an all-time high in 2007 it wasn’t very expensive. In fact, on a P/E basis it was about the same or maybe even a little bit lower valued than it is right now. It turned out though that this wasn’t really the right way to think about risk because you had a very serious imbalance in the U.S. credit markets. Also those new securities were highly levered and not well understood. What we’ve learned is that risk isn’t always visible in the overall market numbers. So I think understanding where credit has been misallocated and where asset values may be much higher than they’ve been historically are good indicators. That’s also the case for risk spreads. Right now it indicates that the actual risk in the system is low, even though the perceived risk is high – and that’s probably where the opportunity is.
What would you do differently now in retrospection?
I thought we had a pretty good risk management and mitigation measures because we had a twenty plus year history of navigating trough a wide variety of markets, like the crash in 1987, the LTCM problem in 1998 or the 2003 deflation problem. We went through virtually all of those episodes beating the market and doing well. We had developed strategies to deal with things when the markets got dangerous. And those strategies evolved around not really doing anything until the Fed came in and pumped a lot of liquidity into the market and began to cut rates aggressively. At this moment we would buy whatever the source of the problem was. At the time of the LTCM crisis for example financial stocks went down 50% from July to September and as soon as the Fed rescued LTCM those stocks had a huge rally. So the point is that all of those crises were similar in that they were all liquidity based crisis, and when the Fed put liquidity in the system that solved the problem. Contrary to that, in 2007/08 the problem wasn’t liquidity. The problem was asset values which supported the debt structures.
What can investors learn from that?
It was the first time we ever suffered losses like that, especially relative to the market and for such a period of time. What we learned is you have to distinguish what type of crisis you have. And that’s not so difficult in my opinion once you understand what the differences are. Of course, the strategies are exact the opposite: In a liquidity based crisis when the central banks pump a lot of liquidity in that solves the problem and you should go in there and buy aggressively. On the other hand, in a collateral based crisis this does not solve the problem at all. The answer to a collateral based crisis is when the central bank authorities get together globally to basically stabilize asset values. We will see if I’m right. I hope I don’t live long enough to see another one of those crises. And the odds are I won’t because they come along only about every sixty or seventy years.
So how are you positioned right now with your personal investment portfolio?
I have a lot of money in my funds and the same goes for my family. Additionally, my personal positioning is virtually identical to that in the funds. But it’s usually a little bit more aggressive, especially when I think the market is doing well as it is today. That’s because I tend to be more optimistic about what I’m going to achieve. Also, I am willing much more than most people to take volatility. In general, some individuals could improve their financial outcomes if they really, really try to think longer term and not get too caught up in what the market’s doing day by day.
Is it true that you are invested in Bitcoin?
I have a speculative rooting interest in Bitcoin. It hasn’t reached the level of what I call an investment. But I think the risk reward on Bitcoin is such that in five or ten years it will either be worth nothing or a lot more than where it’s trading today. Bitcoin’s complicated. What the creators of Bitcoin wanted was an alternative currency system outside of the realm of governments and functioning in a technologically more advanced way than gold. Today, gold has a market value of $8 Trillion whereas Bitcoin has a market value of only about $6.5 Billion. So if Bitcoin were only to achieve one tenth of the value of the existing gold stock then it would be worth $800 Billion or over a hundred times its current price. So putting a relatively small amount in Bitcoin – of what I can lose everything, but I can also make a hundred times – is a pretty good risk award. Even if the probability of making that hundred times is relatively small.
Is there anything at all that concerns you?
The biggest issue I’m concerned about is policy errors. For instance, we had a series of policy errors in Europe since the crisis. Also, political gridlock in the U.S. means that you have this fiscal austerity program. But when you have interest rates this low and when you have infrastructure this aging it ought to be a no-brainer to enhance a huge program to rebuild roads, bridges and telecommunications. Those are assets that will last twenty, thirty or fifty years – not like welfare payments. They will benefit not just the current generation but the next generations too. And they’ll save a huge amount of maintenance capex that will have to be spent anyway as this stuff deteriorates. It’s like a company that lets its asset base deteriorate and then will not be as competitive. Another concern is geopolitics because you just don’t know what’s going to happen. We had a fruit vendor in Tunisia setting of an explosion all around the Middle East. We just had the anniversary of the First World War where Archduke Franz Ferdinand gets killed in Serbia and that triggered all these alliances ending up in the First World War. And right now there’s this situation in Ukraine and we don’t know what Russia is going to do.