Bill Miller is an interesting value investor whose quarterly letters I often review. His portfolio isn't full of obvious value picks, and he tends to be very bullish. I can't remember reviewing one of his quarterly letters that weren't bullish.
The fourth-quarter 2019 letter is no exception as Miller still believes the right way to be positioned is long stocks. I've highlighted his most cogent arguments and play devil's advocate where I can. Miller starts with a review of the very recent financial history:
"A year ago, following the worst December for stocks since 1931, the outlook for 2019 was decidedly cautious and the great worry was that the global economy might be on the brink of recession, due in part to the Federal Reserve's raising of interest rates. Few, if any, predicted a strong stock market given how bad the fourth quarter returns were. The result was the best stock market in years."
I definitely didn't predict a strong stock market. I don't agree with Miller that the result was the best stock market in years. A large part of it was the rebound from the bad fourth quarter, but the mood was like this globally. Miller points that out himself, highlighting fears of the global recession. Yet the S&P 500 (SPY) was especially strong.
It seems most likely that a lot of factors worked together to make this happen. First, the rebound. Second, the Federal Reserve also feared a global recession and got scared from the market reaction to its hikes. The central banks started cutting rates and with a six-month lag, the market started surging just as the rebound was running out of steam. Third, people are becoming increasingly attracted to the stock market as they are flush with cash, the crisis is almost a decade behind us and markets have had a couple of spectacular years. Miller wrote:
"As 2019 drew to a close, the mood was quite different with stocks posting record high after record high. Still, the so-called "chattering classes," those who make their living talking or writing about stocks but not by actually owning or managing them, evinced little enthusiasm. The worry about "irrational exuberance" that Fed Chairman Greenspan raised in 1996 was largely absent. I would characterize the mood as that favorite term of pundits, including those who actually do manage money: 'cautiously optimistic.'"
I admit to writing about markets and having been cautious for all of 2019. I'm not sure it was wrong either, merely unnecessary with hindsight.
Miller also noted:
"Then President Trump ordered a drone strike that killed Iranian general Qassem Soleimani, along with several other Iranian military leaders. Stocks promptly fell, bonds rose, as did oil and gold, all of which were perfectly sensible initial responses to that unexpected event. Not surprisingly, the mood of the pundits changed immediately."
This is always the case if there's a major geopolitical event. For what it's worth, it did not make me any more cautious at all. But it did make me pound the table on energy, the cheapest sector in the S&P 500 while there are clearly increased odds of further geopolitical events.
Miller went on to observe:
"Barron's 2020 outlook issue a few weeks ago surveyed market strategists and typified the cautiously optimistic view: a 'more muted' 2020, with stocks rising 4% on average. Add in a 2% dividend yield and the expectation was for a 6% return. That is about as cautious as can be since, after an above-average return in stocks one year, there is about an 80% probability they are higher the next year. Over the past 30 years, the odds of both years being above average are about 50%. There is about a 30% chance both years will be among the 10 best of that period."
Miller comes up with these great statistics that I find quite interesting, but they also paint a rather incomplete picture. For example, if I had to predict stock market returns, I would always pick a high single-digit number. There are just way more up years. As such, 6% looks way too high for the S&P 500 currently. I immediately believe Miller's good years tend to follow on each other. I understand there's something called momentum, and perhaps we are in the middle or beginning stages of a melt-up here. But there's context too. We are going into an election year. There are signs of inflation, which has been away for a long time. This is an exceptionally long bull market. The Fed stopped dropping rates, though it initiated a from of quantitative easing. Maybe that's a bullish factor?
I'm not about to sell my equities, but I don't start from a zero or neutral base. My basic investing style is to be long. Long with lots of small caps. With that as my baseline, I think it is best to adjust my risk with a cautious world view.
If starting with an allocation of treasuries, one has to push themselves to be a little bit more bullish, but I really hate treasuries in this environment to begin with.
Miller also said:
"The shock and trauma of the 2008 financial crisis were so scarring that people have been and remain risk and volatility-phobic and see every negative event as presaging a serious correction or perhaps a recession and bear market. As long as that attitude prevails, perceived risk will tend to be magnified and real risk will be less than perceived, which provides an opportunity for what Ben Graham called the 'enterprising investor.'"
Miller believes there continues to be a negative attitude toward the stock market, which is not exactly what I'm seeing around me. But he does illustrate his view with another cautious Barron's cover. It's true that the media isn't exactly screaming to jump in. He continued:
"Stocks will not move in a straight line higher even if the bull market continues in 2020, as I believe it will. Setbacks and corrections should be expected, but unless something causes the economy to tip into recession and earnings and cash flows to decline, which I do not expect even if the geopolitical situation gets grimmer, then the path of least resistance for stocks remains as has been for a decade: higher."
In the above paragraph, Miller goes beyond his point that stocks usually go up, so you should be long. He acknowledges that a recession and declines in earnings and cash flows could cause stocks to go lower. This sounds a bit contrite, but it also means he doesn't foresee multiple contractions.
It's exactly multiple contractions coupled with earnings declines that I fear most. Companies have very wide margins within a historical context. They also trade at very high multiples in a historical context. If both change, it will be very hard to have a positive year. I hope Miller is right again.
Read more here:
- David Rolfe Makes an Interesting Case for Alphabet
- Gundlach: The Long-Term Vallue Is in Emerging Markets
- Westshore Terminals Set to Decline Another 70%
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This article first appeared on GuruFocus.