Bill Miller: The World Has 99 Problems, but the Market Isn't One

Discussion of Miller's latest market note

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Apr 19, 2018
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Bill Miller is a very interesting value guru to follow because his portfolio tends to tilt a little bit more toward growth, as opposed to most value guys, who tilt either toward deep value or what I would call quality value. Miller just released his first-quarter 2018 letter. After obligatory remarks about market volatility and the difference between the 2018 market and the 2017 market, Miller gets to the interesting stuff (emphasis mine):

"After the election of President Trump, the consensus was that his rhetoric, unpredictability and disdain for convention would be reflected in more volatile stock prices. That did not happen because none of those things had any impact on the economy, earnings growth or cash flows. The new administration’s focus on reducing regulations and cutting taxes were the only salient policy measures, and both were, of course, positive for stocks. The underlying economic backdrop barely budged: Economic growth continued its post crisis pace of about 2%, job growth, earnings growth, low inflation, low interest rates (all of the drivers of this long bull market) remained intact. As 2017 wore on, it became clear the global economy was entering a synchronized expansion, further solidifying what Jesse Livermore referred to as 'underlying conditions.'"

It is not news to anyone that economic conditions are fairly good. You could argue they have slightly deteriorated, but not enough to read much into. Miller then refers to Livermore, who is a legendary trader and wrote the classic book, "How to Trade Stocks," suggesting he treats these underlying conditions in a similar way. This sets up the rest of the note.

"The market this year looks, acts and feels different, and rightly so. Last year, policy was business and market friendly. This year, tariffs and the possibility of accelerating trade tensions are both business and market unfriendly."

Although the tariffs and trade tensions have not yet had the time to really impact the underlying conditions, they may in the coming years. One of the drawbacks of anti-business rhetoric is it increases uncertainty. Due to the uncertainty, corporations could delay capital investments. It could also be offset by the tax incentives that promote investments.

"The large deficits expected as a result of the tax cuts are coming as unemployment is low and wage gains are accelerating, raising the spectre of inflation moving ahead of the Federal Reserve’s 2% target, and triggering further tightening beyond what the market expects. The yield curve is the flattest it has been during this expansion, an early sign the market is concerned about the Fed over tightening and putting the expansion at risk."

Here I don't entirely agree with the way the issue is framed. If the Federal Reserve tightens more aggressively than expected, it isn't necessarily a mistake. The Fed may have its hand forced if inflation were to return with a vengeance. There is the possibility the expansion is already at risk due to policies that were put in place a long time ago (i.e., quantitative easing) or policies put in place more recently (fiscal stimulus). It may just become a problem as the real economy starts to get going organically.

"The greater risk to the market this year, in my opinion, is not economic, it is political. The President has replaced two key and moderate foreign policy advisors with hard liners in Mike Pompeo at the State Department and the even more bellicose John Bolton as National Security Advisor. Bolton last year authored an op-ed on the case for a preemptive attack on North Korea. The expected meeting between President Trump and Kim Jong-un of North Korea carries more than the usual risks attending meetings with foreign heads of state."

So far, we have seen some restraint exemplified on this front with the rockets launched at Syria. That may sound a little bit counterintuitive, but President Trump chose the least agressive of three scenarios. It seems somewhat cynical to interprete this event as the adminstration saving powder for North Korea. However, Miller's point is well taken. We can expect at least aggressive talk from the State Department and the NSA.

"The Mueller investigation is another possible source of market turmoil, with the continuing speculation Trump will fire him or Deputy Attorney General Rod Rosenstein (or both), potentially setting off a constitutional crisis similar to what happened in 1973 when President Nixon fired Archibald Cox, leading to the resignation of Attorney General Elliot Richardson. The recent FBI raid on the office of Trump’s personal attorney Michael Cohen has led the New Yorker to opine that the end of the Trump Presidency is in sight."

If Trump were to be removed from office, the market reaction to his victory would suggest we would see a sharp drop. However, it may have been the reaction to the surprise election of a Republican instead of the expected Democrat.

"There is nothing in all this that is positive for markets."

So far, Miller is summing up problem after problem, but his market view remains surprisingly bullish:

"If the political outlook is darkening ominously, why am I constructive on the equity market? It goes back to those 'underlying conditions.' Earnings estimates continue to rise, with first quarter numbers expected to be up as much as 25%, which follows the fourth quarter’s strong 15% growth. Dividends in the first quarter grew a solid 9%. Balance sheets are strong, as are corporate cash flows. Profit margins are at records, as are corporate profits, gross domestic product and household net worth. Unemployment is at cycle lows and inflation is quiescent. The earnings multiple of the S&P 500 Index is under 17x, which is hardly demanding compared to 10-year Treasuries at 2.82%, over 30x for a return that cannot grow."

Miller is basically arguing fundamentals are trending up. That may be true for now, but this can reverse very quickly if we see wage growth, for example, or commodity prices continue to go up or the unique global expansion starts to flag.

Miller also argues the market is inexpensive based on a simple 17x earnings multiple compared to the 10-year. I think this is an overly simplified way to look at things. If you look at the cyclically adjusted price-earnings ratio, the market is extremely richly valued. The latter happens to be a much better indicator of future returns. In addition, the Fed is on a tightening path and it rarely reverses course early in that journey. It has never reversed course near these kind of levels. Consequently, we will see higher rates soon enough. The market must discount that instead of rely on current rates.

So where's the market going?

"The 10% correction already experienced seems to me to adequately discount the visible risks noted above, leaving the market poised to go up if these risks either dissipate or fail to morph into more serious troubles. The path of least resistance remains higher."

You know Miller could very well be right. I wrote about Jeremy Grantham's 50% melt-up scenario earlier this year. It is all possible. But in the medium to long term, it seems unreasonable to expect high returns. At some point, the market will crack and Miller may know just when to jump off the train. I'm not so sure if I will get it right.