Article via Christoph Gisiger of Finanz und Wirtschaft Reposted with permission.
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.