Saturday, 27 January 2018

Bill Miller & the coming equity bubble

There is currently a generally held view that one of the biggest risks global equity markets face at present is that interest rates rise more rapidly than expected (perhaps triggered by inflation stirring). I have, to some extent, shared that view. However, Bill Miller - an investor I rate very highly* - has just posted his 4Q letter to investors, and in it, he weighed in on this issue with an interesting perspective:

"There is growing concern that the great bond bull market that began in late 1981 is over (this is surely correct in my view), but divergence on what that might mean for stocks. In the Barron's Roundtable, several commented that rising rates could compress valuations if yields went above 3% and that stocks could end the year down. I think that is wrong. I believe that if rates rise in 2018, taking the 10-year treasury above 3%, that will propel stocks significantly higher, as money exits bond funds for only the second year in the past 10, and moves into stock funds as happened in 2013. Stocks that year were up 30%, mostly as a result of that shift in fund flows".

In ordinary circumstances, I would consider this argument to be a fallacy of composition. If investors sell bond funds to buy stock funds, the bond fund managers will indeed need to sell bonds to fund redemptions, and the stock managers will indeed need to buy stocks with new subscription monies. However, who buys the bonds off the liquidating bond managers? Bond prices will have to fall and yields rise to a market-clearing level that attracts an equivalent number of buyers from somewhere. And those new buyers may have to liquidate other assets - perhaps including individual stock holdings - to finance those bond purchases. Net net, on a system-wide basis these portfolio adjustments ought not to impact overall liquidity conditions materially.

However, as I have discussed in past blog posts, we do not live in normal times. What is different this cycle is that central banks have conjured up an enormous amount of fresh liquidity from the ether through experimental quantitative easing/money printing operations. They have - for the most part - bought bonds off individuals, funds, and institutions with newly printed cash, and the cash received by these sellers has ended up parked in excess bank deposits (held, in turn, by banks as excess central bank reserves). These accounts continue to earn little to no interest (indeed, some depositors in some parts of the world are even being charged negative interest rates for the privilege of having their money custodised).

Risk aversion has prevailed in the post-GFC years, and hence a lot of this newly printed money held in bank deposits has been hesitant to flow into equities, and also - to a degree - into the bond market, given the low yields on offer (and central banks - through their bond buying activities - deliberately priced them out in order to buy them out). Consequently, a lot of the funds have remained idly parked in cash. Stock prices have risen over the past decade not through euphoria and bullish animal spirits, but through investors being dragged ever so slowly - kicking and screaming - into stocks through financial repression and its persistently low rates. This is why we have seen - at least until recently - none of the behavioural factors normally associated with stock market tops (outside of Bitcoin), despite valuations being high. This bull market has indeed been different.

Because there is so much newly printed money sitting idle in bank accounts, Bill Miller might very well be right in his assessment that rising rates could actually serve to propel equity markets much higher. If bond funds begin to disappoint investors, while at the same time confidence levels around the outlook for equities continues to recover, a sizable reallocation from bond funds to stock funds is quite possible, and importantly, due to all the past QE that has occurred, the bonds being sold by bond funds might be purchased by some of the mountains of idle cash currently sitting there doing nothing, coaxed in by rising yields. Were this to occur, it would effectively result in the force of past accumulated QE efforts being channelled indirectly but in full force into the stock market. This could act as rocket fuel to a bull market that is already beginning to gather some serious momentum.

As I have discussed in past articles, market valuations, and dispassionate risk/reward assessments by equity portfolio managers, do not drive markets. Market liquidity factors drive markets, and if stock funds (and passive ETFs) receive rising inflows, they will have no choice but to keep buying, irrespective of valuation. If Miller is right, then absent a major geopolitical or otherwise unexpected shock, then a bond-to-stock reallocation could well continue to propel stocks into the stratosphere.

As I have argued in past blog entries, given the unprecedented degree of monetary printing we have seen this cycle, it ought to not be a surprise if this cycle ends up rivalling or exceeding the valuation excesses we saw during the dot-com era, where mature low-growth blue chip stocks like Coca-Cola got as high as 40x earnings (Coke currently trades at about 25x). The leading horseman of the 1990s tech bubble (Microsoft, Cisco Systems, etc), traded as high as 80x earnings - twice the levels many of today's tech leaders such as Facebook and Google trade at (closer to 30-40x). Mature Japanese blue chips got as high as 80-100x earnings in the late 1980s. We are far, far away from the level of valuation excesses that are truly possible in markets.

As Miller also argues, the path of least resistance for markets remains higher, with the only major caveat being that this momentum will be disrupted if something comes completely out of left field that investors are totally ill-prepared for, which is want to occur from time to time (e.g. a nuclear war with North Korea). The 'known unknowns' will not do it - it will have to be an 'unknown unknown'. Absent such a shock, too much money is currently sitting on the sidelines hoping and waiting for a pull back to enter, for markets to materially decline. Markets will almost always go up when this is the case. They only go down when everyone is suddenly and unexpectedly forced to sell or deleverage due to a major shock, or where an unknown unknown causes investors to panic.

An unexpected recession would also likely do it, and many investors continue to expect one in the US merely because it has been a long time since we last had one. However, developed market corporate investment has been extremely weak in the post-GFC years, and the economic recovery from the GFC far from vigorous (particularly in Europe, where the unemployment rate is still 11%). For this reason, it is quite possible that we are not yet as late in the US economic cycle as many assume (economic cycles do not die of old age, as the saying goes), because the prior absence of corporate investment means that the overcapacity and accompanying slump in both profits and corporate investment that usually emerges late in the cycle and triggers a recession is still quite unlikely to occur for some time. Indeed, with tax cuts and 'America first' policies, US corporate investment looks likely to accelerate from here. A significant increase in the fiscal deficit will also stimulate the US economy this year, and M&A activity still has a long way to go to recover to prior peaks as well.

I remain very concerned that we are still in the fairly early stages of a historic bull market that eventually turns into an all out speculative mania. I very much hope I am wrong - an extended bull market carrying markets to extremely overvalued levels is a value investor's worst nightmare. However, markets are notoriously uncooperative and impervious to one's wishes, and do not provide the opportunities you would like just because they are needed or desired, and with global markets up 5% YTD already, things are not looking good, I'm afraid.


*Bill Miller achieved fame at Legg-Mason for trouncing the S&P 500 for 15 consecutive years - an unheard of feat - before experiencing a disastrous 2008, where he bet heavily and unsuccessfully on beaten-up financials (he reversed course and closed out his positions in September 2008, but only after sustaining heavy losses). His reputation has been forever tarnished. Whenever I mention that I am a fan of Miller, I am immediately asked 'didn't he blow up his fund in 2008?'

Since his 2008 blow up, he has relaunched his own outfit Miller Value Partners, and has again been slaughtering the market year after year. Even including 2008 - and, by the way, if Lehman had not gone under, he would have made an absolute fortune - he has outperformed the market by almost 500bp per year after fees for approaching 30yrs - an incredible feat. I see Miller as the perfect embodiment of Keynes' admonition that "experience teaches that it is better for reputation to fail conventionally than to succeed unconventionally".

My respect for Miller derives as much from the quality of his thinking and ideas as his track record, however. He is an innovative and genuinely independent thinker. He was very early, for instance, into the airline trade (US airline stocks have increased by 4-5x in recent years), recognising well before the rest of the investment community the significance of a consolidating market structure and a change in management incentives towards profitability and away from over-investment. 

The vast majority of value investors missed this opportunity, because "Warren Buffett said you should never invest in airlines". Interestingly enough, several years and several hundred percent after Miller entered, Buffett emerged as a buyer of US airlines, surprising the investment community. This highlights an important truth in markets - you need to be an innovative, independent thinker to succeed in markets. That's how Buffett did it. Would-be Buffett copycats fail to understand that. Buffett is to be admired and learned from, but messianic, uncritical hero-worship and imitation demonstrates, at a deep level, a failure to understand why Buffett succeeded in the first place.