Legg Mason’s Bill Miller says that the path of least resistance for the stock market is higher, but that many investors are continuing to maintain a “perverse affinity” for bonds.
“It’s clear that economically things are getting better, not worse,” Miller writes for the Financial Times. “In addition to gross domestic product numbers, credit spreads have returned to some semblance of ‘normal’, and the bond market has seen record refinancings. Yet stocks still sell below where they sold after Lehman failed, when the world was falling apart.”
Miller says investors are continuing to pour into bond funds and pull money out of stocks funds, however. And while bonds may have been a good investment over the past ten years, he doesn’t think they will be in the next ten.
MIller says that as the economy recovers, the Federal Reserve will rein in its incredibly accomodating monetary policies and shrink its balance sheet. “A neutral Fed funds rate would be in the 2.5 per cent range or thereabouts, perhaps higher,” he says. “Long term, the ten-year Treasury ought to yield about the nominal growth rate of GDP, so somewhere in the 4.5 per cent to 5.5 per cent range, leading to substantial losses in Treasuries and probably investment grade corporates as well. … All this, though, assumes benign inflation of 2 per cent to 3 per cent. If the inflation bears are right, bonds will be a disaster.”
Stocks, on the other hand, were expensive a decade ago, but aren’t anymore. “After spending 10 years in the wilderness, high quality US large capitalisation stocks are cheap compared to bonds,” Miller says, citing some big blue chips that are trading on the cheap.
Miller also says many lower-quality recovering companies are still good buys. “Broadly, I think the names that trade at low valuations on traditional accounting factors such as low price-to-earnings, low price-to-book, and low price-to-cash flow will be the winners this year,” he says. “Companies whose stock prices already discount mid-cycle earnings, as many materials and industrial cyclicals do, may fare less well. Industrial metals prices have had very large moves, as has oil — both appear to be well ahead of fundamentals.”
Miller says he expects a good year for stocks, but that things could go south if the Chinese tighten their economy more quickly than expected. And he says the dollar remains a wild-card; its continued strengthening could underpin a strong market.