ED HYMAN & BILL MILLER – PART I – INVESTMENT LEGENDS’ PREDICTIONS FOR 2014 – Transcript 1/10/2014 #1029

January 27, 2014

CONSUELO MACK:  This week on WealthTrack: Two financial champions were firing on all cylinders in 2013. What’s their plan to finish in the winners’ circle again this year? Wall Street’s reigning king of economists Ed Hyman joins investment legend Bill Miller next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. What kind of a year will 2014 turn out to be? Which economies will thrive and which will falter? Where will money be made and lost?  We have two financial superstars with us to answer those questions and they will be with us for the next two editions of WealthTrack.

One has been an exclusive television guest here every year since our launch nine years ago. He is Ed Hyman, Chairman of independent institutional research firm, ISI Group. Inc. Ed has been ranked Wall Street’s number one economist by institutional investors for an unprecedented 34 years in a row.

Joining Ed is another Wall Street legend who is rarely seen on TV and has appeared exclusively on WealthTrack many times over the years. He is Bill Miller, Chairman and Chief Investment Officer of LMM, LLC.  He is Portfolio Manager of The Legg Mason Opportunity Trust mutual fund which he has run since its inception in December of 1999. Opportunity Trust was the second best performing U.S. stock fund last year, number one in 2012 and trounced the market and competition over the last five years, but badly lagged over the past ten year period. Miller still holds the mutual fund record for beating the market for 15 consecutive years when he ran Legg Mason Capital Management Value Trust.

In part one of our two part discussion I asked them to describe the forces that shaped last year’s economic and market performance, that set the foundation for this year. I began by asking Ed Hyman why from a forecasting point of view he says 2013 was his best year ever.

ED HYMAN: All of this has an element of luck in it, but as I went into the year, I saw that people were pretty defensively positioned.  People were cautious or not dancing on the tables or anything like that, and then I got the simple idea that you want to partner with the Fed; that is, as long as the Fed was expanding the balance sheet, the market was likely to go up, and the Fed had come out and said that they were going to expand the balance sheet all year, if not for infinity, but they said at least all year, and I thought that was like a free pass for the market to go up, and people weren’t necessarily positioned for the market to go up, and the economy was okay.  It wasn’t great for sure, but it was okay, and there you have it. The market went up 30 percent.

CONSUELO MACK:  So that was a market call, but as far as…

ED HYMAN: It was an economic market call.

CONSUELO MACK: So talk about the economic because why, number one, that partnering with the Fed and what the Fed was saying about continuing its very accommodative stance, why that’s so important to the economy, because a lot of the critics of the fed say the economy would have come back anyhow. So why did that have such an important impact on the economy?

ED HYMAN: Well, whether it would have come back or not we’ll never know, but the Fed has been operating on the premise that when they do QE, it pushes the stock market up, and then that helps consumer confidence and consumer spending, and that’s pretty much what happened. The economy did go up. You also had a nice recovery in housing. House prices are up, say, roughly 10% in addition to the market being up 30%, and there was some luck involved as well, but that was the nub of it, that the Fed was easy, pushed the market up.  That worked, and the economy did improve some.

CONSUELO MACK:  So Bill, you had two phenomenal back-to-back years with the Legg Mason Opportunity Trust. So what was it that you saw, especially given what Ed just said? What was it that you saw that convinced you that the market, number one, would be strong and, number two, that you knew where to invest in it?

BILL MILLER: Well, I’ll take off on what Ed said. He was giving the macro view. At the micro level, people were positioned cautiously, and you can see that in the valuations. So bull markets rest on three basic legs. One of them it growth; the economy is growing.  The second one is adequate liquidity. Ed talked about the Fed putting a lot of liquidity in the market, and the third is attractive valuation, and so the valuation of the market going into last year was right around 13, 14 times which, compared to bonds, was extremely attractive and compared to, in essence, long-term history is also pretty attractive. So the backdrop was for a good equity market, and we got that right, but maybe more importantly, the market last year had offered things that you don’t see a year later. So we bought last year. We bought Netflix at $60. It’s $350 today. We bought Best Buy at under $13. It’s $40 today.  We bought Pandora at seven. It’s 33 today. We bought E*Trade at seven. It’s 20 today. So those kinds of things, stocks that went up two, three, four times, you could get those a year ago. You can’t get those today. The market has combed over those pretty well. So while I think the market’s going to have a very good year this year, it’s unlikely to throw up enough names like that to give you those kinds of returns.

CONSUELO MACK:  So Ed, you know, when I think of all things that could have gone wrong last year and, I mean, there was a list that you were covering on a regular basis on ISI, you know, the headwinds that investors worry about, sequester, fiscal cliff, government shutdown, Obamacare, Dodd-Frank, Fed tapering, European recession, China slowdown, so what happened to all those concerns?

ED HYMAN: I think if they hadn’t been there, the economy would have done a lot better.

CONSUELO MACK:   So those really were headwinds in the economy.

ED HYMAN: Sure they were headwinds, and we had a situation where because the headwinds were there and very clear, the Fed was more energetic than they would have been, because they knew they were facing headwinds, and so they launched this QE3, quantitative easing that would go on forever, and now they’re stopping that or tapering it down, but those headwinds were there, and the Fed overcame them, and then as Bill and I were talking about a few minutes ago before we started, the U.S. has a lot of very positive factors as well. You know, the energy boom going on, the tech sector as well. Housing started the year on a strong note. So there are plenty of strong factors out there, and there are a lot of good companies out there like the ones you mentioned, you know, Starbucks or whatever that are keeping the economy going, and then there are things like education, you know, state employment, health care, not nearly as fast-moving but give the economy, you know, sort a general lift to it, and they were, in hindsight, they overcame the negatives. I would just assume the economy stay like this, stay sort of slow. I think it’s going to pick up, but if it picks up, it’ll introduce some new risk like inflation picking up or the Fed tightening more aggressively, but so far it hasn’t really picked up. It’s still just a slow pace.

CONSUELO MACK: So you and I have talked before, and you tell your clients about this as well, that there are cycles in the market that have repeated for the last, I don’t know, four years, and one of them is sell in May, right? So we’ve seen this where the economy gets strong again in the spring.  You tell us what it is and why you think this year is going to be different.

ED HYMAN: Well, I’m not sure this year’s going to be different, so I’m pedal to the metal between now and may, and right now the Fed is doing 85 billion a month. They’ve done 85 billion a month.

CONSUELO MACK: Of buying treasuries and mortgage-backed securities.

ED HYMAN: Buying treasuries, injecting money in the system, obviously quite a bit, a trillion dollars a year.  So we have it all laid out. They’ll do 75, 65, 55, 45.

CONSUELO MACK:  Reducing every month.

ED HYMAN: Not every month, every meeting.

CONSUELO MACK:  Every meeting.

ED HYMAN: But it’ll come down. By December, it’ll be to zero, and I think in the spring investors will look out and they’ll see that by the end of the summer this program will be down to about 20 billion, and they may say, “I think I’ll take my chips off the table now in anticipation of it going down there.” Whether or not they do that will be determined by whether or not people think the economy is now self-sustaining.The worry is that when they start to taper, take this stimulus out of the system, either bond yields shoot up or the economy slumps, and so that will be… You know, every day is a new day, but that will be a time, and I think there’s a pretty good chance, not up to 50, but there’s a pretty good chance we will have another sell in May where the market like last … I guess in third of ’13 it was seven percent. The other ones have been around 15%, but some sort of practicing for that, but between here and there, I think the market is likely to have a pretty strong move, because the Fed over the next three months, the Fed is going to inject $200 billion in the economy, and Bank of Japan will do about the same thing, so you’ve got $400 billion in three months. If you multiply by four, that’s a trillion six coming in the world economy, and the bond market doesn’t look particularly attractive. I think it’s still a pretty good push here, and then we’ll look when we get to the spring to see how things are shaping up.

CONSUELO MACK: So Bill, I’m hearing Fed, Fed, Fed, and I think you told me earlier that, what, this is the greatest monetary experiment that we’ve ever had in monetary history, and who knows how this is going to play out, so what’s your take on what the Fed’s been doing and how it’s going to play out?

BILL MILLER: I divided the two phases. I think that the Fed’s extraordinary monetary policy that we’ve had has been exactly the right policy since the crisis, and I think that the Europeans, if Trichet were still running the ECB, I think they would have had an even more catastrophic situation than they currently have, but even so, I think Draghi’s done a great job over there, but even so, that southern periphery is likely, when this is all said and done, to have results worse than the Great Depression, because they’re sort of on a quasi-gold standard with the euros, so…

CONSUELO MACK: Portugal and …

BILL MILLER: Portugal and Greece and places like that, you know, Italy, Spain, and so we have two experiments running, one of them over here. Clearly the U.S. has done much, much better than Europe, and I think if you look at Japan, what they’ve done is an even more aggressive thing, and it’s working so far.  In the U.S. in terms of me thinking about the Fed and thinking about policy, and Ed had talked about the tapering and what’s going to happen, there’s a Chinese proverb or statement that: “Forget about the waves. Try and find the current”, and so most people are thinking the waves.  You know, as we go up a little bit or down a little bit, going to have a correction here or there? Well, the underlying current, it’s a bull market. So I think that whether the Fed is… The thing I’m concerned about is if the economy grows too strongly, let’s suppose we start printing four plus percent quarters this year…

CONSUELO MACK:  In GDP.

BILL MILLER: In GDP, yeah, and then unemployment drops rapidly, and then capacity utilization rises pretty quickly, and then you pull forward the Fed’s first interest rate increase, and I think that’s where you’re likely to run into some heavy going, because if the Fed doesn’t do anything, inflation will start to pick up, and that’s going to be bad for the market. So I think as long as the Fed pins the short rate around zero, and that’s going to continue into 2015, the market path of least resistance is clearly higher, but if things get going too strong this year, which I think is the greater risk than it’s too weak, then I think that it could get a little bit… towards the end of the year, people will start to worry about what’s going to happen.

CONSUELO MACK: So Ed, number one, zero percent interest rate, fed funds rate until through 2015 you think? Can we bank on that?

ED HYMAN: Well, I agree with Bill completely that if the economy were to pick up, the Fed will react for a variety of reasons. I have become enamored with the idea that we’re in a business cycle like the 1990s. It started slow. Jobs recovery. The Fed was pretty accommodative. Inflation was low. You had a tech boom not dissimilar to what we’re having now, and the economy got better over three or four years. If it was to play out again, unemployment would go to five. Fed funds would go to five. Inflation would probably go to five, but between here and there, the market would go up a lot, and the analogy is we’re in… If that was the right analogy, that we’re in 1996 and the market of ’95 went up 30 like last year, and then the market went up 20 this year, 30 next year, 27 next year after that, and then another 20.

CONSUELO MACK:  Whoa.

ED HYMAN: But I’m saying you have to have a lot of things fall in place on a positive note, but they’re there if we don’t have some unseen phenomenon. The biggest uncertainty is this unprecedented monetary …

CONSUELO MACK: Experiment.

ED HYMAN: Experiment, and we’ll have to take a step carefully each day to see if it looks like it’s working.

CONSUELO MACK:  But it doesn’t seem to be. The fact that it’s an experiment doesn’t seem to be worrying either of you too much. Right?

ED HYMAN: I’m a nervous wreck.

CONSUELO MACK: Are you? Is that any different? I mean, are you more nervous now because of the Fed, or…?

ED HYMAN: Oh, no. For everybody, the reason investors are sort of cautious is they know this is… So you have to weigh and, like we were talking about, people are not really invested, and so it’s not like everybody is bullish, and money’s coming out of bonds. It’s like a downpour now every month for seven months.

CONSUELO MACK: Right. We’ve had these outflows of bonds, record.

ED HYMAN: Every week and …

CONSUELO MACK: But that’s an interesting point because I know that, Bill, because one of the things that, of course, if you’re a contrarian and a lot of… We hear that people are becoming more positive about the outlook of the economy and the markets, and if you’re a contrarian, you say, “whoa, this is not a good sign,” but you said that not so fast. So what we’re hearing is not necessarily what investors are doing?

BILL MILLER: I think there’s a huge difference between what investors and people say and what they do, and so they can say that they’re bullish, but we can look at the asset allocations of corporate pension plans, endowments, wealthy individuals.I think Citibank did a study of their high net worth clients a month or so ago and, if memory serves, between cash, 37% cash and only 25% stocks, so point being 25% stocks and 75% other, and the other was cash and bonds and things like that, low risk, low volatility assets. So I think 25% is a very low asset allocation to stock, so I think …

CONSUELO MACK: Yes, and 37% cash or cash equivalents is huge.

BILL MILLER: So one of the things that I think that’s maybe a little bit contrarian and with respect to QE3 is that part of what QE3 has done, what it’s designed to do is to hold interest rates down by buying treasuries. So if there wasn’t a QE3 in the economy, interest rates would be higher at the 10-year and at the 30-year which means people would have lost money in bond funds even more than they have, and as soon as they started losing money in bond funds last year, they started yanking money out, and so I think if they hadn’t had QE3, the people would have lost money in bond funds a year earlier than that, and then more money would have flowed into equity funds. So I think maybe perversely that what you’re having is the equity market would be a lot higher if it wasn’t for QE3 because bond yields would be higher, and more money would have been lost in bonds and that money would have flowed into equities.

CONSUELO MACK: Now, conversely, if interest rates were significantly higher… I don’t know how much higher they would have been… That means competition as well for stocks. Right? And also that can put a crimp in the housing market. I mean, isn’t this a two-edged sword?

BILL MILLER: Ed made a point earlier when he talked about kind of the late ‘90s and the ’96 period, but what he didn’t mention was that was a period when the Fed began raising interest rates in the mid ‘90s.

CONSUELO MACK: Ninety-four. I remember it well. Alan Greenspan. We were shocked, and the market didn’t like it.

BILL MILLER: So rates were going up, and the stock market was going up rapidly at the same time. With housing, when people talk about lower interest rates are good for housing, higher interest rates are bad for housing, interest rates fell from 2005 or ’06 all the way to 2012 or ’13, and housing collapsed, and once interest rates started to go up, housing began to get better. Housing had a pause last year when we had that big jump from 160 on the 10-year to 260 or three, but now that we’re back around the three level, what you’re seeing is building confidence. I think your survey has shown builder confidence turning back up again. You’re seeing house price appreciation continuing. Building starts are up 20, 25%. So we’re in a long housing cycle, and it’s going to be inhibited modestly by rates but not by a lot, and I think one of the most interesting things about that is that if you were thinking about buying a house in 2006, and you said, “you know, I’m going to wait,” every week that you waited from 2006 until 2012 was the right thing to do, because house prices went down, and financing costs went down, and now since that period of time every week you wait, it’s the wrong thing to do, because financing costs go up and house prices go up, and so I think that’s going to pull people in to housing a little bit more rapidly than otherwise would be the case.

CONSUELO MACK:  So what’s your outlook for housing, Ed? And how key is housing to the economic recovery and also to the stock market?

ED HYMAN: I think if housing comes on, you can four percent GDP. If it doesn’t come on, then you maybe get three percent. By come on I mean, say, housing starts go to a million five or something like that. They’re now at about a million, a million one. So housing plays a big role in here in terms of how much the economy picks up, but my best guess is that growth is around three percent this year and next year, and one of the other things…

CONSUELO MACK: Again, this is GDP.

ED HYMAN: For GDP and earnings may be up 10%. One of the other things that’s happening is that people as of now… Notice this is 2014 now… Next year is no longer this year. It’s 2015 and so people will start to forward earnings. The forward P/Es are going to be using S&P earnings next year, and we’re using 125 FOR S&P earnings. They’re now about 110.

CONSUELO MACK: 105, 110, right.

ED HYMAN: But it takes two steps to get there, this year and next year, and so the P/E you were talking about earlier, the P/E, it cuts it down some, but anyway, people will start to look out. I think right now people are dating the stock market. They’re not really…

CONSUELO MACK:  Committed.

ED HYMAN: They’re not married to it, and we had a conference this morning talking about technology and its role, and you could just feel people getting nervous, like maybe things are really good.

CONSUELO MACK: And they don’t know what to do?

ED HYMAN: We had Andy McAfee who’s from MIT, and he’s talking about the second industrial revolution which I’ll leave it at that. That’s pretty powerful.

CONSUELO MACK: You’re not kidding. Concept. And the industrial revolution coming from technology?

ED HYMAN: Yeah.

CONSUELO MACK: Yeah, and what kind of technology?

ED HYMAN: All kinds. Yeah, medical technology, robotics, metal technology, you know, what computers think.

CONSUELO MACK:  And a lot of it happening here? I mean, in the U.S.?

ED HYMAN: Well, I mean, it really does happen here.

CONSUELO MACK: Yeah, still.

ED HYMAN: Yeah, it gets used outside the U.S. Like everybody in Africa has a cell phone, but like in the ‘90s it’s made in the U.S.A. More or less. China is pretty good, too.

CONSUELO MACK:  Right. As far as it being inventive and right. I know ISI tracks the patents that you see. So is that something?

ED HYMAN: China’s pretty good.

CONSUELO MACK: So we’re seeing real competition from China.

ED HYMAN: Not real competition, but there is in the cultural cities there’s a pretty active technology sector going on.

CONSUELO MACK: Right. So the other big trend that I know you’ve been tracking, Ed, and I’m sure you’ve been following as well, Bill, is that inflation. You describe inflation as MIA- Missing In Action. That’s huge, right?

ED HYMAN: It’s one of the fallouts of technology, is that it keeps inflation down. The energy thing is another just mind-numbing thing. At this conference we also had some people from the energy sector, and the household consumption of electricity today is where it was a decade ago because of windows and washing machines that are more energy efficient, light bulbs more energy efficient.

CONSUELO MACK:  Bill, inflation.

BILL MILLER: Well, the reason inflation is MIA is that the Fed offset a deflationary collapse by getting their balance sheet up to $4 trillion, and so I think with capacity utilization still in the 70s and unemployment at six and a half, you would never expect inflation.

ED HYMAN:  There is some really exciting stuff if you can get off of the war we have had in Washington, quantitative easing, Europe…

CONSUELO MACK:  But also the …

ED HYMAN: The things you mentioned earlier.

CONSUELO MACK:  But the fears of the Fed’s expansion of its balance sheet, that it was going to cause inflation. Not worried about that?

ED HYMAN:  I’m a nervous wreck, but I’m just saying at the moment these things are not doing it, and hopefully my job is to see when there’s a change, and right now it’s going the other way. I mean, the evidence of inflation not being here is awesome. Like they had the Boeing contract. Boeing just signed a contract over the weekend to keep the plane in Washington, very favorable to the company.

CONSUELO MACK:  Right, very favorable to the company. Right, so wages are still low.

ED HYMAN: Under pressure.

CONSUELO MACK:  And actually we are going to have to end this part one of my conversation with the two of you right now, and part two we’re going to go into all sorts of cool things like investment strategy with Bill Miller and with you, Ed.  So stay here, and we will see you two next week, and we’ll see our viewers next week as well. So thank you, Ed Hyman, Bill Miller, for part one of this WealthTrack exclusive with the two of you. Thanks.

BILL MILLER: Thanks.

CONSUELO MACK:   At the close of every WealthTrack, we try to give you one suggestion to help you build and protect your wealth over the long term.   This week’s Action Point is one we have given many times on WealthTrack and it bears repeating. It is: Avoid the underperformance trap. Research shows that investors underperform the very funds they invest in because they jump in when a fund is hot and sell when it cools off. Bill Miller’s funds are classic examples of investors doing worse than the funds themselves over the years.

How do you avoid the underperformance trap? First of all only invest with a fund manager whose style suits your own. If you can’t take volatility don’t invest in a fund that has it.  Second, don’t chase performance.  Research shows a hot streak inevitably leads to a cool streak.   And finally once you identify a fund you want over the long term, buy it incrementally. If it has a few rough years buy some more…if it has a few great years, trim it. If you can’t take the wide swings, avoid it altogether.

I hope you can join us next week for part two of our exclusive conversation with Wall Street legends Ed Hyman and Bill Miller. We will discuss where they see the greatest opportunities and dangers in the year ahead.  In the meantime, to see more of our Great Investor interviews and hear personal insights from our guests in our web- only Extra feature, please visit our website wealthtrack.com. And for those of you on Facebook and Twitter we look forward to connecting with you. Have a great weekend and make the week ahead a profitable and a productive one.


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