Bill Miller: Bearish on Commodities, Bullish on Stocks

Writing in the Financial Times this week, Bill Miller took a bearish stance with regard to commodities, but he also offered up three stock sectors that he thinks are rich in opportunity. In a market in which many risk assets aren't cheap, it's worth listening to someone who is intensely focused on valuations.

Valuing Bill Miller
A word on Bill Miller before we get to the heart of our subject: During the latter end of his fifteen-year streak beating the S&P 500, investors and pundits believed he could walk on water. As the Legg Mason Value Trust stumbled (badly) during the financial crisis, attitudes reversed dramatically. It was a classic case of Mr. Market overvaluing, then undervaluing the same asset -- in this case, Bill Miller himself. Personally, I always enjoy reading his commentary, as he's a very thoughtful and original observer of markets (in addition to being a good writer.)

System 1 vs. system 2
In the FT piece, for example, Miller contends that commodities markets -- and oil, in particular -- are being driven by what psychologists label System 1, automatic behaviors that are the product of the subconscious. System 2, on the other hand, refers to conscious behavior, that calls on logic and considered analysis. Which of the two systems do you think produces better investing decisions?

Commodities: Too hot to handle
Commodities markets are displaying some eyebrow-raising characteristics. As Miller points out:

According to data compiled by Barry Bannister, equity analyst with Stifel Nicolaus, commodity returns relative to stock returns are at 200-year highs on a rolling 10-year basis. One thing is clear about long-term commodity returns: they are cyclical.

I used similar observations in support of the notion that gold is in bubble territory. During the 10-year period up to yesterday, the yellow metal has generated an annualized real return greater than 16%. Let me reemphasize that this is a real return, i.e. none of it is attributable to inflation. If you believe that gold can continue outpacing inflation indefinitely, I have a golden calf to sell you.

What comes after the decade of precious metals?
The same observation holds for silver: Even after last week's massacre, its trailing 10-year annualized after-inflation return is over 21%. For reference, the equivalent return for stocks during the 1990s -- the decade for stocks -- was 14.8%. That wasn't sustainable and neither are the returns that have been achieved by gold and silver. Owners of the iShares Silver Trust (NYSE: SLV) and the SPDR Gold Shares (NYSE: GLD) should carefully review the assumptions that underpin their positions.

The top 3 stock sectors
Moving away from commodities and applying System 2 thinking -- detached and rational -- Miller asks which areas of the market offer value today. He goes on to offer up his answer:

In the assets people do not want, that have no momentum, and that are cheap. Three broad sectors and two broad themes stand out. The S&P 500 sectors are; financials, technology and health care, which are in the bottom decile of their historical valuation ranges. This means they have been more expensive 90 per cent of the time over the past 60 years or so.

The sectors that are flush with cheap stocks
I don't have access to 60 years worth of data, but using Standard & Poor's Capital IQ, I was able to identify the stocks in the S&P 500 that are trading in the bottom 10% of their historical valuation range going back to the beginning of 1995 (on the basis of the price-to-earnings multiple). Sure enough, information technology and health care are among the top four sectors in terms of their concentration in historically cheap stocks:

Source: Standard & Poor's.

Moreover, if we use the price-to-book value multiple instead of the price-to-earnings multiple, the sector with the highest concentration of cheap stocks is financials (21 stocks, better than one in four), followed by health care (11 stocks.) I'm a fan of financials, particularly megacaps, another one of Miller's themes. I first suggested investors look at a basket of the largest commercial banks at the end of November. Miller has large shareholdings in each of the top four banks in the Value Trust; in fact, his third and fourth largest positions at the end of the third quarter were JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC).

More names to look at
As far as names in health care and technology, three names that showed up in my screen and that are also holdings of the Value Trust fund are Cisco Systems (Nasdaq: CSCO), Intel (Nasdaq: INTC), and Abbott Laboratories (NYSE: ABT). Investors could do a lot worse than to look at those stocks. Bill Miller may have misjudged the credit crisis, but he looks well positioned to outperform over the next few years.