The inside vs. the outside view

I've known Bill Miller, Legg Mason's top equity manager, for a long time. He's had his ups (beating the S&P 500 for 15 straight years) and downs (especially last year when he was crushed), but I continue to admire his wisdom and insights (could it be because we both majored in philosophy in college?). I highly recommend reading his most recent commentary, since we are both thinking along the same lines these days, but coming from different directions. He starts with an insight from Michael Mauboussin's new book Think Twice (he's also a Legg Mason guy) which describes two very different ways of analyzing a problem: from the inside and from the outside.

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view...asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

Those who are pessimistic on the economy and the prospects for the market are using an inside view, according to Bill:

PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment, and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery.

Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data, and adjust from there.

A variant of the argument has it that with consumption elevated at 70% of GDP and the consumer retrenching, growth must be sluggish, profits will disappoint, and it will be hard for the stock market to make any headway. 

He goes on to note that past periods of huge consumer deleveraging and increased savings have not prevented the economy from growing at fairly impressive rates. He borrows from another friend of mine, economist Michael Darda, who notes that "The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period." I've argued quite a few times that deleveraging need not mean slow growth, because growth doesn't come from leverage, it comes from work and investment. Debt and leverage can facilitate growth, by helping to distribute spending power to the nooks and crannies of the economy, but debt doesn't create growth since the money that one man borrows must come from another man's pocket.

I have been arguing for months now that the stock market is not overpriced because the mood of the market is still very pessimistic. To back up my claim I've pointed to credit spreads which are still quite high, to implied volatility which is still quite elevated, and to Treasury bond yields, which are still quite low. Bill makes a similar point from a different approach:

As market veteran John Mendelson often points out, it is not what people say that matters, it is what they do. And what they are doing is buying bonds and selling stocks. Through the first 9 months of this year, domestic equity funds had net outflows of $8 billion. During the first week of October, another $5 billion was redeemed. Bond funds, in contrast, had inflows of nearly $300 billion in the first 9 months of this year. Of the top 10 selling funds in America this year, 9 are bond funds and only one is a stock fund, and that one is the Vanguard 500 index fund.

Finally, he notes that "every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1."

Both Bill and I agree that these days it pays to be optimistic.