MARKET COMMENTS Third Quarter 2007 BALTIMORE, Md., Nov. 2
/PRNewswire-FirstCall/ -- On the 20th anniversary of the Crash of
'87, the US stock market took a drubbing, falling 2.56%. In a
curious parallel, the woes that are besetting the market are the
result of a crash in the credit markets every bit as severe as that
which hit equities back then, but which threatens to have more
impact on the US and the global economy. The stock market can close
down for a while and it really doesn't matter all that much. The
primary function of the stock market is not to finance company
operations, it is to price assets. Companies go public once, and
most come to the equity market for capital sporadically, and then
typically to finance long-lived projects or acquisitions. Credit
markets are different. They are the source of liquidity to fund
operations. If they are not functioning, the economy is threatened.
That is why the problems that began in US subprime but which have
spread to encompass a wide swath of the mortgage market, as well as
the commercial paper market, are so serious and have galvanized
central banks and government financial authorities to move swiftly
to try to restore those markets to normalcy. They have only been
partially successful. The new $80 billion or so fund being put
together to provide liquidity to Structured Investment Vehicles
(SIVs)(1) has been viewed skeptically by Warren Buffett, Alan
Greenspan, and Bill Gross -- not an auspicious beginning -- and
markets appear to be beginning to worry that a return to normalcy
might not be the most likely outcome. I share that concern. The
difference between what is unfolding now and the Crash of '87, or
the problems with Long-Term Capital Management in 1998, is that
they were confined to Wall Street, whereas this issue extends to
Main Street and to the value of the biggest asset of most
consumers, their house. When the Federal Reserve (Fed) cut rates
all the way to 1% to try to ameliorate the effects of the
technology bust, it accomplished something seen only once before:
although we had the first recession since 1990, we had only the
second recession ever that did not involve housing, which boomed.
Now housing is in a severe slump, and we will be lucky to avoid its
dragging down the rest of the economy. Although nearly all
recessions have involved a housing decline, there have been two
prior housing declines that did not involve recession: 1951 and
1967. Both of those times large increases in military spending
offset the effects of housing on consumption. The best forecaster
of whether the problems of housing will lead to recession in 2008,
the prediction market at Intrade, pegs the odds at around 45%(2).
This is down substantially from odds of over 50% as late as
mid-October, but up from odds of about 33% a week ago. The issue
for the stock market and for the global economy is the extent to
which the slowdown in US consumption will spill over into a decline
in global production next year. The US has been the marginal
consumer to the world, and our current account deficit reflects
that. Fueled by low interest rates and people withdrawing equity
from their homes to finance spending, consumption as a percent of
GDP(3) rose from 66% in the late 1990s to over 70% today. That is a
record and the most likely direction from here is not up, with
housing prices falling and job growth slowing. Our current account
deficit has already begun to decline, and with the dollar deeply
undervalued against the euro and the pound, and trading at 40-year
lows on a trade-weighted basis, that trend should continue. It
comes with a price. When our current account deficit is expanding,
we are providing liquidity to the rest of the world by buying their
goods with our dollars. When it is contracting, we are withdrawing
liquidity. It was the withdrawal of liquidity as the Fed removed
the monetary accommodation provided by very low interest rates that
led to the subprime collapse, as people could not make the
increased payments on their homes when adjustable rate loans reset.
The tripling of subprime loans from 2001 to 2005 was fueled by very
low introductory teaser rates. Our central bank was the first to
stop tightening; the British and the European Central Bank (ECB)
were continuing until very recently, as were the Chinese, though to
little effect as real rates in China are still negative. The ECB
just last week was hinting that there may be more tightening to
come. It was only in 2002 that the world was worried about
deflation. The forces that gave rise to those fears -- high debt,
excess global labor, falling real prices for technology, and a
global savings glut -- have not disappeared. The locking up of
large parts of the credit market does not help. When the Fed took
the unprecedented step on August 17th of cutting the discount rate
between meetings, and changing its policy statement between
meetings, having only 10 days before affirmed its views that the
risks it was most concerned about were those of inflation and
growth, it signaled just how rapidly things had changed. The 50
basis point(4) cut at the September meeting was consistent with
that. Stocks rallied and bonds sold off when the Fed took action in
mid-August and September, as markets felt relief that the problems
in the credit arena would be dealt with, that those markets would
gradually return to normal, and that the liquidity provided would
give an additional fillip to growth. The stock market rally has
been led by the same groups that have led for 5 years: energy,
materials, industrials, and technology. The same laggards, lagged:
consumer, financials, and healthcare. Growth stocks continued to
shine and traditional value stocks did not. This market has been
remarkably serially correlated. In plain talk, what has gone up
keeps going up, and what has not, does not. Valuation has not
mattered at all. What has mattered is price momentum. This is very
similar to what we saw with tech, telecom, and internet names in
1999. It is not yet that extreme, but it is pretty extreme. The
best quintile of stocks based on traditional valuation factors such
as price to earnings, price to book, price to sales, and dividend
yield, has underperformed the market by over 1000 basis points this
year. The best quintile on price momentum alone, using 3 and 9
month price trends, has outperformed by 1400 basis points. Coming
at it somewhat differently, if you took the 50 best-performing
stocks for the 3 year period ended December 31, 2006, and made that
your portfolio for 2007, you would have returns over double that of
the S&P 500 this year(5). What has worked for the past 5 years
continues to work, and what has worked is the high beta trade on
global synchronized recovery. When everyone was panicked about
deflation in 2002, the right thing to do was to bet on
reflation(6). The winners have been commodities, especially energy,
materials, industrials, non-US, non-dollar, and emerging markets.
What seems to have escaped notice is that all those winners
bottomed with the peaking of junk bond spreads in the summer of
2002, and have risen concomitantly with the consistent narrowing of
credit spreads that began to end in March of this year. If that was
not just a spurious correlation, and I do not think it was, then
there is trouble ahead for those crowded into all the popular
favorites. The first warning sign came with the sell-off in China
that began in late February and briefly convulsed the equity
markets. They bottomed in mid-March and began to rise, with China
beginning its stunning advance. Then came the subprime problems,
which began to be felt in March and got steadily worse. Credit
markets began to take notice. By mid-August the mortgage markets
were in complete chaos and the Fed took action. That again provided
some relief. Now the SIV problem is front and center. Treasuries
are rallying strongly, junk spreads are widening, and the Treasury
Inflation-Protected Securities spread is back to its lows. The
equity sell-off on October 19 was precipitated by the market's
reaction to the earnings of two stalwarts of the commodities cabal,
Caterpillar and Schlumberger, both of which surprised their fans by
issuing less than stellar guidance. Cat went so far as to opine
that the US might be in recession already; its earnings gains were
solely due to non-US growth. If credit is becoming harder to come
by, if spreads are widening, if growth is slowing, then it seems to
me the leadership is about to change. The same strategies that led
when the global economy was emerging from fears of deflation and
entering a period of accelerating growth and synchronized recovery
are very low probability bets to lead if the global economy is
peaking, the US is slowing appreciably, and credit spreads are
widening, not narrowing. Where will the new leadership come from?
The same place it usually does: the old laggards. I think the new
leadership will be US, large-cap, dollar-based, and grow to
encompass what no one wants to own today, especially financials and
consumer. I also think so-called growth stocks will continue to do
fine. When growth becomes scarcer and the discount rate becomes
lower, growth becomes more valuable. More particularly, just as the
right thing to do in 2002 was to buy what everyone was panicked
about, I think the greatest gains over the next 5 years will be
made in those securities people are panicked about today. For
specific names, consult the 52-week new low list. Value Trust
Comments One of the enduring features of the findings in behavioral
psychology as it applies to finance, a subject I have discussed
many times over the years, is the almost complete inability of
those who are aware of them to actually apply them. You can attend
Richard Zeckhauser's seminars at Harvard, read lots of articles and
case studies, be reminded of how recency bias, or anchoring, or the
representative fallacy, or myopic loss aversion impair clear
thinking and skew decision making, and still fall prey to them and
others of their ilk the moment you are confronted with real world
situations. The recent precipitous decline in financial stocks,
especially those related to housing, which sent Countrywide
Financial (CFC) to $12 last week, and led to 20 to 30% drops in
financial guarantors in a day or so -- after they had already
dropped between 25 and 50% this year -- is a case in point. After
falling 20% in a only a few days on no news, and this after being
down 50% for the year, CFC rallied over 30% in one day once they
reported their results and indicated they would be profitable for
the 4th quarter and expect to earn a reasonable return on equity of
10-15% for all of 2008. The price action on both sides was driven
by emotion -- first fear, then relief -- and was hardly the result
of a careful analysis of Countrywide's long term business value.
That, by the way, we think is in the $40's compared to its current
price of about $14-15. This is not unusual. Warren Buffett has
often noted how any knowledgeable analyst would have pegged the
value of the Washington Post at about 5x what it traded at in the
1974 bear market, yet no one wanted it at that price. The 2002 bear
market saw some similarly amazing prices. AES traded under $1. It
will generate over $1 of free cash flow this year and is up 20
times from the lows of 2002. Yet fear set its price, as it did
those of Nextel, Tyco, Corning, Amazon, and a host of other
companies at that time. Today fear dominates the pricing of housing
stocks, of mortgage related securities, of financials, and of many
consumer stocks. Confidence and optimism underlay the pricing of
energy, materials, industrials, and non-US stocks, especially those
of emerging markets, and China in particular. I am reminded once
again of the quote that sits in the front of Ben Graham's Security
Analysis, from Horace's Ars Poetica: "Many shall be restored that
now are fallen and many shall fall that now are in honor." (The
quote does not say "all" by the way, just "many"). In Value Trust,
we have been taking advantage of the market's current turmoil to
make adjustments as the market misprices some securities in
relation to others. Here is what you can expect: the fund will
become more of what it already is, large capitalization US, as we
systematically reduce our mid-cap names in favor of those with
larger market values. As I noted elsewhere, I think large-cap US is
the cheapest part of the equity market and so we will have more of
those names. We will also extend exposure into some sectors from
which we were previously absent. Inter industry valuations are
pretty homogeneous and so concentration pays less than it used to.
In other words, we will own more stocks, and in new industries. We
will still be quite concentrated compared to the average mutual
fund, just less than we have been previously. We will likely reduce
the weightings of many of our top 10 holdings. They will still be
among our largest holdings, we will just have less of them. This is
being done to reduce risk in the over-all portfolio, and to fund
some of the new names we are buying. This is the first time since
1990 we have had two calendar years behind the S&P 500. Perhaps
not surprisingly, that was also a time of panic due to a housing
market recession, soaring oil prices, banks and financials
collapsing. We were able to take advantage of the values then
offered to begin a pretty good period of excess returns. While the
past may not repeat itself, it does often rhyme, as Mark Twain once
said. The chapters to come may be different, but the verses are
likely to sound the same. Bill Miller November 1, 2007 Past
performance is no guarantee of future results. Investment Risks:
All investments are subject to risk, including possible loss of
principal. Because this Fund expects to hold a concentrated
portfolio of a limited number of securities, a decline in the value
of these investments would cause the fund's overall value to
decline to a greater degree than a less concentrated portfolio. The
Fund may focus its investments in certain regions or industries,
thereby increasing its potential vulnerability to market
volatility. Top Ten Holdings as of September 30, 2007 Amazon.com
Inc. (8.8%), The AES Corp. (5.0%), Sprint Nextel Corp. (4.8%),
Google Inc. (4.7%), Qwest Communications Intl. Inc. (4.6%), J.P.
Morgan Chase and Co. (4.3%), Aetna Inc. (4.2%), UnitedHealth Group
Inc. (4.2%), eBay Inc. (3.5%), and Yahoo! Inc. (3.4%). These
holdings do not include the Fund's entire investment portfolio and
may change at any time. The views expressed in this commentary
reflect those of the portfolio manager and Legg Mason Capital
Management, Inc. (LMCM) as of the date of the commentary. Any views
are subject to change at any time based on market or other
conditions, and LMCM, Legg Mason Value Trust, Inc., and Legg Mason
Investor Services, LLC (LMIS) disclaim any responsibility to update
such views. These views may differ from those of portfolio managers
and investment personnel for LMCM's affiliates and are not intended
to be a forecast of future events, a guarantee of future results or
investment advice. Because investment decisions for the Legg Mason
Funds are based on numerous factors, these views may not be relied
upon as an indication of trading intent on behalf of any Legg Mason
Fund. The information contained herein has been prepared from
sources believed to be reliable, but is not guaranteed by LMCM,
Legg Mason Value Trust or LMIS as to its accuracy or completeness.
References to particular securities are intended only to explain
the rationale for the portfolio manager's action with respect to
such securities. Such references do not include all material
information about such securities, including risks, and are not
intended to be recommendations to take any action with respect to
such securities. AN INVESTOR SHOULD CONSIDER A FUND'S INVESTMENT
OBJECTIVES, RISKS, CHARGES AND EXPENSES CAREFULLY BEFORE INVESTING.
FOR A FREE PROSPECTUS, WHICH CONTAINS THIS AND OTHER INFORMATION ON
ANY LEGG MASON FUND, VISIT http://www.leggmason.com/. AN INVESTOR
SHOULD READ THE PROSPECTUS CAREFULLY BEFORE INVESTING. LMCM and
LMIS are subsidiaries of Legg Mason, Inc. (1) A structured
investment vehicle or "SIV" is a limited-purpose operating company
that undertakes arbitrage activities by purchasing mostly highly
rated medium- and long-term, fixed-income assets and funding itself
with cheaper, mostly short-term, highly rated commercial paper and
medium-term notes. (2) Intrade Prediction Market, October 31, 2007.
(3) "GDP" is the abbreviation for Gross Domestic Product, which is
the total market value of the goods and services produced by a
nation's economy during a specific period of time. (4) A "basis
point" is one-hundredth of a percentage point. (5) Source, Legg
Mason Capital Management, Inc. research. The S&P 500 Index is
an unmanaged index of 500 stocks that is generally representative
of the performance of larger companies in the U.S. An investor
cannot invest directly in an index. (6) "Reflation" is an economic
policy whereby a government uses fiscal or monetary stimulus in
order to expand a country's output. DATASOURCE: Legg Mason Capital
Management CONTACT: Mary Athridge of Legg Mason, Inc. for Legg
Mason Capital Management, +1-212-805-6035 Web site:
http://www.leggmason.com/
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