Finance counsels

Legg Mason Inc.’s Bill Miller said odds may not favor Mohamed El-Erian’s forecast for a prolonged period of below-average economic growth.

Miller, the manager of the Legg Mason Value Trust, wrote in a letter sent today to investors that El-Erian’s perspective is an “inside view” that makes a prediction about the future based on current conditions. Such a view doesn’t take historical precedents into account, something Miller called the “outside view” in a reference to colleague Michael Mauboussin.

“Is the ‘new normal’ wrong? No one knows yet,” Miller wrote in his letter. “Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.”

El-Erian, the chief executive officer of Pacific Investment Management Co., is the most prominent proponent of a “new normal,” which predicts slower economic growth, high unemployment and heightened government regulation. Laurence Fink, chief executive officer of New York-based asset manager BlackRock Inc., has said he shares the view. White House adviser Lawrence Summers has rejected it.

Track Record

Miller’s Legg Mason Value Trust Fund, famed for a 15-year streak of beating the Standard & Poor’s 500 Index, has advanced 39 percent this year, ahead of the U.S. benchmark by 16 percentage points. It’s ahead of the S&P 500 for the first time since Miller’s streak snapped in 2006.

Miller stumbled after underestimating the impact of the credit crisis on companies such as American International Group Inc. His fund fell 55 percent last year, as picks including AIG, Citigroup Inc. and Freddie Mac plunged amid writedowns and losses.

Miller, citing Mauboussin’s recently released book “Think Twice” (Harvard Business Press, 2009), uses the surprise loss of Big Brown in the Belmont Stakes as an example to illustrate the shortcomings of the inside view.

The racehorse had won the Kentucky Derby and Preakness Stakes in 2008, and analysts were putting a 77 percent probability on the thoroughbred’s victory in Belmont. Had the analysts looked at how many horses won the third leg of the Triple Crown in the past after winning the first two races, they wouldn’t have been surprised by the loss, Miller said.

Big Brown

“That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing,” Miller wrote in the letter.

Similarly, the Great Depression may help put the arguments of the “new normal” into perspective, Miller wrote. The U.S. economy expanded 17.3 percent in the first year of recovery from the bottom of the Depression. Using the size of a contraction as a proxy for the likely rebound, and adjusting for the drop in output in this recession, would suggest an economic growth rate of around 8 percent for next year, Miller said.

Consumption as a percentage of gross domestic product was 83 percent in 1933, even higher than today’s 70 percent, Miller said. Yet, at the same time that consumers started to de- leverage and save more, unemployment fell, production grew, and the stock market more than doubled from 1933 to 1937.

“There have been eight times the consumer has de- leveraged, and the market rose in six of those periods, with an average gain of 39 percent,” Miller wrote.

‘Maximum Confusion’

El-Erian, speaking at the Toronto CFA Society Luncheon on Oct. 9, said the economy won’t return to pre-crisis strength and the “market is pricing a reset to the ‘old normal.’”

“We are at a point of maximum confusion,” El-Erian said. “Our normal tendency as human beings is to latch to what the ‘old normal’ is like.”

Legg Mason Value Trust has been run by Miller since its inception in 1982. Miller, who initially co-managed the fund with Ernie Kiehne, took sole responsibility in 1990, the year before his winning streak began.

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