... the preponderance of the evidence supports the view that the worst has passed in the market and the economy...

After an awful quarter in which our fund dropped 19.7% compared to a loss of 9.4% for the benchmark S&P 500, we have begun to perform better. In the first few weeks of the quarter, the S&P 500 is up just over 5% and we are up a bit more. Our lead widens if you look back to the Monday the Bear Stearns rescue by JPMorgan was announced. While neither I nor anyone else knows if our period of underperformance is over, it ought to be, if valuation begins to matter more and momentum less in how the market behaves.

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... 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 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)...

The Legg Mason Value Trust slightly outperformed the market in the second calendar quarter, rising 6.49% compared to 6.28% for the S&P 500. This brings our year-to-date returns to 4.8% compared to the S&P’s 7%.

Our returns this year, compared to the market’s, are primarily due to our exposure to housing and housing-related securities, and our lack of exposure to energy. A few thoughts on both are in order.

Amazon is Miller’s sixth-biggest holding, accounting for 4.65% of the fund’s $20 billion in assets, according to Morningstar, and Wednesday’s 25% pop in the stock surely was a big part of Legg Mason Value’s 1.7% gain that day. Even in Thursday’s horrific market with the Nasdaq Composite off 1.76% shortly after noon in the East, AMZN is holding onto a 0.75% gain.

And the e-tailer’s 118% gain this year has helped the fund offset drags from big losers such as Countrywide Financial (CFC), Sears Holdings (SHLD) and IAC/Interactive (IACI). But the fund’s year-to-date return of 4.19% still trails the S&P 500 by 3.91 percentage points by Morningstar’s calculation.

The latest SEC Form N-Q filing for Miller's flagship fund shows what interests him in this market -- and what he's unloading (quarter ending 12/31/06; filed 3/1/07):

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...our continued lack of exposure to energy, which was the second best performing sector for the six months, hindered our performance during the period. This is another area we were clearly wrong about (isn’t hindsight useful?).

The third area where we have not fared well has been in homebuilding, where our exposure is roughly 5% of the portfolio. Here we clearly made a mistake by initiating positions too early. The homebuilders had performed much like the managed care stocks, handily outperforming the market for several years. We were waiting for a significant sell-off to establish positions as we thought the valuations at single digit multiples were too low given the secular advantages of the large builders. When that sell-off occurred late last year, we jumped in, knowing that the news flow would be bad for about 12 months as the super-hot housing market slowed sharply and began to return to normalcy.

There are four main reasons why the [Legg Mason Value Trust] portfolio is currently trailing the S&P 500. The first has to do with our allocation to the internet names which include Amazon, eBay, Yahoo, Expedia, Interactive and Google. These names started the year at roughly 20% of the portfolio and collectively are responsible for close to 400 basis points of underperformance over the past 6 months. Over the last several years, these companies have exhibited a seasonal pattern of weakness in the first half of the year followed by a period of better second half performance. All of these businesses are doing well and trade at substantial discounts to our assessment of fair value. All have traded off on some degree of angst about company-specific near-term issues.

No grass has grown under the feet of Sprint Nextel CEO Gary Forsee since Nextel completed its merger with Sprint last summer. In addition to starting to integrate two large, complex businesses, Forsee spun off the company's local wireline business, partnered with four leading cable companies to offer wireless services to their customers, spent billions to start buying in independent regional affiliates and rolled out a wide variety of content data services with partners such as ESPN.

Eddy Elfenbein submits: Bill Miller, the manager of Legg Mason's Value Trust mutual fund [LMVTX], has beaten the market for the last 15 straight years. This year, however, isn't working out so well.

Here's how the fund (black line) has performed year-to-date against the S&P 500 (gold line):

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