QUARTERLY LETTER

Published Third Quarter 1987
Muhlenkamp Memorandum 1

The Second Quarter of 1987 witnessed some possible turning points of long-term significance.

Our foreign trade balance is now improving in dollar as well as unit terms. This should relieve some of the pressure on the dollar, which is beginning to act as though it has bottomed. Such a bottom is not yet assured, however, and fears of a freefall in April and May hit the bond and stock markets hard. The bond market and interest-rate-related stocks have not yet fully recovered from these fears, although parts of the stock market have.

The budget deficit dropped significantly as people paid their 1986tax bills. Such bills included taxes on large capital gains voluntarily taken in1986 due to the tax law changes. (Very little mention has been made of the incentive in 1987 to take losses.)While improving, the budget deficit problem is nowhere near solution, and spending restraint by Congress remains as important as ever.

Based on 4% inflation and current earnings levels, the stock market has become fully priced. Those of you who have been with us since 1980-82 know that we then talked about the possibility of a good investment decade. We argued that if Reagan could get inflation under control, as he seemed to be doing, interest rates would come down, driving stock and bond prices upward. This has happened. For stock prices to increase from these levels, corporate earnings must improve while inflation remains below 5%. Fortunately, this may happen.

As a precedent, the decade of the1950's looked much like the past seven years. During the 50's, inflation declined from 7% to 1%, allowing stock P/E multiples to expand from 7to 17. In 1960, Benjamin Graham (who wrote the book on Security Analysis) was quoted as saying the market was fully priced. Yet prices advanced for another eight years! They rose in concert with earnings; P/E's were remarkably stable.

To us, the message is that some of the key variables are probably changing, and the market may be more volatile during this transition. If as we expect the stock market is becoming earnings driven, positive earnings surprises will drive individual stocks up and negative surprises will drive them down. Consequently, we've become a little quicker to sell at the hint of bad earnings, and shortened our purchase list to those companies expecting good gains.

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.