QUARTERLY LETTER

Published Fourth Quarter 1987
Muhlenkamp Memorandum 2

To start with the obvious, since spring we have been wrong on interest rates. We expected the economy to muddle through, which it has, and should continue to do. We expected inflation to rise from the 1-2% level of 1986, but not to exceed 4.5%. This seems to be on the mark as well. We also said in July that the trade deficit was beginning to improve. Since then, the reported numbers have stalled, but we believe the positive underlying trend continues. Given a muddling economy, tame inflation and an improving trade deficit, we expected interest rates to edge down. Instead they have risen two points, driving bond prices down and discouraging any rise in interest-rate related stocks such as utilities, banks and savings and loans.

What happened? Although we said in January that a weak dollar might result in higher interest rates, we greatly underestimated the market's response. After declining in March, the dollar has been relatively stable, yet interest rates continue to rise, often triggered by rumors or fears of a weaker dollar. Our error came in viewing dollar interest rates primarily in light of the domestic economy. Money has become a world commodity (not unlike wheat or oil) and the actions of other country's markets and governments (especially Japan and Germany), can have as much influence on U.S. interest rates as our own. Since these countries are much more sensitive to the dangers of inflation than ourselves, they have pushed their interest rates up to levels 5-6% over inflation, taking ours along with them. We believe Japan and Germany no longer have an incentive to raise rates, and therefore, with U.S. inflation in the 4-5% range, U.S. interest rates should go no higher. The returns available on long-term bonds are now competitive with U.S. stocks.

If we owned no bonds or interest sensitive stocks, we would view this as a buying opportunity, like 1982 and 1984. Having owned these securities for a year or more and being disappointed with their performance does not change the mental conclusion, but I will admit that it tightens the stomach. The payoff should finally come when interest rates stop rising. For stocks in general, earnings remain key and we are monitoring them closely.

The budget deficit is still a major problem. The solution is reduced spending. (The $180 billion deficit divided by sixty million families gives a tax increase of $3000 per family to close the deficit through higher taxes. Think what that would do to household budgets!) Yet our politicians insist on playing partisan and fractionated politics, often at the expense of the country.

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