QUARTERLY LETTER

Published First Quarter 1988
Muhlenkamp Memorandum 3

May All Your Days be Interesting.
—old Chinese curse.

I've always thought of the above as a blessing - but 1987 was a little too interesting. Since our letter of October 23, 1987 and our meetings of October 29 and 30, 1987, several events and trends that we discussed have become clearer:

First, the marketplace did not break down. Second, selling occurred in a large number of stocks due to margin calls the first week or two after the crash, and tax-loss selling through mid-December.

Unlike the Dow Industrials, which bottomed on October 19, the average stock bottomed between a week after the crash and the end of November. Prices were driven down by forced selling, without regard to value or relative attractiveness. Stockbrokers told us that most of the funds generated remained in cash. We, too, did some tax-loss selling, but only where we found other stocks that we preferred.

The reaction of the general public to the stock market meltdown has been very modest. Most areas of the economy are continuing the patterns in evidence before October. Consumer spending is slowing a bit from very high levels, and basic materials production is booming from very low levels. Unfortunately, this modest reaction includes our politicians, who want to spend more, not less.

As soon as tax-loss selling ended in mid-December, stock prices began moving up strongly, particularly for those companies with strong balance sheets and good earnings. Since we have been betting on this for some time, we find it heartening. For example, well-run banks are now being differentiated from poorly run ones. We still think the entire banking group is cheap (along with most savings and loans and insurance companies), but it may require lower interest rates before these companies are fairly priced.

Interest rates and the bond market have been flat since October. This despite a continued decline in the dollar. Whether current attempts to support the dollar will be successful, we don't know. Recent indications that the U. S. trade deficit is diminishing should help immensely.

In a nutshell, this is where we are today: relative to inflation of 4-5%, stocks and bonds are now under priced. But as has frequently been the case for the past five years, stocks in general remain hostage to the bond market. Stocks can't move up unless bonds move up first. The bond market is in turn hypersensitive to interest rates worldwide and the dollar's value versus other currencies.

Central governments are now trying to stabilize the dollar, after helping to push it down for two years. Should they be successful, interest rates should stabilize or trickle down and selected stocks will do well. Should they be unsuccessful, the bond market will set the tone for stocks. If interest rates hold at current levels, the key to stock performance will be individual company earnings.

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