QUARTERLY LETTER

Published Fourth Quarter 1988
Muhlenkamp Memorandum 6

1988 - A Fascinating Year of Fear vs. Reality

Following the Stock Market Crash of 1987, many experts, economists, and financial seers predicted a Depression. These predictions were amplified by the news media; which always prefers the dramatic to the mundane. Instead the economy just kept rolling along.

So we kept our fear but reversed the cause - the economy was too strong and would result in more inflation. But the economy tapered off.

The Fed, after making money available after October 19, continued to slow monetary growth (we repeat - inflation is monetary, and is not caused by a strong economy).

We feared the trade deficit was too big and the dollar would collapse (after already declining 30-50% in three years), but the trade deficit gradually declined and the dollar stabilized.

We feared the budget deficit was out of control - and it may be - but it is not uncontrollable (holler at your Congressman to spend less), and at least is no longer getting worse.

In the end, what did we get for our year of fear and trembling? We learned that, as Calvin Coolidge put it, most anticipated troubles are intercepted before reaching us. We also learned that the headlines and static of day-to-day market gyrations are not what economic reality is made of. For a truer, bigger picture, we must look longer term.

Consider the period January 1, 1987 to June 30, 1988. For calendar 1987, our average account was down 2%. For the eighteen months, January 1, 1987 to June 30, 1988, our average account was up 13%. In other words, when the worst stock market crash in history is put into the context of twelve months, our result is a minus 2%. When it is put into the context of eighteen months, we did better than if we had held cash or bonds. Don't get me wrong, we wish we'd been smart enough to sell in August (we didn't) and buy in December (we did). But when being only half-right gives good returns, we can hardly complain.

In sum, 1987 presented a great chance to be a "hero" or a "bum." (the papers were full of each). If 1987 is the once-in-a-generation cost of participating in the reality of long-term superior returns of equity ownership, frankly, we are willing to pay that price.

Turning to the political arena, the most fascinating item we witnessed all year was Michael Dukakis' nomination acceptance speech. He praised Ronald Reagan, by name, twice, and never mentioned Jimmy Carter. He said that he is not challenging the Reagan ideology, but only his competence. That is, he wants to do the same thing, only better! Aside from whether you believe his ideology is the same as Reagan's (it hasn't appeared to be in the past), it's an amazing statement from the leader of the opposition party.

After the Democratic Convention, when Dukakis was ahead in the polls by 17 points, we were told he would be elected (he might), raise taxes (he might), and put us into a recession (it would). The immediate result; however, would likely be a market rally. Higher taxes would shrink the budget deficit (assuming flat spending) and reduce interest rates -both positives. The negatives would come a year or two later.

When you receive this issue of the Muhlenkamp Memo, we'll be a few days on either side of October 19, 1988. This anniversary will present a great opportunity for the media and the pundits to relive October 19, 1987. (In the Pittsburgh area on October 19, 1988, Muhlenkamp and Company is sponsoring "Adam Smith's Look at October 19, 1987" on WQED. We have no idea what he'll say, but he's usually fairly objective.) Suffice it to say that conditions are quite different from a year ago, and we see little or no chance of a repeat any time soon. So many people are prepared for another collapse that the real surprise will likely be on the upside. Count the number of optimists versus pessimists you've heard in the last year.

From an investment perspective, not much has changed from three months ago. We still see inflation at 4-5%. We see the economy gradually slowing. The dollar has been fairly stable. Short-term interest rates ran up and appear to have stabilized. Long-term rates have been stable at a level almost competitive with the average stock, so company earnings must do well for individual stocks to do well. Corporate earnings have been superb, but gains are slowing. The election is only a few weeks away and will answer some questions. The next move will likely be up, triggered by lower interest rates and favoring companies with good balance sheets and good earnings.

* This thesis came from a speaker at an investment conference. I have found that conference speakers tend to be negative. I don't know why, but it may be that you must be different to be paid to speak, and since Wall Street is normally bullish and free, maybe you must be negative to command a fee.

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