QUARTERLY LETTER
Published Third Quarter 1989
Muhlenkamp
Memorandum 10
The Second Quarter of 1989 witnessed further
evidence of a slowing U.S. economy. The Federal Reserve Board's
tight two-year hold on the growth of money and gradual increase
in short-term interest rates are having the desired effect
of slowing GNP growth. The latest monthly numbers do not yet
show lessening inflation, but weakening commodity prices and
modest growth in wages suggest that slower growth is on the
way for the Consumer Price Index as well.
The surprise in the second quarter was the
strength of the dollar, but dollar strength is relative to
other currencies, so they must be considered as well. In particular,
the yen and deutsche mark were weak, probably due to political
problems in Japan and Germany. A more telling episode may
have been the turmoil in China. The problems in China seemed
to result in the buying of dollars (instead of gold, for instance),
implying that international investors view the U.S. as a safe
haven and do not expect increased U.S. inflation any time
soon. To appreciate why investors avoid currencies undergoing
inflation, see our "Time Bomb" essay on the effect
of inflation on the value of money.
The net result of a slowing economy, controlled
inflation and a rising dollar was lower interest rates and
higher bond prices. Rates on long-term treasury bonds dropped
a full 1% in the second quarter, from 9.25 to 8.25. Though
the bond market may now be a bit ahead of itself, interest
rate pressures remain downward and should stay that way for
some time, indicating that quality bonds should do well. A
recent move by the Federal Reserve Board to reduce the Federal
Funds rate in line with other short-term rates tends to confirm
this.
The drop in interest rates allowed the general
stock market to work its way higher. Within that context,
financial stocks such as banks and savings and loans moved
up nicely. A slowing GNP generally means lower profits for
companies in cyclical industries; many paper and chemical
company stocks were flat to down during the quarter for fear
that their earnings would collapse in 1990. We think these
fears arc overdone, but expect them to continue until the
markets get a better handle on the extent of the slowdown.
We continue to hold shares of some leading cyclical companies
selling at low multiples of earnings and cash flow and/or
those with diverse end markets. We may increase our positions
in cyclicals if it appears the economy and earnings are not
as weak as the market is currently discounting.
We repeat our warning: The Fed appears to
be navigating masterfully between too rapid growth and recession,
but the risks of recession are greater now than any time since
1982. This is not a time to flirt with companies with marginal
staying power or weak balance sheets.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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