QUARTERLY LETTER

Published Fourth Quarter 1989
Muhlenkamp Memorandum 11

The Third Quarter of 1989 witnessed continued gradual moves toward stability in economic data. When we read the charts in the "Money & Investing" section of the Wall Street Journal, we read them from the bottom up. They currently tell us the following:

First, commodity prices are flat to down, confirming our previous expectation (based on slow money growth) that inflation is rolling over and likely to decline. Recent reports on the wholesale and consumer price indices also confirm this, but consensus fears still focus on inflation.

Second, the dollar has been trading in a range of about 10% for two years now. This is the first period of stability exceeding six months since 1980. (And you don't hear much about the trade deficit any more because the numbers are steadily improving.)

Third, short-term interest rates, after peaking in the spring, fell in June and were allowed by the Fed to fall further in July. To us, this Fed action was the surprise of the third quarter. We expected the Fed to wait for additional evidence of economic slowdown before lowering short-term rates. By acting when they did, the Fed governors made a recession less likely and boosted stock prices in July and August.

Fourth, long-term interest rates declined (driving bond prices up) beginning in March. The interesting point here is that long-term rates started down while short-term rates were still moving up. This is unusual! Normally long rates follow short rates and the bond markets follow the Fed. Recently, the bond markets have anticipated (trusted?) that the Fed has inflation under control. The recent numbers on slow GNP growth, declining inflation and lower short-term interest rates have served to validate that trust.

The stock market reacted to lower short-term rates with strength in July and August. Of greater interest to us is that the strength was selective, reflecting good values and good earnings.

Everyone asks, "Which way is the market going?" This was the key question when business economics were overwhelmed by changes in inflation and interest rates, as they were from 1965 to 1982; or dominated by changes in the dollar and interest rates, as they were from 1980 through 1987. If we are right that changes in these areas are now much more modest and subdued, the relevant question today is: "Which companies are doing well and are undervalued?"

When I entered this business in 1968, inflation, interest rates and the dollar had been stable for 15 years. Consequently, price/earnings ratios had been stable for 15 years. Investors believed that, for a given company, if the earnings went up the stock price would go up. We believe we are returning to such times, and are therefore looking for such companies.

October 16, 1989 Addendum:
Once again the quick money players have even us a chance to buy good companies cheaply. On Friday, October 13, 1989, financing for a leveraged buyout of UAL Corp. fell through. People who had bid up various stocks on takeover hopes immediately sold them out, taking many other stocks down with them. Where we like the company and the price, we're buying.

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