QUARTERLY LETTER

Published Third Quarter 1990
Muhlenkamp Memorandum 14

After advising patience for more than a year, we were glad to see the second quarter of 1990 provide some rewards for those who have taken our advice.

The long-term trends we've been reviewing with you for two years remain in place. In 1988, the Federal Reserve Board began to tighten the money supply in order to slow the U.S. economy, which had been growing strongly for six years and was reaching full employment. The Fed did this to forestall inflationary pressures, which often accompany a strong economy. Normally, such action by the Fed takes 6 to 12 months to be reflected in GNP growth, and 12 to 24 months to be reflected in prices (inflation). These time lags appear to be holding - GNP began slowing in the first half of 1989, and inflationary pressures, after a weather augmented spurt last winter, seem to be abating now.

The major difference from other postwar periods of Federal Reserve restraint is that this time the Fed has acted gradually. The advantage of gradual action is that it allows people and businesses time to adjust supplies and inventories to changing levels of interest rates, final demand, etc. and makes dramatic adjustment (read recession) somewhat less likely. The disadvantage is that it requires patience, a commodity rarely found among securities traders, politicians and the media. Consequently, the past year and a half we've seen several complete cycles of inflation and recession fears, often with the emotional winds changing in response to a single month's GNP data. These fears have caused great short-term volatility in the stock and bond markets, but the net effect has been modest. Both stocks and bonds have traded for a year in a range of plus or minus 10 percent.

At the same time, the markets have managed to burst speculative bubbles in Japanese stocks, "hi-yield" bonds and commercial real estate. This has hurt speculators, but had little effect elsewhere. There remains a risk that tighter oversight of banks by the comptroller of the currency could cause a credit crunch, but political sensitivity on the part of those most affected make this scenario unlikely.

The new cloud on the horizon is the increased probability of higher taxes. Our politicians want to raise taxes to cover their spending (lower the deficit) and help lower interest rates. Whatever form such taxes take, they will have a depressing effect on the economy. If the taxes are narrow, their economic effect will be narrow. If they are broad, their effect will be broad, and increase the probability of a recession. If President Bush can gain ground in other areas (especially Entitlement Reform, Budget Process Reforms and Discretionary Spending Reductions) the package could be a net plus for the populace. This will depend on Congress and, more specifically, you and me. Every now and then, proposals are put on the Congressional table and Congress must respond. They will respond to pressure from the home front, so give it to them. Many people complain that their voices aren't heard, if you pick your shots, yours will be! Bush's current proposal is one of those shots.

So where are we today? We are where we have been, but further along. We still see inflation no worse than 5%, but we now believe we are over the top and the reported numbers are heading downward. We still view a recession as unlikely, but the odds of one occurring have increased. We suspect that the low point of the slowdown will be in the second or third quarter of 1990. If so, the question becomes not whether the Federal Reserve will begin to ease, but when. The trigger is likely to be continued good numbers on inflation or a significant debt reduction package in Washington. The longer the Fed waits, the more likely recession becomes, along with lower inflation.

Under these assumptions, stocks and bonds continue to be fairly priced (plus or minus 5% to 10%). Bonds will respond to interest rates. Individual stocks will respond to interest rates and to earnings.

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