QUARTERLY LETTER
Published Fourth Quarter 1990
Muhlenkamp
Memorandum 16
A Tough, Tough Quarter
In July, we were congratulating the Fed
on engineering a slowdown in the U.S. economy with a minimum
of pain and dislocation. The Fed was nearing its stated economic
goals and it looked to us like it could soon begin easing
credit to allow growth to begin again. Then Iraq's Hussein
invaded Kuwait and added war fears to the existing fear of
recession. This additional fear and the public's response
to it make recession more likely.
As we wrote in Iraqnaphobia, the economic
effect of increased oil prices and a prolonged slowdown/recession
is to lower corporate values by 5 to 10 percent. But prices
at any given time are determined by a combination of economic
values and emotional responses. Right now, emotions are driving
prices.
A glaring example is the price of oil. Three
months ago, oil sold for $16 to $18 a barrel. On October 9th,
it hit $40 and traders who forecast $50-$60 were quoted on
the news. But the removal of Iraq and Kuwait's production
of 4 to 5 million barrels per day has been nearly offset by
increased production from other OPEC members. Those who have
done supply demand studies conclude that the economic price
of oil is $22 to $27 per barrel. Thus, the current $40 price
includes a $15 war premium, and the $50 to $60 guesses are
based on a shooting war that destroys oil facilities, but
this too could be temporary. It's ironic that Hussein's stated
goal in the OPEC meetings (before he invaded Kuwait) was a
price of $25 per barrel. Now the price is $40 but the world
refuses to by his oil.
Similarly, stock and bond prices are set
by a combination of long-term economic values of underlying
companies and the current level of fear or hope in the marketplace.
Today, we see many examples of companies and executives buying
their own stock because the "price is cheap" and
"it's a good value." At the same time, the public
is selling because "the price is down and we fear it
may go lower." The last time we saw this dichotomy was
in late 1987.
In such circumstances, we find it useful
to step back and broaden our horizon. Specifically, we ask
ourselves: What is the likely duration of a war and/or recession?
Does it threaten U.S. national security? What will be the
value of specific companies when it is over? Three years ago;
for example, we would have feared a superpower confrontation.
Today, that's not a threat. When we look at individual companies,
we find a lot of good ones that are cheap, some compellingly
so. Many of these are the same companies whose insiders are
buying their stock. Some are companies we already own at higher
costs. Some are companies in which we sold positions earlier
this year because they appeared fully valued. Others are companies
we haven't seen at such attractive prices since late 1987,
the last time fear was rampant. We've begun to nibble at the
stocks of these companies. So far, we're only nibbling because:
- The news from Iraq-Kuwait may get worse
on a short-term basis.
- Our Federal Reserve is partially constrained
by Iraq-Kuwait and by the falling value of the dollar. Chairman
Greenspan has also tied Fed easing to Congressional actions
on the budget, our representatives in Washington are dithering
to no end on this one.
- We expect tax-related-selling pressures
through year-end.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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