QUARTERLY LETTER
Published First Quarter 1991
Muhlenkamp
Memorandum 17
1990 was a difficult year for investors.
A major part of our job is to protect our investors in difficult
years, and we did not protect you very well in 1990. We will
outline what we saw in 1990, what we see now, and some of
what we did right and wrong.
The major events of 1990 have two headings:
War and Recession. We will discuss each separately, though
their effects in 1990 were interrelated.
War
On August 2,1990 Iraq's Saddam Hussein sent
his armies into Kuwait and, within a few hours, occupied that
country. He has since stripped Kuwait of most things of value
excepting, of course, the oil underground. On September 18,
1990 we issued a special Interim Edition of the Memorandum
entitled "Iraqnaphobia" in which we said the following:
"The effects (of the Gulf crisis) are
both economic and psychological. Economically, four to five
million barrels of oil per day were removed from the marketplace.
This has driven the price of crude from $18-20 per barrel
to $28-30 per barrel an increase of over 50 percent! (At the
retail level, gasoline has increased 20%.) This energy cost
increase will prolong the current GNP slowdown by 6 to 9 months,
and deepen it into a probable recession. It will also result
in higher reported inflation for the next 6 to 12 months as
the higher energy costs work their way through the various
price indices. In turn, these higher inflation numbers will
make it difficult for the Federal Reserve to ease the money
supply as soon as it would like. The net result of this delayed
upturn in U.S. GNP growth is to lower economic values by 5%
to 10%.
Overlaid on the economic effects are the
psychological aspects of the crisis. These take two forms.
First, fear and uncertainty about the eventual outcome have
taken an additional 5% to 10% out of stock and bond prices.
Second, our perception is that a continuing public focus on
the Mid-East and its uncertainties may make people more cautious
with their pocketbooks. Unlike 1987, when the American public
largely ignored the stock market break, this time the trigger
(a fear of war) is more immediate, and thus more likely to
have real and lingering effects.
We believe it is important to put all this
in context. First, the Mid-East conflict does not threaten
U.S. survival or (even) prosperity. A similar situation five
years ago would have raised the specter of superpower confrontation.
Such an outcome is not likely today. Second, the degree to
which George Bush has solicited and received international
cooperation will discourage future incursions by the Saddam
Hussein's of the world. It's clear that Hussein perceived
the rules of the international game to be quite different
from the rules that President Bush has now made explicit."
We elaborated on this theme in our October
newsletter, by which time the spot oil price had hit $40 per
barrel and traders who forecast $50-$60 were quoted on the
news. Even at that time the futures price (for delivery a
year hence) was $25 per barrel. The difference ($15 per barrel)
was a war (or fear) premium. It's no coincidence that the
bottom in the stock and bond markets coincided with this peak
(so far) in spot oil prices.
When the oil price first hit the mid thirties,
and gasoline hit $1.25 per gallon, my wife Connie and I discussed
the effects of the price increase. The average American drinks
about a gallon of soft drinks per week, as does Connie. She
also drives 8,000 to 10,000 miles per year. We concluded that
if gas went from $1.00 to $1.30 per gallon and stayed there,
and she drank water instead of cola, she'd break even. I wish
we hadn't had that conversation, because since then I haven't
been able to take seriously the prediction of dire economic
consequences due to higher oil prices. Many people obviously
do take this prediction seriously. Informal polls among well-informed
people during the fourth quarter of 1990 showed over 60% of
respondents thought Saddam Hussein threatened the prosperity
of the United States. Thus my perception of the long-term
effects of Iraq-Kuwait was very different from that of the
public and the market. Hindsight says we would have served
you better in the short term by selling immediately after
the invasion.
It's now mid January, and although comments
on the war are becoming obsolete daily, I feet the need to
make a few:
First, Jean Leister and I are concerned
about the safety of our offspring in the Army (even though
they're still in Germany), but the useful time for concern
was when they joined up.
Second, all people with loved ones in the
Gulf fear for their safety. Only a small percentage of these
fears will be realized, but knowledge of this small percentage
helps very little. When the danger is past, the majority left
unscathed will breathe a huge sigh of relief. Once again,
the fear will have been greater than the reality.
Third, giving sanctions "time to work"
assumed that the goal was to harm the Iraqi people, or that
Hussein would respond to his people's pain and vacate Kuwait.
The sanctions did succeed in making the point that the world
was united against Hussein and his regime.
Finally, by way of perspective: On the first
day of raids on Iraq, the majority of U.S. casualties were
suffered by 7 peace marchers in New York who were hit by a
drunk driver. We kill 45,000 people per year on our highways.
People who insist on driving lethal projectiles after inebriating
themselves kill sixty people per day. I do not trivialize
anyone's suffering as a result of this war, but are the casualties
of Operation Desert Storm more important or significant simply
because we as a nation are paying such close attention to
them? Further, which of the war's effects are temporary and
which are permanent?
Recession
We repeat: Saddam Hussein does not threaten
the prosperity of the United States. Even if he were successful
in keeping Kuwait, the economic impact on the U.S. would be
less than that of the oil price hikes of the 1970s on Japan
(which imports all its oil). The public's response to the
fear of war has resulted in a lengthening and deepening of
the slowdown, making it a recession. But all the rhetoric
and hand-wringing on avoiding a recession ignores the fact
that the slowdown itself was done on purpose, just like every
slow down or recession since World War II. We (the Fed) did
it because the long-term gains from a slowdown are expected
to be greater than the near term costs. What we can slow down
on purpose, we can speed up on purpose, and our Federal Reserve
is now beginning to do just that. Today the Fed is constrained
in ways it wasn't in the past, but we view that as a positive.
Everyone knows the world has become a competitive
market for goods, but not everyone knows that it has also
become a competitive market for money. In 1973, when OPEC
quadrupled the price of oil, the U.S. made the political decision
to pay for it by printing money, rather than allowing the
price of gasoline to reflect the new world price. The Arabs
accepted our printed money because there was no good alternative
(other than raising the price of oil again, which they did
in 1978). Today, no one has to accept our money. The Japanese
economy has become much larger and their currency is trusted,
partly because they didn't inflate in the 1970s. The German
D-mark remains a currency to trust. On top of this, U.S. budget
deficits have made us huge debtors. Foreigners won't continue
to lend to us unless they trust that the dollar will hold
its value. This is why we monitor the value of the dollar.
Because of all this, our Federal Reserve doesn't have the
option of printing money, as it did in the 1970s. Therefore
inflation is less likely.
We monitor German and Japanese interest
rates relative to the U.S. to see how much flexibility the
Fed has. A significant premium in foreign interest rates relative
to those in the U.S. could drive down the dollar and make
Fed ease less likely. Since fall, German rates have been stable
and Japanese rates have declined, allowing our Fed some flexibility.
The skies are not all clear; however, we can still foul things
up. Nobel Laureate economist Milton Friedman says that the
Great Depression of the 1930s started as a normal recession
until three things happened:
- The Federal Reserve actively shrank the
money supply.
- Congress raised taxes a lot (to balance
the budget).
- Congress passed the Smoot-Hawley Tariff
Bill, which increased tariffs on a broad range of imported
goods.
This time around, we're flirting with a
couple of these, but not to a great degree:
- The Federal Reserve has slowed the growth
of money, but the growth is still positive.
- Congress raised taxes a little. (Estimates
are that the new taxes will cost the average American $1-$3
per week, depending on how much you drink or smoke.)
- The General Agreement on Tariffs &
Trade (GATT) talks on international trade are stalled. We
would point out that a failure to lower tariffs is much
less negative than a large increase.
An area of additional concern for many people
is the U.S. financial system. Even with the well-publicized
failure of the Bank of New England and scores of money losing
S&L's the U.S. still has too many financial intermediaries.
We expect additional closings and absorption's of weak players
by stronger institutions, both public and private. This consolidation
must occur for the system to remain viable. The fear and uncertainty
this process creates is a plus for the long term, as it forces
depositors to more closely scrutinize their bank or S&L.
Federal deposit insurance reform must be part of any regulatory
"solution" to this problem. Once the economy is
growing again, and weak institutions have been closed or consolidated,
lenders with higher risk portfolios and relatively less capital
should be weaned away from Federal support. Such limitations
would eliminate the kind of "blank check" lending
activity that created much of the trouble in the first place.
Meanwhile, the Fed stands ready to put money into the system
should a short-term crisis arise. We would also note that
the stock market bottoms of 1982 and 1984 coincide with bank
failures.
In the final analysis, the U.S. remains
in charge of it's own destiny. The problems in the Mid-East
exacerbated a slowdown in our economy. In our case, we allowed
for an economic slowdown, but failed to anticipate the level
of fear engendered by a likely (now real) Mid-East war.
Frankly, we can't find disaster in either
the war or the recession. Many do see disaster. So far, that
has been our error. Yet we hold to our long-term conclusions.
So where are we today, January 21, 1991?
- We are in the middle of a war. Our military
is performing admirably. The planning and coordination are
obviously superb. Meanwhile, the politicians seem to be
keeping an unprecedented coalition together. So the worst
fears of the families of most of our servicemen will not
be realized.
- We are in the midst of a recession. The
Federal Reserve has begun easing, as it has in each recession
since W.W. II. So far, the actions of other central banks
have not appeared to limit our Fed. Historically, loosening
by the Fed in the midst of recession has been the best time
to buy stocks. Balance sheet strength of individual companies
remains critical.
- The elections are over. Year-end tax-related
activity is over. We're in the midst of year-end earnings
reports. Many companies are taking write-offs to put bad
news behind them. Where we do see value, we like to also
see these earnings reports or receive other assurances from
management before putting your money to work.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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