QUARTERLY LETTER
Published Second Quarter 1991
Muhlenkamp
Memorandum 18
Fear taketh away ...
It is popular to accuse generals of always
fighting the last war. We've just witnessed a time when the
generals and the President did not fight the last war, but
most of the politicians, media, investors and the public insisted
on doing so. Congress called on the very civilians responsible
for the failed war policies of Vietnam to give "expert"
opinion on the feasibility of winning a war in the Gulf. The
media featured doomsday economists and oil futures traders
who told us oil prices would skyrocket and shortages and rationing
were coming once again. No one mentioned the fundamental difference
between the supply and demand forces operating in the 1973
refusal by OPEC to sell oil to us and our 1990 refusal to
buy oil from Iraq. The public and investors bought it, and
stock prices fell.
... and reality giveth back.
They began to rebound; however, as soon
as it became apparent that the war would not be a disaster
for the U.S., and that sufficient oil supplies were available.
Within four weeks of the initial air strikes, and before the
ground war ever began, stock prices rebounded to their pre-war
levels. Both the decline and the rebound occurred in anticipation
of these events, and well before any of the details were known.
But we're still in a recession.
As we said last quarter, the depth and duration
of this recession has been increased by the war and the public's
response to it. The broad parameters of this recession still
look quite familiar, the major difference this time is that
the Federal Reserve acted very gradually. After squeezing
the money supply since mid-1988 in order to slow the economy
and inflation, the Fed began easing in late 1990. It did so
because the slowdown/recession was becoming apparent and the
pressure was coming off prices in many areas of the economy.
True to historical form, the stock market responded upward
as soon as the Fed's ease was apparent (with the timing of
the war news helping to dramatize the move).
Recent reports of lower inflation in the
wholesale and consumer price indices indicate that the Fed
can continue to ease, yet the media focuses on the negative
aspects of the recession. No mention is made of the fact that
we (the Fed) slowed the economy on purpose, because the long-term
beneficial effects of lower inflation and lower interest rates
are expected to be greater than the short-term costs. No mention
has been made of the lower bank prime interest rate flowing
through to lower rates on Adjustable Rate Mortgages (which
is taking effect right now), or of the savings available to
fixed rate borrowers who refinance their loans.
We continue to believe that the recession
will mean even lower inflation and interest rates than we
were expecting. It will also give us a longer recovery. For
equity prices to move up in response to these conditions is
normal. They are the signs that economic growth is coming.
A Review ...
In the summer of 1989, we wrote a "Time
Bomb" essay demonstrating the effects on "income"
of declining inflation and interest rates, and warning (anyone
living on income) that interest rates were likely to drop
in the near future. Since November 1990, short-term rates
have dropped two full percentage points, from 8% to 6%. Many
people living off the income from their CDs and money market
funds are now seeing this time bomb explode as they are asked
to roll over their CDs at the new 6% rate. In the early 1980s,
when interest rates dropped, investors who insisted that they
needed higher rates bought high-yield bond funds. Only later
did they learn that their high-yields entailed significant
risks to principal. We've been curious as to the vehicles
which will be provided this time to satisfy the demands for
"more income." So far, we've only seen advertisements
for International Money Market Funds (the ads don't tell you
that they'll lose principal when the dollar appreciates) but
it's early in the game, and we expect to see additional vehicles
touted. Those of you who read or kept our ensuing essay know
that you can't expect to continue to receive interest rates
significantly above inflation by investing in CDs, money market
funds or other short-term investments (the decade of the 1980s
was an historic aberration). The good news is that long-term
rates have not yet fallen, so that income investors can still
lock in rates over 8% by buying long-term bonds. Of course,
those bonds will fluctuate in price (nothing is free!). If
we're wrong and interest rates increase, the price will decline.
If we're right and rates decline, you will want to be sure
your bonds aren't called, which is why we like Treasuries
... and a question?
Demographers have been telling us
for years that when the baby boomers hit 40-something, they
were likely to slow their spending and increase savings. But
by mid-1990 only those who were searching very hard could
find evidence of this. Charlie Smith says the difference between
a Yuppie and a Couch Potato is a mortgage. I maintain that
the biggest difference between wanting a BMW and a Ford is
an attitude. It strikes me that the war has been the best
excuse in a decade for a change in attitude. With the fear
of war, the American public has not bought anything postponable
for six months. Will they decide that having fewer bills to
pay is kind of nice? Will "Born to Shop" T-shirts
become passé? Let us know what you think and what you
see.
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Memorandum, for more by Ron Muhlenkamp.
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