QUARTERLY LETTER

Published Second Quarter 1993
Muhlenkamp Memorandum 26

The stock and bond market rallies of the Fourth Quarter extended into the First Quarter of 1993. Our holdings participated nicely and we had a good quarter and a superb six months.

The trends we have been talking about for the past couple years remain in place. The American public has concluded that ever-larger houses with big mortgages are no longer the moneymakers they were in the 1970s. Rather than "trading up on the equity," people are refinancing their mortgages at lower rates. Roughly 1/3 are also shortening the length of their mortgage, paying it off in a shorter period of time. Thus, a good portion of the spending power available from the lower rates is being used to pay down debt rather than spending it on additional goods and services. This has the net effect of moderating the growth in the economy (relative to other recession recoveries) and is putting downward pressure on interest rates.

As homeowners have refinanced their mortgages from 11% to 8% rates, they have driven the rates on CD's from 8% to less than 5% (banks work on a 3% spread). This has cost the savers (many of whom are their parents) a huge loss of income. CD's are now yielding about 3%, and because of this, the savers are going elsewhere in search of good yields. Many of the products being offered to fill the searcher's demands will ultimately be disappointing to them.

Meanwhile, the new administration in Washington is trying to boost the economy with a stimulus package, but the net effect of this package will have the opposite effect. The government has told the public that their taxes are going up -- that doesn't encourage them to go out and spend money. At the same time, the government is telling businessmen that regulations and their taxes are going up a lot-that doesn't encourage them to hire more people. Our government expects to create jobs in those areas of the economy which it sends money to (through subsidies) but somehow doesn't expect jobs to shrink in those areas where they take money from (through higher taxes).

Our government's longer-term goal is to shrink the federal deficit. This won't happen unless they come to grips with entitlements, including Social Security, and their current package contains nothing in this area. Consequently, this package will have little or no effect on deficit reduction.

I recently received a copy of Bankruptcy 1995 by Harry Figgie, Jr., president of Figgie International and former member of the Grace Commission. This book contains the best summary description of the current federal deficit problem that I have seen. Mr. Figgie's thesis is that by 1995 Federal interest on the debt and entitlement spending will exceed federal tax revenues and -- since these expenses can't be cut -- the U.S. will be bankrupt.

He also lists the three areas to watch to monitor the problem (with which I agree). First is the interest on the federal debt. Mr. Figgie concludes (in 1992) that because of the debt, interest rates can't fall. Since 1992 rates have fallen by 1/3 (the federal debt has an average maturity of six years) helping to postpone bankruptcy. The second area to watch is whether the Federal Reserve monetizes the debt by printing money that would revive inflation (which is why we monitor the money supply). The current Federal Reserve insists that it will not monetize the debt, but prior members of the Federal Reserve Board made the same insistence, while printing money at a rapid rate. The third area is whether Congress and the administration address the problem. This gets interesting: they believe they are addressing the problem - right up to the point of spending less. Meanwhile, the public is addressing the problem by paying down personal and corporate debt (helping to drive interest rates down) and by supporting Ross Perot as a way of holding the politician's feet to the fire. My observation is that politicians never lead the public, but only follow as required. In my opinion, the outcome will be decided by public pressure (or lack thereof) over the next several years. So far, the effect is that politicians are talking about deficit reduction, which is always the first step. I believe it was Winston Churchill who said, "In a democracy, you can always count on politicians to do the proper thing, but only as a last resort." To our politicians, a cut in spending is the last resort.

People who study the age distribution of our population have been saying that when the baby boomers turned 40-something, their focus would shift from buying houses and cars to saving for college and retirement. It is now happening. We believe the experiences of the '70s and '80s, as discussed in our prior newsletters, are reinforcing this trend and the recent recession also reinforced it. We also believe the current administration's actions reinforce this trend, despite their opposite intent. The net effect of this is an economic recovery that is slower than normal and continued downward pressure on interest rates. When 260 million people change their minds, it makes a powerful trend.

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