QUARTERLY LETTER

Published Second Quarter 1994
Muhlenkamp Memorandum 30

The stock and bond markets have just suffered a free fall that has most people baffled and some scared. The popular media initially blamed the decline on the Fed's action to increase short-term interest rates, but has become muted as prices fell beyond any reasonable reaction to the change in short-term rates.

To understand what has been going on, we need to review a bit of history. Referring to our "Are Stocks Too High?" essay and charts may help you understand the following argument.

Background: During the 80s we warned our clientele that based on inflation, interest rates had to come down, and they did. Long-term interest rates declined from 13% in 1981 to 7% in late 1993, but the decline didn't occur in a smooth steady fashion. Changes in policy by the Federal Reserve Board, economic strength and weakness, and typical market bouts of hope and fear all served to drive rates up and down over various periods of time. Financial markets have become international and U.S. long-term rates were affected by long-term interest rates in other countries, particularly Germany and Japan, and their rates in turn were affected by their economies (which peaked after ours and are still in recession) and by the actions of the Bundesbank and the Bank of Japan. Specifically, even though the U.S. Federal Reserve lowered short-term rates, beginning in 1990, to counter the U.S. recession, our long-term rates didn't resume their decline until Germany and later Japan started to lower their rates in response to their domestic recessions.

This was the pattern until late 1993. Germany and Japan were still in recession. So the next move in their rates was likely to be down, but U.S. long-term rates had reached "normal" levels making them less likely to fall further. Meanwhile, the dollar was (and still is) undervalued. It appears to be 30-40% undervalued versus the D-mark (if you travel to Germany, goods are 30-40% more expensive than similar goods in the US) and 10-20% undervalued versus the yen. These two factors led us to believe that when interest rates next declined in Japan and/or Germany, the effect in the US would not be lower interest rates, but a rise in the dollar. This expected rise in the value of the dollar is the principal reason that we haven't owned foreign securities in recent months. We still expect this to happen.

Apparently a number of other investors had the same expectations. Some of them were hedge funds that bet heavily on this expectation and did it with very heavy leverage (borrowed money). The profitability of doing so was increased by the wide spread between short-term and long-term interest rates in the U. S. Then several things happened which reinforced one another and made the highly leveraged positions untenable. First, the Fed raised short-term interest rates 1/4 point. We viewed this as a modest, long-term positive, but it increased the carrying costs of the leveraged transactions of the hedge funds, squeezing the profitability of their position.

Then President Clinton, who had just made a major effort on NAFTA and GATT (the only economically good things he has done so far), started attacking the Japanese on trade issues. This unsettled the international markets. The experience over the past 50 years is that Germany and Japan are much more reliable about protecting the value of their currency (not inflating) than is the U.S. So, in response to Clinton's remarks, the D-mark and yen rose in value against the dollar. This caused the bets on the dollar appreciating to become losses and since the margin was so great, some hedge funds were hit by margin calls. They were forced to sell bonds and stocks into rapidly falling bids. One measure of the deleveraging pressure is that initially treasury bonds fell more than corporate bonds and munis -- not a normal occurrence. (Later, near quarters end, corporate and muni bonds caught up -- on the downside.) The forced selling -- selling to raise funds -- spread to the stock market. The selling started in the big stocks where big money could be raised quickly, but the bids soon fell on other stocks as well. Articles in the Wall Street Journal on April 1st, page C1, concerning Mike Steinhardt and March 30th, page C1, concerning Granite Partners, give a pretty good description of the recent forced unwinding. We found particularly interesting the assertion that the manager of Granite Partners was able to deny the problem in February and postponed his selling until March. Normally, selling due to margin calls is completed within five-ten days. The article suggests that we had a fresh batch of selling at quarters end because some managers were in denial. This poses an interesting question. If one manager can deny the problem for a month, can another manager deny the problem for two months? Possible, but we think it is unlikely. So, as the market appeared to stabilize in the first week of April, we've invested most of our cash.

What we continue to find fascinating is the public's fear of U.S. common stocks and their continuing confidence in bonds, utilities and foreign stocks. Since last fall, stock prices fell 10% and were chronically in the news and had everyone nervous. Meanwhile, utilities fell 25% and treasury bonds fell 20%, but everyone still believes that, "bonds are safer than stocks!" As recently as mid-March, we were getting calls urging us to buy foreign stocks for "safety" as if stocks in emerging markets are somehow safer than those in the U.S. Our experience indicates that what the public fears is often less risky than what it doesn't!

Could we get another down leg in the market? Yes, we could. But big moves require big reasons and we don't currently see big negative reasons. The last time we got a 20% down move it required a recession and a war to do it. Both are very big reasons, very real negatives, and affect nearly all citizens. International trade rhetoric and margin calls on leveraged hedge funds are less big, less "real", and affect far fewer people. Our experience has been that changes in psychology can occur at any time and can result in price moves of up to 10%. 10% is a small move. We can't price our houses, our cars, or anything else we own tighter than +/- 10%. Why should we expect to value companies tighter than +/- 10%. And why do people panic when the market prices of our companies move 10%?

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