QUARTERLY LETTER

Published First Quarter 1995
Muhlenkamp Memorandum 33

We are hearing from our clients some confusion about the stock and bond markets in 1994. A typical comment is, "When I read the company reports, they are doing well- why are my stocks down?" In fact, if you look at anything other than stock and bond prices, 1994 was a very good year. Gains in Gross Domestic Product have been near ideal, inflation has remained in check, and employment has expanded nicely. Bosnia is still a mess, but Haiti did not prove disastrous and Somalia seems behind us. The health care bill was defeated, GATT was passed, and the new Congress is talking seriously about cutting spending. Sounds like a very good year. Yet since September 1993, bond prices are down over 20%, utility prices are down over 25% and most other stock prices are down 5-10%.

We believe that stock prices are down because bond prices are down. Bond prices are down because of a number of factors:

• Bonds had reached full value
• Uncertainty by our trading partners on the terms of trade
• Declining value of the dollar
• An increase in commodity prices
• The Fed raised short-term interest rates
• Strong growth in the GDP
• A number of investors owned bonds on margin (borrowed money).

Many of these factors operated in concert, reinforcing each other, so it is difficult to assign individual cause and effect weights to each one and we will not attempt to do so, but we will discuss each in turn, including our reading of where we are today.

In Muhlenkamp Memorandum #28, (fourth quarter 1993) we discussed why we believed bonds had reached full value at a 6% interest rate (3 % over inflation) and concluded, "The time to be heavily invested in long bonds has just come to an end." Since that time interest rates on long-term bonds have risen to 8%, while inflation remains below 3%. This 5% difference makes long bonds attractive once again.

(If you have a copy of The Wall Street Journal, the charts on page C-1 help illustrate the following discussion.)

Uncertainty over the terms of trade and the declining value of the dollar are inextricably linked and must be discussed together. Most Americans know that we have had large trade deficits and large budget deficits for over a decade. A trade deficit means that we buy more goods from other countries than they buy from us. We pay for the difference by sending them dollars. A federal budget deficit means that our federal government spends more on programs than it takes in from tax revenue and must borrow the difference by selling Treasury Bonds. What most Americans do not know is that many of the dollars that we sent to foreign countries to fund our trade deficit were used by people in those countries to buy our Treasury Bonds, thus helping to fund our budget deficit. In mid-February 1994 the Clinton administration started bashing the Japanese on the terms of trade, creating great uncertainty among our trading partners on what the U.S. trade policy was likely to be. These partners quit buying our Treasury Bonds, sending bond prices down and interest rates up. Overnight the dollar fell 4% versus the yen. The dollar continued to fall in value relative to the yen and the D-mark until November, when the US Congress ratified the GATT Treaty and U.S. trade policy was clarified. We believe the decline in the dollar between February and November 1994 contributed to the decline in the bond market over the same period. Both declines seem to have ended in November.

The U.S. Federal Reserve Board has the task of setting U.S. monetary policy to foster healthy economic growth without inflation. Its primary tools include expansion and contraction of the money supply, and the setting of short-term interest rates. What makes its job interesting (some say difficult or impossible) is that its actions tend to affect the economy (GDP) with a time lag of 6-12 months and to affect inflation with a time lag of 18-24 months. The power of the Fed is such that every recession we have had since World War II has been instigated by the Fed as a means of countering inflation. Since long-term rates are heavily influenced by inflation (although the lags can be very long), often the Fed raises short-term rates as a means of preventing increases in long-term rates. In determining its targets for short-term rates, it looks at a number of factors, but the major factors are inflation, growth in GDP, employment levels, and the strength of the dollar. In February 1994, short-term rates were less than inflation, indicating that rates were lower than could be justified. Also, while inflation in the Consumer Price Index and the Producer Price Index remained at roughly 3%, commodity prices (CRB Index) were moving up at a more rapid rate. Also, GDP was growing faster than desired, and unemployment was decreasing. The dollar was flat to increasing in value.

So the Fed raised short-term rates a notch. Over the course of 1994 the Fed raised short-term rates 6 notches. During that time the CPI and PPI have remained below 3% and the CRB index has been flat since mid-year. Growth in GDP and employment levels remain stronger than the Fed desired, leading to fears of future inflation (One conclusion of the Keynesian theory of Economics is hat strong growth in GDP causes inflation. I was taught this 30 years ago only to watch it be disproved by the facts of the last 30 years, but the facts have not managed to kill the theory. So strong growth in the GDP still engenders fears of future inflation.) The dollar has been falling. As the Fed raised short-term rates throughout most of the year, long-term rates also went up, causing speculation that "the market" did not believe the Fed was serious about controlling inflation. But when the Fed raised short-term rates in mid-November, long-term rates fell. We believe this change in market reaction is significant.

A number of the investors who owned bonds on margin received margin calls and have been sold out. The hedge funds whose bonds were called made the ews in February and March. Orange County, California made the news in December. The difference is that when margin calls resulted in the sale of bonds in February, the long-term bond market fell; when margin calls resulted in the sale of bonds in December, the bond market absorbed it without falling. We believe this change in market reaction is also significant.

So where are we today?

Position: We are looking at a "20% off" sale. Bond prices and stock P/E's are 20% lower than they were a year ago. After warning our clients about bonds being fully priced a year ago, we decreased our ownership of bonds but continued to hold a number of stocks that others view as interest rate sensitive. Consequently, in 1994 we gave back much of the premium returns (over the S&P 500) which we earned in 1993. But the companies have done well and we fully expect their stock prices to reflect it. Meanwhile, the U.S. economy remains strong and foreign economies are picking up. U.S. politicians are moving toward spending less money, a topic we have been discussing for years. Our Federal deficit will not be solved until we come to grips with Social Security, but we welcome every bit of progress we see, and we currently see progress on cutting spending. Some Congress people are now saying that they're seeing greater support for cutting spending than for lowering taxes. This sounds too good to be true, and we're skeptical; but we should get a good reading on the mood of the new Congress by monitoring it's actions over the next couple of months.

Trends: During most of 1994, the trend was toward a lower dollar and lower bond prices, which caused lower P/Es on stocks. The trends to a lower dollar and lower bond prices appear to have reversed in November. We believe the passage of GATT helps ratify a firming in the dollar. We believe that the decline in long-term rates when the Fed raised short-term rates in November signaled a turn in the bond market. We believe the absorption of the Orange County news by the bond market ratified the change in trend. We conclude that U.S. long-bonds are now compelling buys and that many stocks are even better buys.

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