QUARTERLY LETTER
Published Third Quarter 1995
Muhlenkamp
Memorandum 35
Six months ago, in Muhlenkamp
Memorandum #33, we wrote, "We are looking at
a 20% off sale." Since year-end bond prices have moved
up 16% and stock prices have moved up over 20%. Prices are
now back to fair values. The sale is over. Long-term Treasury
interest rates have historically equaled inflation plus 2.5-3.0%.
Inflation is currently about 3%. So at current interest rates
of 6.6%, the bond market is now close to fair value. Stock
prices and P/E's are back to levels, which imply returns of
8-9%, which also match the historic returns of 5-6% over inflation.
So we judge current stock prices to be fair. And since we
prefer stock returns of 8-9% to bond returns of 6.6%, we currently
prefer stocks to bonds, but with last winter's sale now over,
both markets are likely to be more volatile.
Going forward, we expect it to be a stock
pickers market and we are spending our time picking stocks.
We also find it interesting that, for at least the past 25
years, one of the best signals to buy stocks has been to do
so when the Fed lowered short-term interest rates. (That's
why Marty Zweig says, "Don't fight the Fed!") The
Fed lowered interest rates in the first week of July. For
many market timers, this should have signaled the beginning
of a bull market.
Meanwhile, other background factors continue
to improve. Domestically the odds of the Fed achieving a "soft
landing" are looking better all the time. The US will
not solve its deficit problems until it comes to grips with
Social Security, but a reduction in government spending is
an improvement and, despite their differing agendas, the President
and the Congress seem to be driving toward a reduction in
government spending. Internationally, Bosnia remains a mess,
but it's a known mess. Russia could still implode but each
month or quarter that goes by allows her former satellites
to progress toward free economies and democratic governments.
Mexico seems to be improving after serving as a warning to
other emerging countries that relying on international money
flows is a risky business.
We do have two major concerns. One is Japan,
where the economic situation is not unlike the U.S. in the
early '30's. There is still potential for Japan to trigger
a worldwide depression (which makes this a particularly foolish
time to bash Japan on trade). Should this happen, there would
be few safe harbors for our investments. We view the odds
of Japan imploding as fairly low, but the consequences are
dire enough that it must be monitored.
Our second "concern" is that the
undervalued dollar will appreciate, driving down the dollar
value of foreign investment. Fortunately, we can avoid this
risk by avoiding foreign investments.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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