QUARTERLY LETTER

Published Third Quarter 1996
Muhlenkamp Memorandum 39

At year-end, we wrote, "Stock and bond prices are fair, the long and intermediate trends are positive, and the short-term trends are neutral." The price actions of various markets since then have diverged widely.

In early 1996, stock prices moved up 8-10%, giving us an equivalent of twelve months of returns in five months. In this same time period, bond prices moved down 10%. Our judgment in late June was that this stock-bond spread was as wide as it was likely to get. (Some dividend discount models, which showed stocks fairly priced relative to bonds at year-end, showed stocks overpriced relative to bonds by 30% in late June.) This made stock prices vulnerable to any continued weakness or any accident in the bond market.

Our readers know that we believe prices in any market can swing plus or minus 10% at any time for any reason. Moves within a 10% range are psychological "noise". We believe the recent decline in bond prices has been mostly "noise", abetted by fears of increased inflation. These fears are aided by some economists who are predicting higher inflation and higher interest rates. Specifically, the chief economist of Morgan Stanley is predicting treasury rates as high as 8-½% by year-end 1997. While we don't (yet) believe this prediction, we must respect the possibility (and the author). The real point today is that with bond prices already down 10%, any bond market "accident" could trigger another 10% decline, whether the fundamentals justify it or not. In 1994, the Orange County bankruptcy was such an accident. While we think such an accident is less likely to happen today (largely because a big one happened just two years ago), the nature of accidents is such that they are hard to predict. To sum the above in one sentence - the price moves of the stock and bond markets since year-end have made stocks vulnerable to any further decline in bond prices. The 2% price declines in the bond and stock markets, in response to the strong results in employment numbers released on July 5th, demonstrated this thought process and the resulting vulnerability.

Meanwhile, on a short-term basis, stock prices were widely dispersed around the 8-10% gain in the averages. Recent focus on small capitalization and technology stocks has highlighted a speculative bent in the marketplace. This was reinforced by the recent tendency to consider a move of a few weeks duration as a trend and a counter move of a few days as a correction. Our judgment was that a correction that dampened these speculative juices would be the best thing that could happen, and since early June, we have been witnessing such a correction. The problem is that such corrections seldom confine themselves to the areas of concern- they often spread to the rest of the market. If we are about to get a broader based correction, the current weakness in the high-tech stocks, aided by weakness in the bond market such as occurred on July 5th, should trigger it.

The above was written in the first week of July. Since then, the correction in high tech stocks spread to the broader market, and appears to have climaxed on July16th. We believe the correction in high tech stocks was necessary, and a positive development. In fact, we judge the price action of the past month as nearly ideal. (To be truly ideal would require that our stocks go up while all others go down.)

We still judge the long-term and intermediate-term trends to be positive, but prices are full enough, and short-term trends are "dicey" enough, that we became more nervous than we have been for some time. Consequently, we culled out some holdings and accumulated some cash. Since July 17th, we've been buying selectively. However, we want to see a few more weeks of market response before we are willing to say the correction is over.

The bigger question is one of economic theory. Most of the people who are now "chief economist" in various places (including Morgan Stanley) studied economics 30-40 years ago. Most of them were taught that growth causes inflation, and consequently fear that good growth in the current economy will cause higher inflation and higher interest rates. We believe the U.S. experience of the past 30 years has proved that growth does not cause inflation. The chief economist at Donaldson Lufkin and Jenrette, based partly on a similar belief, is predicting long-term treasury rates of 4-½% by year-end 1997. This is opposite of the prediction of Morgan Stanley. Strange as it may seem, both economists could be right. Financial markets are people, and eighteen months is ample time to reflect first the fears of higher inflation rates and then the (possible) reality of lower inflation rates. It is these conflicting prospects that make the current markets so "interesting".

Meanwhile, of course, other concerns that we have been monitoring remain active. So far, our troops in Bosnia remain unwounded, but the bombing in Saudi Arabia marks their vulnerability. The election results in Russia indicate continuing progress towards a freer people and freer markets in that country, albeit often in fits and starts.

Current politics in this country remain more theater than policy, and soap opera theater at that. Two of the more interesting presidential election results in recent history were Carter over Ford in 1976 and Clinton over Bush in 1992. In each of these elections, I believe, the American people chose an unknown promise over a known, dull quantity. Clinton' s problem in 1996 is that he' s now a known promise, facing a known, dull Dole. The only argument I have heard for re-electing Clinton is that "things are pretty good, why change them." I would respond that things are pretty good largely because Clinton failed in his agenda. The only thing Bill Clinton has accomplished so far is to make Richard Nixon look honest by comparison.

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