QUARTERLY LETTER

Published Fourth Quarter 1996
Muhlenkamp Memorandum 40

The investment markets in 1996 continue to evolve in a beautiful fashion. Near mid-year we became a bit cautious because the market appeared vulnerable to a correction triggered either by bond prices or by a broadening of the correction in high-tech stocks. Since then, both have occurred. Frankly, we would have preferred a bigger correction, particularly in the high-tech area, but we have no complaints. Meanwhile, the real key in 1996 has been stock selection- and we have done very well.

The next likely trigger for a broad market move will be the presidential election, and/or the debate in economic theory, which was briefly mentioned in the last two newsletters (38, 39). This debate is now front and center for the stock and bond markets. The debate is, "Does Economic Growth Cause Inflation?" Keynesian economic theory says growth causes inflation. Classical economic theory says that only the printing of money causes inflation. If you took economic courses 30 - 40 years ago, the odds are very high that you were taught the Keynesian theory (that growth causes inflation). I took these courses and that is what I was taught (I'm 52). Most of the people who are now "chief economists" were also taught this theory. Economic history of the last 30 years has proven that growth doesn't cause inflation. Specifically, the changes in policy by Paul Volcker and Ronald Reagan in 1979-1982 proved that money growth, not GDP (Gross Domestic Product) growth, causes inflation. But the evidence has not caused many economists to change their minds.

More recent refinement of the theory states that growth greater than 2 1/2% will result in increased inflation after a time lag of about 18 months. We have now had GDP growth exceeding 2 1/2% for 18 months (which is why the issue is now front and center). So the Keynesians have been expecting increased inflation, starting just about now, and have predicted higher interest rates as a result. Specifically, Morgan Stanley's chief economist has been predicting long-term U.S. Treasury Rates of 8 1/2% by year-end 1997.

Conversely, at Donaldson, Lufkin and Jenrette, their chief economist (based partly on a belief that growth doesn't cause inflation and partly on his forecast of a recession in 1997) is predicting long-term Treasury Rates of 4 1/2% by year-end 1997. Folks, that is a huge difference! If rates go to 8 1/2%, a 6% 30-year Treasury which was priced at $1,000 on 12/31/95 would be priced at $740 at year-end 1997. If rates go to 4 1/2%, the same 30-year Treasury would be priced at $1,230. Similarly, the S&P 500, which was priced at 620 on 12/31/95, would be likely to sink to 550, or soar to 850 by year-end 1997. So the outcome is far more than academic.

An interesting sidebar is that these predictions were both made in early 1996 with a horizon of nearly two years. Two years is a short time in economics but a long time in the stock and bond markets. Two years is ample time for the markets to swing one way based on hope or fear, and then to swing the other way based on reality.

During the first half of 1996, the yield on long-term Treasuries rose from 6% to 7 1/4%. The price fell from $1000 to $850. We believe this move was based on a fear of inflation in concert with the Keynesian Theory. Evidence for this includes a 2% drop in bond prices and in stock prices on July 5th, when the government reported GDP growth for the second quarter of 4.6%.

Through the first nine months of 1996, the reported economic numbers have been mixed enough that neither economist saw a need to change his forecast - until now. The first change occurred on October 4, when in response to lower employment numbers (and an up tick in the unemployment rate), the economist at Morgan Stanley shifted his GDP growth prediction to 2% in the third quarter and 4% in the fourth quarter (from 3% in each quarter) and lowered his interest rate ranges for 1996 from 8%+ to 7 1/4%+. That day, the bond market jumped over 1% and the stock market rose 1%. The numbers for the remaining months of 1996 will be key to determining which theory is accepted. We believe the classical theory (growth does not cause inflation) will be affirmed once again, that interest rates will decline, and that the stock market will do well with a focus on individual stocks - stay tuned.

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