QUARTERLY LETTER

Published Second Quarter 1997
Muhlenkamp Memorandum 42

Be Careful What You Ask For!!!

In an interview on CNNfn on March 25, I remarked that I was hoping for a market correction. When asked, "How much?" I replied, "Another 10% would be good." So far, we are getting the correction I asked for. The question now is whether or not we get more than I requested.

The reason I was hoping for a correction is two-fold. The narrow reason is that people have been sending us money - and we like to buy stocks cheaply. The broad reason is that we had a very strong move in prices since mid-1996, so that by year-end, most stocks were fully priced. Further strength in January and February made them somewhat overpriced and subject to a correction. Some technology stocks looked particularly vulnerable, but we also expected price corrections in financial stocks and consumer non-durables as well. Note: we believe those stocks which have done the best over the recent past were most susceptible to price corrections. This is normal, necessary and healthy. It keeps the "Game of the Stock Market" from getting too far removed from the "Business of Investing". The "Business of Investing" is the discipline that ties stock and bond prices to the underlying business and the economic fundamentals, including Gross Domestic Product (GDP) and inflation. The “Game of the Stock Market” is the hyped hope and fear which you see in the popular media every day.

In February we took a hard look at everything we own. Our standard was based on what we knew then and what we expected in first quarter results of the companies we own. Our discipline was, “If the price drops 15%, will we wish we had sold or would we buy more?” If we’d wished we’d sold, we then sold. You will note that we didn’t sell much. If we wanted to buy more, we held and hoped to buy more at cheaper prices. Prices are now cheaper.

This discipline should temper our decline in a correction but is not designed to neutralize it. Frankly, we don’t always get corrections when we want them. So, we limit the dollars we bet on short-term moves. As long as the long-term and intermediate-term fundamentals are favorable (as they are), we are willing to live through short-term psychological corrections. We choose this because we find the long and intermediate term disciplines more reliable than short-term market timing. Of course, corrections can get out of hand. The same “momentum players” who like to drive high prices higher also like to drive low prices lower. In our judgment, the current price correction has been healthy – so far.

The trigger for the price correction in bonds and in stocks was the U.S. Federal Reserve’s action in raising short-term interest rates on March 25, 1997 from 5 ¼ to 5 ½ .

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