QUARTERLY LETTER
Published Third Quarter 1997
Muhlenkamp
Memorandum 43
A Bonanza Quarter
After providing the correction I asked for
on March 25, 1997, the markets went on an upward tear with
the DJIA and the S&P 500 gaining 17% for the quarter ending
in June. Several positive things happened:
- GDP growth was
stronger than expected.
- Inflation was less than expected.
- Corporate profits were stronger than
expected.
These factors allowed:
- Long-term interest rates to decline and
Treasury bond prices to gain 5%.
- Investors to anticipate (correctly)
that the Fed would not raise short-term rates in July.
- Stock prices to soar.
Normally, the next step is for the market
to digest its recent upward move. It can do this either by
moving sideways or by declining. The actual direction is likely
to depend on quarterly earnings that are now being reported.
Individual stock prices are likely to reflect individual company
earnings.
Meanwhile, the ongoing challenge to the
economic theory that "growth causes inflation",
which we've been relating to you for over a year, remains
front and center. We wrote earlier that the two economists,
whose arguments frame the opposing theories for us, had each
extended their time frames but had not yet changed their conclusions.
The first apparent change in conclusion occurred on July 3rd.
The chief economist at Morgan Stanley, Steve Roach, lowered
his inflation estimates for 1997 from 3.2% to 2.5% and for
1998 from 4% to 3.2%, respectively. He also lowered his targets
for long-term interest rates by 1/2%.
Mr. Roach has been adamant that GDP growth
greater than a 2 ½% annual rate must result in higher
inflation and interest rates. This is the first time (since
his predictions in early 1996) that he has lowered his inflation
projection. He did this despite GDP growth greater than his
expectations. Since 1997 is half over, he really had no choice.
On July 7th, he explained his rationale for the change. He
believes that his inflation projection was early. That the
time lag between growth and inflation is longer than he had
expected. Hence, no fundamental change in conclusion. The
debate continues!
Where do we stand?
We continue to believe that the long-term
and intermediate-term fundamentals are quite favorable. To
wit, inflation is not getting worse and the economy is expanding.
We believe that, on average, stocks are fairly priced. Therefore,
prices in the near term are likely to be quite volatile with
the market focusing on individual companies and stocks. There
is also the possibility of a rapid 10% market move - up or
down. Frankly, since we like the long-term, we would like
to see another 10% down move similar to the one in April,
but partly because it happened recently, we don't expect a
repeat. (That would be too easy - No, I cannot explain this
comment in rational terms.) Our experience shows us that big
moves (greater than 10%) have big reasons. We don't see a
reason for a down market move greater than 10%. We repeat
- We do expect high volatility.
We think the key to success in this market
is finding good companies at good prices. We are spending
our time and effort in this endeavor.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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