QUARTERLY LETTER

Published Fourth Quarter 1997
Muhlenkamp Memorandum 44

Another Great Quarter — Selectively

The Third Quarter was marked by volatility in stock prices. The market did correct - selectively. The DJIA corrected 8%, peak to trough, before finishing the quarter up 3.5%. The S&P 500 corrected 7%, peak to trough, before finishing the quarter up 7%. We corrected 3%, peak to trough, before finishing the quarter up 14%. Thus, those who expected lower prices were teased, only to be frustrated once again.

Economically, the growth in Gross Domestic Product (GDP) continues, as does the gradual decline in inflation. This growth without inflation is frustrating to Keynesian economists who believe that growth, at current levels, necessarily causes increased inflation. These are the same economists who, using the same theory, were unable to explain the high inflation and low GDP growth "stagflation" of the late 1970's. Some of these economists are now saying that current conditions are inexplicable, while others are saying that increased inflation is merely delayed longer than they had expected. To date, I haven't seen evidence that these economists are willing to question their basic economic theory.

Meanwhile, Dick Hokenson, Chief Economist at Donaldson, Lufkin and Jenrette, who had been predicting a recession in late 1997, rescinded his forecast in mid-August. He is now forecasting "positive but more moderate real growth."

Where do we stand? - where we stood three months ago. We continue to believe the long-term and the intermediate term fundamentals are quite favorable. To wit, inflation is not getting worse and the economy is expanding. We believe stocks are fairly priced. Companies continue to add value at an 8-10% annual rate. We are confident that shareholders will realize that 8-10% over time. In the near term, however, prices are likely to continue to be quite volatile with the focus on individual companies and stocks. We call this a period of digestion. To date, the current digestion of the prior strong upward move has been appropriate; but we suspect it's not over yet. A friend said he thought the period was more like indigestion, but I suspect that his "mental picture" of normal digestion is less messy than mine. We still don't see a reason for a market down move greater than 10%; however, we do continue to expect high volatility. We think the key to success in this market is in finding good companies at reasonable prices. We are spending our time and effort in this endeavor.

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