QUARTERLY LETTER

Published Fourth Quarter 1998
Muhlenkamp Memorandum 48

The Third Quarter of 1998 was brutal. So far this year, U. S. economic fundamentals, (Gross Domestic Product growth, inflation, and interest rates) have matched our expectations. Despite this, the market's actions over the past three months have focused on investors' fears and, at times, have approached a self-feeding panic. We think it is way overdone.

Since April, there have been three down legs in the equity markets. The first one we expected. It was simply a 10% correction.

The second leg occurred when several pieces of bad news hit at the same time. Clinton's testimony before the grand jury shouldn't have surprised anyone, but it may have produced a negative effect, particularly on foreign investors. The terrorist attacks against the United States were a surprise, but only in a narrow sense. The third part was Russia imploding and defaulting on its debts. Again, this didn't surprise us; we had been expecting it for years. But Russia's problems commanded headlines and an emotional response out of proportion to their economic impact. Maybe it's because most of us were raised on a fear of Russia. At any rate, all this news hitting in a short period of time caused stocks to decline and continue to decline as momentum players kept selling.

The third down leg occurred more recently when a sizeable hedge fund, with blue-chip people running it, flirted with bankruptcy. That surprised a lot of people, including us. It also rattled the financial markets. The banks that loaned the hedge fund money bailed it out instead of letting it go bankrupt. Since then, the banks are enforcing their margin calls on other hedge funds (there are a lot of hedge funds) forcing them to sell securities. Some people who are in a position to monitor these funds expect half of them to go out of business. Bank loans to hedge funds are short-term loans; they don't have 20 or 30 years to pay them back. So margin calls result in immediate sales, regardless of price.

This results in continued momentum selling by professionals, and panic selling by the public. Many people are selling for emotional, not economic, reasons. In some cases, they know it's a mistake but can't stand the pain. Again, they're selling regardless of price.

Where are we today?

There are two main questions yet to be answered:

1. Is there another big surprise that could hit the markets?
   Yes, always.
   
2. Having changed their investing patterns; will people change their spending patterns?
   Changes in spending affect the economy. We saw it happen in 1990 with the Gulf War. However, it did not happen in 1987 or 1994 when we had market declines without economic declines. At this point, the economy is still doing well. Six months ago, the Fed wanted a slow-down in the economy. Today, investors fear a slow-down in the economy. The only difference between six months ago and today is that stock prices are down. The jury is still out as to whether a decline in the stock market will drive a decline in the economy.

In the past month, we heard from Dr. Milton Friedman and Dr. James Tobin, both Nobel Prize winning economists. Milton Friedman probably knows more about the Great Depression than anybody living today. Dr. Tobin was an economist for the Kennedy administration. Dr. Friedman said that the odds of a worldwide economic depression are trivial, while Dr. Tobin said the odds are quite small. We believe that problems and perceptions have to get pretty bad for governments to change. You have to go through a certain amount of pain just to get government attention. But national governments are beginning to respond. Japan has just passed meaningful legislation and our federal government has now lowered interest rates by a quarter of a point, twice. Both are responding to the slow-down instead of worrying about inflation (the reverse of three months ago). We believe there has been enough pain inflicted, and it has scared enough people that further actions will be taken by government bodies. Unless an additional major problem hits the fan, it is a great time to invest. We still have 10-20% of our assets in cash and Treasury bonds. We are starting to put that money back to work in stocks, because we are seeing some great companies at very cheap prices. We do believe that there will be continued selling through the end of the year for tax-loss purposes. We don't think we have to be in a big hurry, but it is a time to do our homework and prepare to buy the values we see.

If you wonder about the wisdom of what we are doing, or have trouble sleeping at night, we suggest that you take a close look at the companies whose stock we own. Think of them as businesses, not pieces of paper; review their balance sheets, their income statements, and their cash flow statements, then determine whether you're comfortable investing in these companies at the current prices. And remember that our money is invested in these companies right along with yours.

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