QUARTERLY LETTER
Published Second Quarter 1999
Muhlenkamp
Memorandum 50
In the first quarter of 1999, the market
continued to display a split personality. Two groups were
strong - big "security blanket" institutional favorites
and Internet stocks. This is an interesting pair - the former
are viewed as "safe" stocks and the latter are viewed
as speculative. Our holdings have not kept pace with these
two groups and some of you have asked why. We believe a number
of factors, some economic and some psychological, have come
together to bring us to this point. More importantly, we think
the psychological factors have run their course and a shift
is now occurring. In fact, market psychology seems to be shifting
in the third week of April (between draft 1 and draft 2 of
this letter). The accompanying graph explains much of this
split personality. The graph compares consumer confidence
to business confidence over the last four years. The scales
are different, but they are nearly proportional. Notice that
the two lines tracked together until mid- 1997 when the problems
in Far East Asia hit the news. At that point, business confidence
fell, but consumer confidence continued to rise. In early
1998 business confidence leveled off, only to fall again when
Russia defaulted in August 1998 and the bond and stock markets
declined. Overall, business confidence fell by nearly one-third
and has just begun to recover. Consumer confidence also fell
when the markets declined in 1998, but only by 10% and has
since recovered two-thirds of its fall.
We believe that:
- As the problems in the Far East hit the
news, followed by declines in the price of world traded
commodities (oil, grain, steel, paper, and chemicals); confidence
fell among businessmen in the affected industries. It also
created a lot of uncertainty in industries not directly
affected by the trouble in Asia.
- When the markets fell in August and October
1998, business confidence fell again. If you recall the
headlines of last fall, many people said that the market
declines predicted a recession in the United States. We
believe this fear of imminent recession is portrayed in
the graph of business confidence. In talking to businessmen
since last fall, we've received two responses. Those who
sell to other businesses report a fall off in sales, as
businesses limited their purchases. Those businessmen who
sell to the public report, "Our business is fine, but
others must be hurting." When we ask why they believe
that others must be hurting, their response is some form
of, "The market is down."
We believe that the confidence of institutional investors
tracks business confidence more closely than consumer confidence,
partly because both get input from the same financial press.
Over the years we've observed that when
investors get nervous, they retreat to investments in which
they feel safe. Bond investors retreat to Treasury Bonds;
stock investors retreat to large stocks. This resulted in
the "Nifty 50" in 1972 and the "Security Blanket
30" in 1998. The effect in the bond market is to open
wide gaps in the yields available in low quality bonds versus
treasuries. The effect in the stock market is to open wide
gaps in value between smaller or more volatile stocks versus
the favored few. We see these gaps today, but we expect these
gaps to close. If inflation were to rise and GDP to fall,
as they did after 1972, we would expect treasury bonds and
security blanket stocks to fall as they did after 1972. We
don't expect that to happen, because we expect inflation to
remain contained and GDP to grow. We expect most of the current
gap to be closed by the lower tier moving up. We also expect
the security blankets to lose their premiums. Some will lose
their premiums gradually; others will lose their premiums
suddenly.
Also, we've observed that when people get
fearful, they can sustain that fear for a period of about
six to nine months. If the fear is not realized in that time,
it gradually dissipates. The fear of an imminent recession
based on the stock market decline is about six months old,
so we expect this fear to dissipate starting right about now.
This expectation is buttressed by our reading
of the current business cycle. For the past five years, discussions
with Wall Street analysts invariably began with the statement,
"At this point in the business cycle," the assumption
being that the long expansion had to soon end in a recession.
This attitude was so pervasive that we spent a fair amount
of time thinking about a non-cycle cycle. Most of the U.S.
economy has had a non-cycle cycle. But we have just witnessed
a recession on the international scene, and the familiar pattern
applies: the financial market(s) falls, the economy(s) goes
into recession, and the central bank(s) lowers interest rates.
True-to-form, economists are now upping their forecast of
1999 GDP both in the U.S. and internationally. In the past
two months, analysts in the industries which we call international
cyclicals (oil, steel, aper, chemicals, and farm equipment)
are issuing buy recommendations, some of them for the first
time in five years.
Conclusion - if you want to play the business
cycle, we've just begun a new cycle. Not coincidentally, Japan
just lowered its income tax rates, which, we believe is the
most useful thing they could do to help their moribund economy.
In contrast to business confidence, consumer
confidence has remained high except for a brief dip when the
markets fell in the fall of 1998. The American consumer is
doing well. Anyone who wants a job can get one, and anyone
who wants a better job can move up. Throughout the period
of falling business confidence, consumer confidence held up
as did auto, housing and retail sales.
We think high consumer confidence is one
reason the Internet stocks are doing so well. The public is
latching on to the Internet phenomena, opening on-line brokerage
accounts and buying Internet stocks. They are bidding up the
prices of many Internet companies that have no current earnings
and no foreseeable earnings. This is purely speculative, and
people speculate when they have disposable dollars and high
confidence that the future will be good. We have people telling
us that value investing is dead and we need to buy more technology
and internet stocks, no matter the price. Whatever the public
wants, Wall Street will gladly sell them. Today a "dot
com" after your company's name will cause the public
to bid up your stock price. A few years ago, the fad was iotech
stocks and international mutual funds. Prior to that it was
gold coins, REITs and limited partnerships. This will continue
until the fad loses its luster and people start losing money.
The Internet is a great tool for empowering
the consumer and for enabling businesses to lower costs, but
we're not sure how many of these Internet companies will survive
or make money. In an April 19, 1999 Wall Street Journal
editorial (page A22), Wharton School professor Jeremy Siegel
sums up the dilemma of internet companies, "The secret
of the Web is the very bane of profitable selling - the ability
to switch in an instant to a merchandiser with a cheaper price."
In the long run, it takes profits to sustain high P/E's and
stock prices.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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