QUARTERLY LETTER

Published Fourth Quarter 1999
Muhlenkamp Memorandum 52

The Third Quarter of 1999 was brutal. The rationalization process, which we have been describing for a year, is taking longer than we expected. In our Second Quarter Newsletter (Issue #50). we described the "split personality" of the market since the fall of 1998. And explained why (we believe) it happened. We printed a plot of the split between consumer confidence and business confidence. We stated that the split reflected the fear of recession by businessmen (and by institutional investors) based on projections by economists and broadcast by the media.

We said that we expected GDP to grow (no recession) and the fears of recession to dissipate starting right about then. (The updated chart of confidence levels illustrates the point.) That part we got right. In April, it became quite apparent that the U.S. was not entering a recession and top name cyclical stocks soared. Alcoa, Caterpillar, Dupont,Goodyear, International Paper and 3M were each up over 20% in the month of April alone. Meanwhile, since April a number of "security blankets" have lost much of their premiums. Abbott Labs, American Home Products, Clorox, Coca Cola, Disney, Gillette and Pfizer are each down 30%. Since April, many of the Internet stocks have lost 30-50% of their April prices, including America-On-Line, Amazon, Ameritrade, E-Bay, E-Trade and Mind-Spring.

So we opened our July letter with, "It's working folks. The things we wrote about in April are happening...." We still believe that is true, but the statement was premature. The economy continues to expand at a healthy rate and the data indicate that inflation is under control. But the reality has not yet alleviated the fear of inflation. We find it interesting that the stock market bears have been able to keep their fear, despite a reversal of the cause from "too little" growth to "too much" growth. The abiding fear is that too much growth causes inflation, even though Reagan and Volcker disproved this theory twenty years ago.

Nevertheless, for six months, we have been dealing with the fear of rising inflation despite very little data to support it. My observation remains that people can hold a fear for six to nine months. Unless confirmed by data, the fear then dissipates. We expect the fear to dissipate between now and year-end. We find it interesting that long-term Treasury Bonds, which should be the best market barometer of inflation fears, bottomed in late June, in early August, in mid-September, and again in October; each time at yields of 6.1 - 6.4%. Another reason we expect volatile unsettled markets through year-end is the normal year-end tax-selling and tax-swapping activity in the marketplace.

Part of our frustration is due to the fact that we have been right in our assessment of the economy. Furthermore, most of our companies are meeting our expectations and a number of "security blanket" stocks have lost part of their premiums. Further still, a number of our stocks have been bought, usually for cash, by competition or by management. Many of our companies are buying in their own stock. So businessmen are seeing the same values in our companies that we are.

We have updated our table from April on our top holdings. Since April, the only difference is that our P/Es are lower now than they were then. So the values are even greater, but so far, the public investors are not interested. The public is playing a "momentum" game focusing on those stocks that have had the greatest price move lately. But the rotation among groups is rapid and the declines can be as dramatic as the advances. In April, the top group was Internet stocks, many of which have lost 30-50% since then. Today, the top groups are media and telecoms that, like the Internet stocks, are being bid up on the basis of hope for future profitability. Not all of these hopes can be realized. Even those companies who win the battle for the customer will be unlikely to earn enough profit or cash flow to justify current prices. This is why we don't own them. Instead, we own companies that demonstrate good profitability today, and whose stocks are modestly priced based on their current profitability. Over the years we have found this a much more reliable way to earn good returns. Today we're finding more values and better values than we've found at any time since late 1994. Our expectation is that other investors will begin looking for these values as their fear of rising inflation dissipates between now and year-end.

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