QUARTERLY LETTER

Published First Quarter 2001
Muhlenkamp Memorandum 57

Be careful what you ask for!

Inflation remains under control.

The economy is slowing rapidly. For two years, professional economists have feared that the economy was growing too fast and would engender higher inflation (even though this theory was disproved 20 years ago). In response to these fears the Federal Reserve raised short-term interest rates from 4.75% to 6.50% in the period from mid-1999 through May 2000. The express purpose in raising rates was to slow the economy. They (and we) are now getting what they asked for.

The split in the stock market continues. One part, which we call the "hype" stocks, continues to dominate the media and public attention. Beginning with internet-based brokerage stocks in late 1998 a segment of the public discovered the "game of the stock market." Encouraged by Wall Street and the media, the focus of the game expanded to other Internet stocks, followed by telecom and biotech. By March 2000, the fad ran out of money and of new ideas – it has since collapsed. The plot of the NASDAQ in the chart below illustrates the ride.

Meanwhile, the rest of the market acted as it usually does when interest rates are rising. In 1999, more stocks were down than up, even though corporate earnings were strong.

In January 2000, long-term Treasury Rates peaked, and have since fallen from 6.7% to 5.4%. As rates have come down, many stocks are doing well, led by financials and homebuilders. This pattern is similar to that of 1994-1995 and to that of prior slowdowns.

Of interest, the last two increases in short-term rates by the Fed occurred after long-term Treasury Rates had already begun their decline, much as the Fed raised rates in February of 1995 after long-term rates peaked in November 1994.

Currently, the interesting question is whether the Fed is successful in engineering a soft landing and avoiding a hard landing or recession. The Greenspan Fed managed this feat in 1994-1995 after failing in 1990. We believe the Gulf War in 1990 damaged consumer confidence and turned a slowdown into a recession. We believe the uncertainty surrounding the Presidential election in 2000 damaged consumer confidence but not enough to give us a recession. Nevertheless, the question remains.

By lowering short-term rates by 1..% on January 3, 2001 the Fed signaled that it will do what it can to make the landing soft. We note that the Fed has ample room to lower rates further. Current short-term rates are well above their normal level relative to inflation. And the strength of the dollar eliminates it as a constraint on Fed policy.

Furthermore, the new administration is pushing for a meaningful cut in taxes which would help the economy. Some fear that the proposed $1.3 trillion cut over 10 years is too big, but it.s 1.. of the projected budget surplus and, relative to GDP, 1.. the Kennedy tax cut of the early 1960s.

So we.re expecting a soft landing, but recognize that it.s not yet
assured. We do think it.s a good time to buy selected stocks.