QUARTERLY LETTER

Published Second Quarter 2001
Muhlenkamp Memorandum 58

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. It will take some time for investors to sort through the rubble of the once-hot stocks, making this a very tricky part of the market.

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 5.5%. 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.

We are beginning to see signs that consumer confidence and spending are stabilizing. Consumer confidence recently up-ticked after declining for five straight months. Housing orders and housing stocks remain healthy. Auto sales seem to be leveling off after declining. We will continue to monitor this data along with retail sales to track the mood and actions of the consumer. By contrast, as of yet we see no signs of stability in business confidence or business spending on capital goods, high-tech or otherwise. We continue to see no signs that inflation is a problem.

By lowering short-term rates by 2% in four steps since January 3, 2001 the Fed signaled that it would 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 $1.6 trillion cut over 10 years is too big, but it’s ¼ of the projected budget surplus and, relative to GDP, ½ the Kennedy tax cut of the early 1960s. The only real economic negative we see going forward is Congressional reluctance to pass Bush’s proposed tax cut. The argument we made in Issue #56 (on the website at: www.muhlenkamp.com) remains valid. At current tax rates, many workers are ambivalent about incremental production. The Senate which is fond of calling itself the "World’s Greatest Deliberative Body," is reluctant to let U.S. taxpayers keep more of our money. They insist that government spending must grow faster than the economy. Discretionary domestic expenditures grew by 6% in 1998, 11% in 1999 and nearly 8% in 2000, well over inflation and GDP growth. (Folks, putting Congress in charge of the Federal Budget is like putting teenagers in charge of the family budget. It results in higher spending because no thought is given to where the money comes from.)

Meanwhile, the Senate has acted quickly to pass laws helping incumbents "Campaign Finance Reform" rapidly morphed into further incumbent protection. Folks, the battle is not between Republicans and Democrats, it’s between incumbent politicians and taxpayers. The interesting thing is that our politicians will do exactly what we tell them to do. If half the people who receive this newsletter call their Representatives and Senators and tell them to pass Bush’s tax cut – it will happen. The phone number for the Congressional switchboard is 202-223-3121. The website is: www.house.gov or www.senate.gov.

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. By the time the above economic and political questions are answered, we expect most stock prices to be significantly higher.

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