QUARTERLY LETTER
Published Third Quarter 2001
Muhlenkamp
Memorandum 59
The U.S. has reached that stage common to
all slowdowns/recessions when the negative economic effects
are quite apparent and the positive effects are not yet visible.
As often happens at this stage, we are seeing and hearing
from those who believe that (for reasons unique to this time
and circumstance) the U.S. economy will not rebound in the
usual fashion. We see no evidence that this is true. On the
contrary, the signs we see indicate a high probability that
the consumer is in good shape and will bring the economy back.
I have just re-read our past newsletters,
including those written during the 1990-1991 recession and
the 1995 slowdown. In doing so, I was reminded that in the
1970s I concluded that people had to live through four or
five recessions before they came to view recession as a normal,
non-threatening part of the business cycle. But since we’ve
had just one recession (1990-1991) in the past 19 years, a
large part of the investing public and the media have limited
experience with market actions through a recession.
So let’s start with some background. A slowdown/recession
is the primary risk to the economy over the intermediate timeframe.
Historically, that time frame was 3-5 years and was viewed
as the business cycle. (In our weather analogy, we call it
the seasons.) In the 1960s and 1970s, the cycle was regular
enough that the stock market ran in a four-year cycle (even
when the economy didn’t). I have since concluded that the
cycle was driven as much by politics as by economics, but
in investment matters, the fact is/was more important than
the cause.
As investors, our first concern is whether
a recession can evolve into a bigger problem such as a depression
or hyper-inflation (what we would call a "change in climate").
Milton Friedman maintains that a normal
1930 recession evolved into the Great Depression because we
in the U.S. did three things dramatically wrong:
- To protect our gold supply, we raised
interest rates.
- To balance our federal budget, we raised
taxes.
- To protect our manufacturers, we raised
tariffs.
When you think about what these actions did to the American
consumer, it’s no surprise that we suffered a depression.
Today, we are lowering interest rates and lowering taxes,
so we see no danger of a depression.
Inflation results from a too rapid growth
in the money supply. Currently, the Federal Reserve is not
allowing the money supply to grow fast enough to give us an
increase in inflation. Moreover, remember that the Fed raised
interest rates starting in 1999 for the express purpose of
slowing the economy to limit fears of inflation. They did
this because they, and we, view inflation as a greater risk
to prosperity than recession. I repeat, the Fed did this on
purpose. Today we see low probability of the risk of depression
or increased inflation. We also see a low probability of the
third big risk to the economy, which is war.
Conclusion: The big picture looks good.
Slowdowns/recessions also serve the economic
purpose of curbing prior excesses. In most recessions the
parts of the economy exhibiting the greatest decline are the
very parts that exhibited the greatest recent excesses. In
the current cycle, that area is investment in technology.
In the 1982 recession, it was investment in real estate.
We believe that the negatives this time
around are largely those of perception. The perception was
that the strength of consumer spending on technology was ever
upward. Wall Street and the media abetted this perception,
focusing on tech stocks and implying both a long-term trend
and imputing a greater importance to this sector than was
warranted economically. Again, the pattern was similar to
real estate in the late 1970s. If, in fact, computer and telecom
equipment are capital goods, we’d expect that they’d magnify
and lag the economy’s cyclical peak and decline. They are
doing just that.
There is a remaining risk. Our observation
has been that if people are going to change their minds about
spending and saving (thereby giving us a change in the investment
climate) they are most likely to do it in the middle of a
slowdown or recession. In the past, such a change in mindset
followed a lengthy period of time when their prior mindset
caused economic pain.
We see no signs of economic pain caused
by the public’s current mindset. And, in fact, those areas
of consumer spending which are normally most vulnerable to
a slowdown, housing and autos, have remained surprisingly
strong in the current slowdown. The fact that most consumers
are about to receive a tax refund/tax cut can only be a plus.
Conclusion
The intermediate picture looks like a "normal"
slowdown or recession. We won’t really know which until it
no longer matters in an investment sense. We are investing
your money (and ours) accordingly.
We do expect continued short-term market
volatility. We also expect continued declines in the remaining
overpriced tech stocks; these declines will be aided by tax-loss
selling beginning in a few months. We also expect the media
to continue to focus on these volatile stocks, allowing us
to make good money on the ones they’re ignoring.
Read our quarterly newsletter, Muhlenkamp
Memorandum, for more by Ron Muhlenkamp.
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