QUARTERLY LETTER

Published Fourth Quarter 2001
Muhlenkamp Memorandum 60

Commentary

It strikes me that the American people have just suffered a death in the "family." We’ve just come through a period of shock and mourning. During this time, our neighbors have taken up the slack, pitching in to support us both emotionally and physically, doing with us and for us the things that needed to be done to get us through a rough time.

Frankly, since leaving the farm 40 years ago, I didn’t expect to see that again. On a farm, animals and crops need to be tended on their own schedule, regardless of human troubles, including death and disability. So neighbors pitch in, tending the animals and the crops when a family is unable to do so. In suburbia, where I now live, physical support of a bereaved family is much less because the need is much less, usually limited to cooking food and possibly providing shelter. In the past few weeks, we’ve seen the entire U.S. act as one neighborhood. The response was immediate, voluntary and universal.

Suddenly, the things that concerned us a few weeks ago became irrelevant. The need to rescue our neighbors and support their families, both physically and emotionally, took precedence. It affected all of us.

When my wife, Connie, and I tuned into Jay Leno’s show on September 19th, he announced that he was going to start telling jokes again. Apparently, for a week, he didn’t feel like telling jokes. In truth, I don’t know, because we didn’t feel like watching. I’m told that David Letterman did a monologue that was highly patriotic. This from a comedian who built a career on comedy that is often (New York?) cynical. Both men are successful because they’re good at reflecting the mood of the American public. They’re just now easing their way back into the normal working pattern. I suspect the rest of the country will be easing its way back to normal working patterns, each of us on our own timetable.

So how does all of this get reflected in the investment markets?

Long–Term

The response of the American public to the mass murder of September 11th has been superb. The response of most of the world has been sympathetic. As a consequence, we continue to believe the long-term picture for the U.S. economy is positive.

Intermediate–Term

We believe the recent events will turn the slowdown in the U.S. economy into a recession. We also believe the bottom, which we thought in early September had been reached, is now delayed by a few months. If asked for a pattern, we could use the Gulf War of 1990-91, which we believe turned a "soft landing" into a recession. One difference is the fear built up gradually in 1990-91 as war became more and more likely.

The fear then dissipated quickly. (The market recovered during the air war, before the ground war ever started.) This time, the worst news was concentrated in a of couple hours. We expect the psychological recovery to be gradual. We do expect interest rates to continue to decline, probably allowing many homeowners to refinance their mortgages, thereby lowering their monthly payments and increasing their disposable income.

In the 1960s and 1970s, I came to consider recession as a normal part of the business cycle. I learned that the media always played up the negative news and the fears of another depression. But I also observed that people acted in ways that made recession self-correcting. Partly from the fear of layoffs, people worked harder, spent less and saved more. For the 2-5% of the working population that lost their jobs, building up savings was necessary. However, after four to six months of increased savings, the 90-95% of people who didn’t get laid off resumed their normal patterns of spending. We expect that this recession will self-correct in a similar manner.

Short–Term

The Federal Reserve is providing liquidity to the system as promised. I believe it was necessary to close the markets temporarily. As a result, the bond markets were closed for two days – the stock market for four days. I believe it was necessary to open the markets on the 17th. After all, many people periodically convert (sell) some of their invested assets to spending money on a regular basis. At Muhlenkamp, we send funds to many of our investors for this purpose, typically on the 1st and/or the 15th of the month. Partly for this reason, we expected the stock market to decline for the first few days after it opened. Also because we knew that some companies, including insurance companies, would need to raise funds.

As the week progressed, we observed several interesting patterns: In the first couple days, we saw a move toward large, name brand stocks which many commentators label a flight to quality. (We call it a flight to security blankets.) Later, these stocks also declined.

Despite large volumes traded in the large institutional stocks, there wasn’t much depth (ability to trade large volume without sizeable price changes) in most stocks. I’ve been told there wasn’t much depth in the bond markets either. This included the Treasury market, normally the most liquid (and the deepest) market in the world. The loss of 700 employees of Cantor Fitzgerald, the largest bond-trading firm in the world, most likely had an effect. In conversation with traders, some sounded like their normal aggressive selves, others, particularly in the New York City area, told me their "heart isn’t in it." I suspect that the loss of traders and of heart by those remaining had a major effect on the depth of the market. So we had selling by those who needed to raise cash, selling by those who were fearful, and most likely, selling by some who trade on short-term momentum.

We did see an interesting pattern among our investors. In the first few days of market activity, our direct shareholders bought more shares. Our indirect shareholders, those who work through a broker or financial planners, redeemed shares for the first six days. Since then, they too have bought more shares.

Market action over the first several days indicated that financial professionals were seeking security blankets much more than the public is. This may be because financial professionals were more likely to have known people who were trapped in the WTC than the public.

Unlike selling, buying usually requires a measure of hope and/or confidence. But even confident buyers are in no hurry when it looks like prices will be lower tomorrow. This is true at any auction, not just for stocks. So, the value buyers waited until their stocks were truly irresistible as they were at month-end.

I learned a long time ago that when prices are irresistible, quit resisting and buy. While another "shoe" can always drop, it would be pretty hard for it to be more painful than the one of September 11th.

In summary, we think the mass murders of September 11th made the slowdown/recession deeper and longer, so that the proper strategy today is similar to the one of six to nine months ago. That strategy is to invest in those companies that will benefit from lower interest rates and from the rebound in the U.S. economy. We are following that strategy.

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