QUARTERLY LETTER

Published First Quarter 2002
Muhlenkamp Memorandum 61

In our quarterly letters to you over the past three years (available on our website at www.muhlenkamp.com), we have spelled out our thoughts on the evolving economic and market pictures.

In 1999, the U.S. Federal Reserve Board (the Fed) began raising interest rates. It did so because many economists feared that continued economic growth would re-ignite inflation (even though this theory was disproved by Paul Volcker and Ronald Reagan twenty years ago).

The Fed’s goal was a slowdown and "soft-landing" in the economy much like it engineered in 1994-95. Instead, partly for reasons beyond Fed control, we are in a recession much like the one of 1990-91. This is our tenth recession since WWII. Each of these recessions had been triggered by the Fed raising interest rates, usually for the purpose of combating inflation or the fear of inflation.

We used to expect a recession every 3-5 years as a normal part of the business cycle. I entered the investment business in 1968. By the mid-1970s, I concluded that recessions were inherently self-correcting. In a recession, the typical wage earner works a little harder, saves a little more, and spends a little less. After a few months, when she no longer fears losing her job (though 2-3% of workers have lost theirs), she will have improved her financial position and gradually resume her normal spending pattern. But the fact that recessions are inherently self-correcting, doesn’t mean they are always self-correcting. In 1930, our government’s response to recession was to raise interest rates, raise taxes and raise tariffs, giving us a depression. In the late 1960’s, our government’s response was to print money, giving us inflation. Inflation encourages people to spend more, save less and to speculate, making the problem worse. Inflation is not inherently self-correcting. It took a change in government policies to reverse the trend.

Knowing this history, when the Fed sets out to slow the U.S. economy, we always look for signs or actions that would turn a normal cyclical recession into depression or inflation. As we reported in July, we see few signs of either at this time.

We did mention in July that war could have a dramatic effect on this U.S. economy, but we viewed war as unlikely. Obviously, September 11 proved us to be wrong. But we have learned some things since September 11. The direct effects of September 11 have lengthened and deepened the slowdown, ensuring a recession. For a period of time, measured in days to a few weeks for most of us, discretionary economic spending was unimportant. "Our heart simply wasn’t in it." But when the auto companies offered 0% financing, many consumers responded by buying new cars.

Putting these observations together, our best description is that on September 11 most Americans suffered a "death in the family" resulting in a temporary pause in economic activity, but not necessarily a change in the normal pattern of spending habits.

Further complicating the current economic/market cycle has been the public discovery of, and fascination with, the "game of the stock market." This fascination began in mid-1998, and after three years, many of the hyped stock prices are back to where they started. The nearby plot illustrates the round trip of the fad. What remains to be seen is whether the public maintains its fascination with the stock market, either with the same stocks or with new ones.

An additional fear for some people is that the U.S. could go the way of Japan. Most of you know that the Japanese economy has been stagnant for a decade. Folks, we already went the way of Japan; we did it in the 1970s. Our economy was stagnant in the 1970s. The difference was we also had high inflation, which Japan does not.

For a decade the Japanese have been trying to jump start their economy with increased government spending by building more roads, bridges and airports. We tried a similar approach in the 1970s based on economic theories I was taught in the 1960s. Increased government spending didn’t work for us in the 1970s, and it hasn’t worked for Japan in the 1990s.

Last spring, I had a chance to meet with several economic leaders from Japan representing business and government. They wanted to know how Japan could duplicate the U.S. success in information technology and venture capital. One of them asked, “How can we get grandma to pull her money out of her Post Office Savings Accounts (paying ½% interest) and put it into venture capital?” I replied, “My God, you don’t want to. Grandma has no business in venture capital. What you might get grandma to do is the same thing that my grandma was willing to do, lend money to the kids and grandkids in order to buy a house.” I asked, “In Japan, how long does it take the average family to buy a house?” They said, “That’s a two-generation project.” Which means, as a practical matter, it’s unavailable to them. The man next to me at lunch was in his late 30s. I asked him, “What would it take to get you to work overtime?” He couldn’t think of anything. Folks, when your working population doesn’t perceive it in their interest to produce more, your economy will not grow! It is as simple as that. Until Japan learns some of the lessons that Ronald Reagan taught us, their economy will not grow.

So our conclusion remains – the risk in the current economy/market remains that of a normal cyclical recession. The long-term picture for the U.S. remains good. The short-term picture remains one of high stock price volatility.

As we go through this recession, the media will focus on the bad news. It always does; apparently bad news sells. To help your own perspective on the current recession, study the last one. Go to the library and read the business magazines from early 1991.

Past performance does not guarantee future results. The principal value and investment return will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. The NASDAQ Index is a market capitalization-weighted index that is designed to represent the performance of the National Market System which includes over 5,000 stocks traded only over-the-counter and not on an exchange.

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