Quarterly Letter
by Ron Muhlenkamp   
2006 was a difficult year for us. Although our expectations on the economy were reasonably accurate (a soft landing), our expectations for the performance of some of our stocks were not. Specifically, we did not anticipate the degree and rapidity in which orders for new homes evaporated and the backlogs of homebuilders shrank. We also did not anticipate the repeat of unusually warm winter weather, causing the price of natural gas to fall dramatically. We have been encouraged by the action of the management of our companies. As their businesses slowed, they’ve used the resulting cash flows to buy in stock. We do think this will benefit us going forward.

When I write these Quarterly Letters, my challenge always lies in how best to describe to you what we’re seeing in the economy and the marketplace. To do that, I find that I have to put current observations in context of what went before. It helps me a lot to read our prior newsletters. It particularly helps to understand a “transition” year like 2006.

Many of you know that there have been four phases to the markets in 2006:

Phase I – January through April, the markets focused on economic growth and the fear that too much growth would cause inflation. Long-term treasury rates rose from 4.6% to 5.4%. The markets were led by commodities, emerging markets, and small-cap stocks. Stocks like Alcoa and Caterpillar peaked in April-May.

Phase II – Mid-May to mid-June, everything corrected.

Phase III – June to October, the markets focused on a fear of recession. Long-term treasury rates fell back to 4.8%. The market was led by defensive stocks – such as utility, food, and healthcare. Stocks like Verizon, Kraft and Merck peaked in September-October.

Phase IV – Since July, the markets’ fears of recession have been gradually dissipated. As a result, the leadership has shifted to more aggressive and more cyclically sensitive stocks, including big companies like IBM and Merrill Lynch, but also some small companies like Harley-Davidson and the homebuilders.

If we’re right in expecting the economy to have a soft-landing, rather than a recession, we expect Phase IV to continue.

Note that the four phases described above are the normal rotation that the markets experience when the economy goes through a recession. But, in a soft-landing, the declines are less and the time period is shortened. The rotational pattern has not surprised us, but we had little conviction in calling the timing of it. We had more conviction in the soft-landing scenario than we did in timing the markets’ rotations. So we looked pretty dumb in late Phase I and in Phases II and III.

At this point, we’re once again seeing springtime – an economic expansion. We presented our best description of what we’re seeing at our November 9, 2006 investment seminar, Where to from Here? I highly recommend that you watch it on our website (www.muhlenkamp.com), or ask us for a free DVD. If you do not have a DVD player, we can also provide a transcription.

Also to put all this in context, I encourage you to read our prior Quarterly Letters
(also available on our website), particularly the following:

‘Memorandum #66 – Published Q-2/03
How we look at, and value bonds and stocks.

‘Memorandum #68 – Published Q-4/03
Described the normal pattern of recovery from recession.

‘Memorandum #70 – Published Q-2/04
Further monitoring of economic recovery.

‘Memorandum #73 – Published Q-1/05
How we benefited from uncertainties in the marketplace.

‘Memorandum #76 – Published Q-4/05
We’re at an interesting point in the economic/investing landscape.

‘Memorandum #79 – Published Q-3/06
Assessment of where we are long-term, intermediate and short-term; i.e. climate, seasons, daily weather.

‘Memorandum #80 – Published Q-4/06
Transition period coming to an end.

The comments made by Ron Muhlenkamp in this article are his opinion and are not intended to be investment advice or a forecast of future events. Copies of past newsletters are available on our web site at www.muhlenkamp.com.

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