by Ron Muhlenkamp   

The U.S. economy and the capital markets continue to work their way through the transition period which we’ve been discussing for nearly two years. We continue to believe that the economy will experience a “soft landing,” not a recession. Our mistake has been to believe that the markets would have a soft landing as well. That has been true for some industries but not for housing and financials, of which we’ve owned too much.

First some background:

Since WWII, the U.S. Federal Reserve Bank (the Fed) has purposely raised interest rates to slow the economy at least 12 times. Ten of those times it culminated in recession and once (1994) in a soft landing; i.e. a decline in the growth rate but no decline in GDP. In most cases the Fed raised interest rates until something broke, i.e., a sizable company went bankrupt. (In 1970, Penn Central went out of business; in 1984, it was Continental Illinois Bank.)

In recent years, the Fed has taken a more gradual approach and has been quite open (transparent) about its intention. In 1994, the Fed engineered a soft landing. In 2001, it appeared on track to do so until the attacks of 9/11/2001 tipped the economy into a recession. In the current cycle, the Fed raised short-term rates to 5¼% over a two-year period and waited. We judged the squeeze to be insufficient to cause a recession and have been predicting a soft landing. We also expected a soft landing in the bond and stock markets. We missed on two counts.

Although the Fed stopped raising rates in early 2006, participants in the mortgage and credit markets continued actions that only made sense during the ultra low, short-term rates of 2002-2004. Specifically, mortgage providers continued to write adjustable rate mortgages and as rates moved up, rather than writing fewer mortgages, they modified the terms to be able to keep writing mortgages until they broke the market and themselves in February-March 2007. Meanwhile, managers of leveraged buyout funds and hedge funds, which had great success in the period of ultra low short-term rates, attracted huge amounts of money which they attempted to put to work as the rates became much less attractive. In an attempt to continue prior good returns, many of them used greater leverage at a time and under conditions when they should have used less. They pushed their market until it broke in July-August 2007.

While the point of maximum pressure appears to have passed in each of these markets, the fallout will go on for a couple of years in mortgages and possibly longer in the credit markets.

We can never say for sure that some other market won’t break, or that an outside event like 9/11/01 won’t occur, but we don’t currently see additional likely candidates. We said late last year at our November 9 seminar that the first sign of the transition period coming to an end came in the spring of 2006 when long-term treasury rates peaked and rolled over; (see “Where to from Here?” on our website at www.muhlenkamp.com). Since then long-term treasury rates have remained in a range below that peak. The second sign that the transition period is coming to an end occurred in August 2007 when the Fed lowered short-term interest rates. Normally this is also a sign that the time is right to buy financial stocks. We’re about to find out.

We are now observing that a soft landing tends to take longer than a recession and gives ample time for the uncertainties in the marketplace to drive stock prices lower much like a recession would do. This time it has been a split market. Some stocks and industries have done well while others have done poorly. Despite the focus of the media and the markets on the problems, several averages are doing very well and are near all-time highs.

The question remains: If the above is apparent in hindsight, why didn’t we see it coming? Good question. My best answer is that my hindsight is better than my foresight.

Bottom line: This transition has taken longer than we expected, but the pattern is familiar. We find it interesting that market participants alternate between despair and euphoria while the economy marches on and major market averages near all-time highs. We believe it’s a good time to put money to work.

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.