Conversations with Ron

Every week, Ron Muhlenkamp conducts a Friday morning meeting with staff. Following are excerpts of our weekly conversations:

What are the major lessons learned over the past year?

1.             Watch for changes in things that have been stable.

2.             Pay more attention to my own maxims, specifically, “If you change the rules a little, you change the game a lot.”

First, the change in the velocity of money…whether you call it securitization¹ or the shadow banking system, money that was created outside of the Federal Reserve by Wall Street bankers, such as Morgan Stanley and Goldman Sachs, overwhelmed what the Fed was doing.

For forty years, I found it useful to monitor the Fed as a warning sign for bear markets and recessions. That did not work in the last four years. When the Fed starting squeezing interest rates in 2004-05, the shadow banking system continued creating, or leveraging, money at a much faster rate, thus increasing the rate or “velocity” at which money was used in our economy. Strictly speaking, the Fed did not lose control of the money supply, but it did lose control of the velocity with which the money supply was being multiplied. Velocity kept growing until about July of ’07 and, then, fell off a cliff.

The change in velocity is still negative. At some point, it will likely return to neutral and then go positive, but it probably won’t ever get back to what we thought was normal five years ago. The very fact that much of the securitization has now gone away means that it should no longer accelerate to the down side.

Second, changing the rules… Mark-to-market accounting came into effect in November 2007, requiring that the assets held by a bank or insurance company be “marked” to the prices of similar assets which have been selling (or not selling) in the open marketplace. Historically, other ways to value assets, including using amortized or appraised values, have been used. I am not going to argue about which of the methods makes more sense. My point is when you shift from one accounting method to another, there is an adjustment period that has to occur. I refer to this as a “step function.”

Could you clarify what you mean by “step function?”

A step function is a change from one level to another in a brief period of time. It’s like stepping on or off a curb;  or .

When the public lowers their spending by 5% (thereby raising their savings by 5%) in a six-month period, it doesn’t necessarily mean that they’re likely to lower spending by an additional 5% in the next six-month period.

We’re seeing step function patterns in a number of areas, including consumer spending, consumer savings, retail sales and truck tonnage.

Speaking of the consumer, how do you think he is faring?

We’re seeing signs that the consumer, having stepped down his spending, is now leveling off — and we think there is the potential for consumer spending to grow from this new level. We don’t think consumer spending will snap back quickly to where it was four years ago, but having taken a step down, (whether at restaurants, or going on nearby vacations, or with housing or autos), we think it has probably set a new norm and should grow from here.

Gasoline, having run up to $4 per gallon is now at $2, no higher than it was two years ago. Grain prices, having run up, have come back down. You’ve probably noticed that mortgage rates, (the average mortgage is about 6%), are now below
5 percent. Some of you have recently rolled your mortgage down from 6% to 4½% and 45/8 percent. Well, that’s just as good as lowering the amount of your mortgage by 20% or 25 percent.

So the direct consumer costs for food, clothing, and housing are no higher than they were a couple of years ago. Obviously, if you lose your job that cancels out everything I’ve just said. But, for the 90% of people who don’t lose their jobs, their direct costs and cash flows² are in pretty good shape.

You’ve talked about the consumer, what about the taxpayer? Will the taxpayer benefit in terms of TARP or TALF or PPIP?

Bond prices fell off a cliff in October ’08; that is, as yields went up, bond prices dropped dramatically. Since then, bonds have looked interesting to us. Frankly, they look like good investments to us for the first time since 1984. (The bonds we bought in 1984 were sold in 1993, so it’s the first time in fifteen years that bonds have looked attractive to us.)

If the government is buying such bonds, then, the government will likely make money on them. You’ve heard me say many times that when you borrow money, it’s not whether you borrow money, it’s what you spend it on. If you spend it on bridges that go nowhere, then that’s a loss. But if you spend it on things that actually return value to you, whether it’s a bridge that’s going somewhere, (which is what government should normally be doing), or if you’re buying bonds that actually pay off, you can make money.

You may recall that the federal government once lent money to Chrysler, some thirty years ago. Because Chrysler stayed in business, and managed to make some decent products, the government made money on those bonds.

There are a whole lot of people who fear that with all of the money the government is putting into the economy, we’re going to have inflation down the road. Well, at least, the Fed and the Treasury are aware of this. Nevertheless, two or three years down the road, as the economy recovers and as velocity becomes positive, the government will have to soak up that extra money. What it is trying to do now is to avoid deflation, or to avoid a more serious recession. Could that give us inflation down the road? Absolutely. But first, you get the alligators and then, drain the swamp.

Historically, financial stocks lead the market into a decline / slowdown and, in turn, lead the economy out of the recession. Do you believe that will happen, given the stake(s) of the Federal government?

I’ve studied the recessions since World War II. For most recessions you could take your cue from the Fed. Each time we’ve had a recession it was triggered, on purpose, by the Fed to slow the economy down, usually because it feared inflation was getting too high.

When the Fed squeezes the economy, it squeezes through the banks, which means that banks tend to be among the first stocks to go down. When the Fed concludes that inflation is under control, it starts releasing the pressure on banks, making them early rebounders. This time, we’ve made it tougher on banks. The Fed (and FASB 157) changed the rules (repeatedly) as well as the interest rates. This has driven many stock prices to bankruptcy levels. They’re likely to get sizeable bounces off these levels, but it will be hard to determine new fair values until the rules are stable.

What are your thoughts on today’s buying opportunities?

The public and companies are responding normally and appropriately to the recession. We continue to see great companies selling at cheap prices. The Fed and the Treasury are now aiding the banks and printing money. While velocity is still negative, in March, we saw major changes. Forced selling has matured; mark-to-market accounting has been alleviated; forced buying has begun. We’re putting our cash back to work.

As of 3/31/09, the Fund held 0.0% of Morgan Stanley, Goldman Sachs, and Chrysler.

Fund holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security.
Current and future portfolio holdings are subject to risk.

 What is the velocity of money?
Irving Fisher, an American economist, developed the equation:

MV=PQ.
Let M = money;
       V = the velocity of circulation of money;
       P = price;
       Q = quantity of real output (goods).

This equation says the “change in money x (times) velocity = change in price x (times) quantity.”
Historically, if money grows faster than the quantity of goods, the price of goods goes up to reflect the change. That’s called inflation. The assumption has always been that velocity is stable – mostly, because it’s difficult to predict. In fact, for most of the past thirty to forty years, velocity has been relatively stable. But during 2004-07, it grew rapidly and, in the last year, it has collapsed.