At our investment seminar on November 5, 2009, Ron Muhlenkamp presented "What's the New Normal? Economics, Rules, Markets" to an audience of clients, shareholders, and prospective investors. Afterwards, Ron entertained questions from the audience.

A video of the presentation and a booklet summarizing its content are available on our website at www.muhlenkamp.com.

What makes this recession different?

First of all, anything that occurs twelve times over a 64-year period, I tend to think of as a cyclical pattern. For years I've said that recessions serve a useful function. I now think recessions are necessary - they are needed to rid excesses in the economy. I also think that recessions are self-correcting. During a recession, people tend to spend a little less; work a little harder; save a little more; and the pattern tends to heal itself. (In contrast, I do not believe that inflation is self-correcting. Therefore, I am always more concerned about inflation than recession. Inflation kills the dollar and consumer purchasing power.)

What we've recently experienced was not a normal, cyclical recession. To answer the question about what makes it "different," we need to examine interest rates and the role of the Federal Reserve.

10-year U.S. Treasuries are the benchmark for long-term lending; refer to Figure 1.

Figure 1 10-Year U.S. Treasury Note Rate, 1945-2009

In 1981, 10-year Treasury note interest rates hit 14%-15 percent. After a steady decline, the 10-year Treasury rate is currently at 31/2%-4 percent. We do not think the rate will go much lower. Some people do, however... those who expect deflation, (i.e. when inflation is below 0%), expect the 10-year Treasury rate to drop. We do not.

Figure 2 shows the 10-year Treasury Note, less the Effective Federal Funds Rate, which is the spread on which banks work. Right now, the spread is on the order of 4%, so banks are on their way to achieving profitability/decent balance sheets.

Figure 2 10-Year U.S. Treasury Note Rate Less Effective Federal Funds Rate, 1945-2009

But this plot can tell us much more...

When long-term interest rates are above short-term interest rates, we refer to that as a positive, or a normal yield curve. When the reverse is true, we refer to it as a negative, or an inverted yield curve. What you see on this chart is that an inverted yield curve usually precedes a recession.

When the Federal Reserve (Fed) squeezes money, (i.e., when it raises short-term rates), it tends to trigger a recession. During a recession, the Fed lowers short-term rates to stimulate the economy - and that's just what it has done. The yield curve has now gone strongly positive, and banks are now making good money on the spread between short-term and long-term interest rates. Because of this pattern, over time, recessions become self-correcting.

Sometimes, however, things get complicated. You've heard me say a number of times that after 9/11 [2001], taking interest rates to 1% wasn't the mistake. Keeping rates there for two or three years was a major mistake, allowing people to go out and get adjustable rate mortgages below 4% because they were priced off T-bills at 1 percent.

When the Fed started raising rates, the media talked about "tightening." We argued that until rates got to 3% or so, they were just getting back to normal. (Today, the same argument applies.)

As rates were moving up in 2005-06, however, we were preparing for a recession. But the Fed stopped raising rates at 51/4 percent. As a result, I thought we might get a soft landing. I was wrong. Wall Street was wrong. Frankly, I think that had the Fed continued raising rates to 6%-7% - having triggered the recession back then - we would have avoided a lot of the junk that has since come back to haunt us.

Here's why:
When rates went up in 2005-06, folks on Wall Street should have said, "The cost of money is going up. We need to back out. We need to borrow less." Rather, they responded, "The spread is getting narrower; we have to 'up' our leverage to make money." Some investment banks used as much as 30-to-1 leverage to make a deal work. Folks, if you have to borrow $30 for every $1 you have in equity in order to make a deal work, it isn't a good deal. These activities greatly affected the velocity (turnover) of money, which is another factor in determining why this recession is different.

So the fact that we didn't raise rates enough to trigger a recession meant the nonsense loans continued through '06 and '07. Bottom line: In trying to avoid a recession, we made things much worse and much harder.

My fear today is, if we keep rates too low for too long, there are a number of hedge funds in the U.S. that are borrowing at very low rates, buying everything from gold, to commodities, to foreign stocks. It's called the carry-trade. In 2008, such firms were told by their brokers and bankers that they would no longer carry as much exposure - and the hedge funds were forced to sell.

Two things concern me:
1. The Fed doesn't seem to be too worried about this; and
2. Even when the Fed starts to raise
interest rates, I'm quite certain it's
going to get political pressure to keep rates down.

How this will sort out, I don't know. The longer short-term rates remain cheap, the more likely we are to repeat a version of the same problem that we created when we had low interest rates for three years.

As a result, we continue to monitor a variety of factors:

• Consumer Spending;
• Business Investment;
• Velocity of Money;
• Federal Reserve and Treasury;
• Credit Defaults / Bank Health;
• Taxes; and
• Regulation.

Throughout 2009 consumers appeared to be cutting back on their spending. How does this affect the economy?

In the fourth quarter of 2008, consumer spending as a percentage of GDP (Gross Domestic Product) fell about 5%, and consumer savings rose by about 5 percent. The question then was whether this was a step function - like stepping off a curb, or a new trend - like the first step down a flight of stairs.

Since the beginning of 2009, consumer spending has been basically flat. So now
the question is to what extent consumer spending resumes growth or stays subdued. If spending resumes, then providers of discretionary goods should do well, as they did following the 2001 recession. If consumer spending stays subdued, (and consumer savings grow), then providers of financial services should do well, as they did following the 1990 recession.

Frankly, I think people should rebuild their savings. Savings are necessary to weather the normal swings of economic life and the unplanned emergencies which are part of that life. As a group of people, we've dissipated our savings habits over the last twenty years.

In our public presentations, we have begun to ask two questions:
1. "Over the past two years, how many of you have cut back on your spending?" (Nearly everyone says they have.)
2. "How much has it hurt?" (Not so much.) This implies to us that subdued spending may continue.

Do trends in consumer spending influence your investment decisions? If so, how?

Coming out of the 1990 recession when people were rebuilding their balance sheets, we made a lot of money owning companies like Merrill Lynch, which is a retailer of financial services. In fact, coming out of the 1990 recession, in the first half of the 1990s, Merrill Lynch's revenues grew faster than Walmart's. (I think Merrill Lynch has a great chance to do that again, provided it hasn't lost its credibility. I really don't know whether or not this is the case.)

Today, almost everyone who's had financial advice has been disappointed in the last two years. As a result, I think there's going to be a great market for financial advice. I just don't know who's going to supply it, whether it's going to be the broker, banker, accountant, financial planner, or insurance salesman. It might even be an industry that we really haven't identified yet, but somebody out there is going to service this demand. I think there's going to be a huge demand, and somebody will supply that service.

Coming out of the 2001 recession, which really didn't hit the consumer, you wanted to own companies specializing in consumer discretionary goods. For example, at that time, we made a lot of money in housing stocks; we made good money in Winnebago. (I doubt that Winnebago is going to be terribly strong soon, coming out of the current recession. The stock price has bounced very nicely from nonsense levels in March '09, but I doubt there's going to be a huge demand for Winnebago's for the next year or two.)

Do you think the U.S. is going the direction of Japan and, if so, how will that impact our dollar?

Those are two separate questions. Let's talk Japan first.

In the 1970s I learned from Milton Friedman and Paul Volcker that inflation is always monetary. Most of the world's central bankers, I think, have learned the same lesson based on what they've been doing since then. In the 1980s, I learned from Ronald Reagan that once food, clothing, and shelter are covered, economics is all about incentives. I see no signs that economists or politicians have learned this lesson.

For twenty years, the Japanese have been trying to boost the economy through government spending by building more roads and highways, bridges and airports. They never really put the incentives in the hands of the consuming public or the individual worker.

I don't know too many people who work overtime so the government can build another bridge. I know a lot of people who are willing to work overtime so they can buy a Corvette or take a vacation, or have a nicer house, or whatever it is - the discretionary kinds of things that we own.

In the U.S., consumers still have the opportunity to respond to those types of incentives. Currently, however, there are a number of issues on the table in terms of tax rates and regulations that could lessen or negate those incentives. If we kill the incentives, we'll kill any growth in the economy.

The second question is about the dollar and, of course, with the dollar - with any currency - everything is relative. When the dollar is strong it's good for the American consumer, but it squeezes the American producer. When the dollar is weak, it squeezes the American consumer, but it's good for the American producer, assuming his costs are in dollars if he's trying to sell to the rest of the world.

There are people saying, once again, that a weak dollar is good for the American producer. Yes, but it squeezes the American consumer. The same people who thought our trade deficit was too big a couple years ago, now that it's been cut in half, are complaining that we're in a recession. Well, nothing's free. The dollar has gotten much weaker versus a number of currencies, especially those that are commodity-based such as the Canadian dollar or the Australian dollar.

It appears the stock market has experienced a V-like recovery. Is this true - and is it sustainable?

The big rebound in the stock market isn't so much that the fundamentals are particularly good, it's simply that we had serious amounts of forced selling in '08 and early '09. A lot of people want to measure the market from March, as if in March prices were realistic; in March, there were fire-sale prices.

Today, we think prices are, on average, on the order of fair levels. But, what I'm trying to tell people is ignore the fact that they're up a lot because they're up from a nonsense base. Don't even think of it as a base. The question going forward is completely independent of what's happened during the last nine months.

Prices were driven to nonsense levels because of the forced selling that was caused by deleveraging amongst hedge funds and the resultant redemptions that took place in both hedge funds and mutual funds. That, we think, is over.

Have your criteria for a company to be investment-worthy altered at all in the last six months to a year?

No, the criteria haven't changed. We want companies with good profitability. We suspect that the profitability of two years ago won't be matched for the next couple years. What used to be an average ROE (return on equity) of 13%, may look more like 11% going forward, which means that the P/E ratios would be below where they otherwise should have been.

If inflation is 0% and long-term treasuries are about 3% - and they're 3%-4% at the present time - then a company with an ROE of 7% or 8% should be worth book value. When we work through that process, a lot of companies are selling at what look like reasonable values. So no, the criteria haven't changed. The companies that meet those criteria change over time, but the criteria have not changed.

When we find companies that are nicely profitable and it looks like they can remain that way, and aren't doing dumb things with the cash, that's what attracts us to individual investments. Some of these things you can't predict, you can only monitor. Other things you must say, if they're generating "x" dollars in cash, how much is that worth to me? If it gets beyond that [amount], then you pull some money off to the side.

We were fully invested last spring (2009). Where investments met our targets, we moved out of them; where we see others that fit, we put money in. In the final analysis, it's about the cash companies are generating and how much that cash is worth.

As of 12/31/09 the Fund held 0.0% of Winnebago and Walmart. The Fund held 3.0% of its assets in Bank of America, of which Merrill-Lynch is a wholly owned subsidiary.

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.

Glossary for "Q&R":
Return on Equity (ROE) is a company's net income (earnings) divided by the owner's equity in the business (Book Value). This percentage indicates company profitability or how efficiently a company is using its equity capital. ROE = Earnings/Book Value.

Price-to-Earnings (P/E) is the current price of a stock divided by the trailing 12 months earnings per share.