By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

At the end of the third quarter the U.S. economy is by most indicators in good shape. Real (inflation adjusted) GDP growth the first two quarters averaged 3% and forecasts are for the full year to come in at about 3%. Small business and consumer sentiment indicators are at high levels. Unemployment is quite low and most credit metrics are looking fine. Companies are bringing overseas cash back home and are, in general, doing three things with it: investing in their business, sharing it with employees, and sharing it with owners (the mix varying a bit by company). If you are looking for reasons to be optimistic the domestic economy provides plenty of them.

There are also some reasons to worry (there always are). Domestically, the worries center on inflation (which is approaching 3%) and rising short-term interest rates. Long-term interest rates haven’t really done much all year, which is somewhat surprising given good economic growth and 3% inflation. Rising short-term interest rates are being driven by the Federal Reserve which kept the Federal Funds Rate near zero from 2009 until 2015 and is now steadily raising that rate to get back to what they consider “normal.” There are two problems with this: no one is quite sure what “normal” is anymore (more precisely, the interest rate that neither spurs nor retards economic growth—a neutral rate) and there is the distinct possibility that some businesses have become accustomed to very low interest rates and will not survive in a higher rate environment. So the Fed is feeling its way along, slowly raising the Federal Funds Rate and reducing the assets they hold, hoping they don’t disrupt economic growth. Higher inflation will put the Federal Reserve on the horns of a dilemma, which is why it is a worry. The Federal Reserve has a target of 2% inflation, which we are now above. At some inflation level the Fed will feel compelled to raise rates more rapidly to fight inflation which would increase the odds of slowing the economy and would be negative for asset markets. So it is entirely possible that, despite their best intentions, the Federal Reserve’s monetary policy either creates problems in an economy dependent on cheap credit, or spurs higher inflation first, then chokes the economy to curb the inflation they stoked. Currently we have 3% real economic growth and 3% inflation—so far so good.

Internationally, we find more reasons for worry than reasons for optimism. First, the strong dollar is creating problems for countries that borrowed a lot of dollars. This has exacerbated existing problems in a number of countries and we’ve seen their currencies plummet, most notably Argentina and Turkey. The potential exists for them to default on their dollar denominated loans which would impair the banks and others that lent them the money. At the extreme, those defaults could ripple through the international banking system and create a wider problem. That’s not what we expect to happen, but we are watching for the early warning signs that something like that is occurring.

Second, on a global basis, monetary policy continues to move back towards normal as central banks end their extraordinary policies. You may recall that the central banks of the U.S., Europe, and Japan all dropped interest rates to essentially zero and implemented asset buying programs in order to spur economic growth and generate inflation. The U.S. Federal Reserve was the first to start moving back towards normal by ending their asset purchase program in 2014, raising short-term rates beginning in 2015, and reducing their assets beginning in 2017. The European Central Bank (ECB) is the second major central bank to move back towards normal. The ECB has announced it will end its asset purchase program in December 2018 and will look to begin raising rates perhaps in mid to late 2019. We think this will allow interest rates in Europe to rise which will reduce upward pressure on the dollar and create downward pressure on U.S. long-term interest rates. This is a big step towards tighter money on a global basis.

We think the loose central bank policies inflated pretty much all asset prices around the world. Additionally, all kinds of borrowers have taken advantage of the abundance of cheap money—countries, companies, and individuals. We expect the withdrawal of that monetary support to exert downward pressure on asset prices and are concerned that some of those borrowers will not be able to support the debt they took on. It’s a big shift and it will take time to unfold and time for the problems to become manifest, but we are four years into it with another big move coming. We think the plunging currencies of Turkey and Argentina are first of the problems that will unfold in this tighter monetary environment.

The above is really a reiteration of what we’ve been saying all year. A strong U.S. economy boosted by changes in the tax code and reduced regulations is a positive force in the markets. The shift from a very loose monetary environment to something less loose is a negative. We said at the beginning of the year that these two drivers (strong U.S. economy & the tightening of the money supply) would shape the markets in a fashion we couldn’t predict.

In March, President Trump injected a wild card as he seeks to restructure the trading relationships between the U.S. and other countries. In general, the pattern seems to be for the U.S. to unilaterally levy tariffs on imports until we convince the other party to sit down and seriously bargain. Some countries came to the table after the first round of tariffs: Korea and Japan. Others came right back at us with their own tariff schemes for a round or two then sat down: Mexico, Canada, and the European Union. We have yet to get China to the bargaining table after what is, by my count, four rounds of tariffs and counter-tariffs. So far, the markets haven’t reacted much to this activity, but the potential remains for global trade (and by extension global growth) to be significantly affected. So we’ve added “Trade” to our worry list and we’re incorporating it in our thinking. We’ll keep you posted.

So far this year, we’ve done more selling than buying and are holding a bit more cash than we were at the start of the year. This activity has been bottom up driven: a number of our holdings met our sell criteria and so were reduced or sold and the number of buying opportunities has been low. We are comfortable holding a little more cash given the change in the monetary environment and will put that cash to work when we find a lucrative opportunity.

The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

Central Bank is the entity responsible for overseeing the monetary system for a nation (or group of nations). The central banking system in the U.S. is known as the Federal Reserve (commonly referred to “the Fed”), composed of twelve regional Federal Reserve Banks located in major cities throughout the country. The main tasks of the Fed are to supervise and regulate banks, implement monetary policy by buying and selling U.S. Treasury bonds, and steer interest rates.

Federal Funds Rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. It is the interest rate banks charge each other for loans.

Gross Domestic Product (GDP) is the total market value of all goods and services produced within a country in a given period of time (usually a calendar year).

No File Found

Click here for a printer-friendly PDF of the Memorandum.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

In this Muhlenkamp Memorandum:

Quarterly Letter
At the end of the third quarter the U.S. economy is by most indicators in good shape. Real (inflation adjusted) GDP growth the first two quarters averaged 3% and forecasts are for the full year to come in at about 3%…

Don’t Let Financial Fraud Happen To You
In the good old days, scammers could only reach you face to face, by mail, or by phone. Now, they can also attempt to deceive you through email and on the Internet. Unfortunately, you always have to be on guard…

Register for our Upcoming Webcast
Join Tony Muhlenkamp as he hosts a chat with portfolio managers Ron and Jeff Muhlenkamp. Hear about current market activity and the state of the economy. In addition to listening to the discussion, you will have the opportunity to ask questions.

Archive Available – August 30, 2018 Webcast
During our webcast, Ron and Jeff updated participants on the changes in the economic indicators that they monitor and the potential threats and improvements to the U.S. economy and asset markets. They believe the U.S. government has removed some impediments to business, but are wary of cross-currents that might create problems. They also talked about what they are seeing in foreign economies, especially changes to the currency rates compared to the U.S. dollar and the ongoing changes to trade and tariffs.

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Join Tony Muhlenkamp as he hosts a chat with portfolio managers Ron and Jeff Muhlenkamp. They will share their observations on the markets and the economy and what they feel is important to monitor.

In addition to listening to the discussion, you will have the opportunity to ask questions.

Date: Thursday, November 15, 2018

Time: 4:00 p.m. – 5:00 p.m. ET

Registration is required, so CLICK HERE TO REGISTER

After registering, you will receive a confirmation email containing information about joining the webcast.

No File Found

During our webcast, Ron and Jeff updated participants on the changes in the economic indicators that they monitor and the potential threats and improvements to the U.S. economy and asset markets. They believe the U.S. government has removed some impediments to business, but are wary of cross-currents that might create problems. They also talked about what they are seeing in foreign economies, especially changes to the currency rates compared to the U.S. dollar and the ongoing changes to trade and tariffs.

Watch the video archive or read the amended transcription (including slides).


Click here for the amended transcription (including slides).

Click here for slides only (no audio or transcription).

If you have questions or comments about the content of the webcast, don’t hesitate to send us a message or call us at (877)935-5520 extension 4.

For the Top 20 Holdings and performance data as of the most recent quarter-end, refer to the SMA All-Cap Value Fact Sheet.

The opinions expressed are those of Muhlenkamp and Company and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

No File Found

Click here for a printer-friendly PDF of the Memorandum.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

In this Muhlenkamp Memorandum:
Quarterly Letter
Allow us to summarize what we’re seeing so far this year. The U.S. economy is doing well, with 1st quarter Gross Domestic Product (GDP) growth coming in at 2%, unemployment in May was a low 3.8%, and inflation was 2.8%…

Relevant Elements for Investment Strategy
I’ve had conversations with clients that have touched on themes and topics that I think are worth sharing. Some of the topics are long term and strategic, others are more tactical, and the challenge is to weave them into something that is useful and intelligible…

Register for our Upcoming Webcast
Join Tony Muhlenkamp as he hosts a chat with portfolio managers Ron and Jeff Muhlenkamp. Hear about current market activity and the state of the economy. In addition to listening to the discussion, you will have the opportunity to ask questions.

Archive Available – May 24, 2018 Webcast
During our webcast, Ron and Jeff walked us through a number of economic and financial indicators to better understand the U.S. economy and asset markets. They concluded that the economy will likely continue to grow at 2% or a little better, but that rising interest rates and other actions of the Federal Reserve increase the likelihood of problems with businesses or countries that need low interest rates to survive. They believe the markets will remain volatile as investors grapple with these two diametrically opposed pressures.

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By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

Allow us to summarize what we’re seeing so far this year. The U.S. economy is doing well, with 1st quarter Gross Domestic Product (GDP) growth coming in at 2%, unemployment in May was a low 3.8%, and inflation was 2.8%. The interest rate on 2-year U.S. Treasury notes at the end of June was roughly 2.5%, 10-year U.S. Treasury notes yield almost 2.9%, and the average 30-year fixed mortgage rate in the county is 4.4%. As of June 30, 2018 the S&P 500 Total Return Index is up 2.65% since the beginning of the year. The Federal Reserve continues to raise short-term interest rates and continues to reduce their balance sheet as they said they would. Internationally, the dollar is up about 5% against a basket of foreign currencies year to date. The stock markets of a number of emerging markets have sold off with Turkey down 32%, Brazil down 20%, and China down 20% as examples. The European Central Bank (ECB) continues to pursue their policy of negative interest rates and asset purchases, though they have reduced the amount of assets they purchase each month and have reiterated their intention to end the program by the end of 2018. The Bank of Japan (BOJ) continues to pursue its policy of low interest rates and asset purchases as well. Italy has elected a populist government which raises the prospect of policy conflict with the rest of the European Union and disagreements over immigration are threatening the German coalition government led by Angela Merkel.

What do we make of all this?

First, we still don’t like bonds with a duration of longer than three to four years as they are mispriced relative to inflation (historically the 10-year treasury yield would be roughly 3% above inflation, which would make a 5.5% – 6% yield “normal” with today’s inflation). Second, while it is appropriate and necessary (necessary because abnormally low interest rates are killing savers, pensions chief among them) for the Fed to raise interest rates and try to get them back to something approaching the historical norm, we foresee two challenges: the easy money policies of Europe and Japan are keeping our long-term interest rates low, hindering our efforts; and a decade of cheap money has gotten baked into a lot of business plans. Higher cost money will be a problem and no one (neither the Fed nor us) can know exactly what interest rate will start to cause serious problems. So while the Fed intends to return rates to normal without disrupting either the markets or the economy, they may be unable to pull off such a feat.

Third, higher inflation would put the Fed on the horns of a dilemma: should they stick with the slow pace of rate increases and risk still higher inflation and all the problems that would bring or should they raise rates faster and risk slowing the economy in a bid to keep inflation at a reasonable level? Market participants are alert to this dilemma and paying very close attention to inflation data.

Fourth, the tax law changes passed at the end of 2017 plus regulatory changes are having a beneficial effect on the economy. The economic indicators we monitor all look pretty good with few signs of trouble to be seen. Corporate earnings were strong in the first quarter with sales growth of 8% and earnings growth of 22%.

Fifth, Europe and emerging markets are the most likely sources of external economic shocks. Europe because of the political turmoil, emerging markets because many of them borrowed heavily in dollars when dollars were cheap and will find it difficult to repay the loans now that dollars are more expensive.

We’ve been saying all year that we expected economic growth and earnings to increase but that higher interest rates should cause price-to-earnings ratios (P/E) to decline. Both of those things are happening, roughly offsetting each other so far resulting in only modest changes to stock prices and a small decline in bond prices. 

That’s what we see at a high level. Economically things are pretty good but there are a number of things that could upset the economy or the markets and we’re keeping an eye out for them. We continue to spend most of our time looking for investment opportunities and managing our current investments. We are comfortable carrying a bit of cash given the tug of war between the economic strength and monetary tightening but we are equally comfortable putting money to work when we find what we believe is an attractive investment.

The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

Gross Domestic Product (GDP) is the total market value of all goods and services produced within a country in a given period of time (usually a calendar year).

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

S&P 500 Index is a widely recognized, unmanaged index of common stock prices. The S&P 500 Index is weighted by market value and its performance is thought to be representative of the stock market as a whole. You cannot invest directly in an index.

No File Found

During our webcast, Ron and Jeff walk through a number of economic and financial indicators to better understand the U.S. economy and asset markets. They conclude that the economy will likely continue to grow at 2% or a little better, but that rising interest rates and other actions of the Federal Reserve increase the likelihood of problems with businesses or countries that need low interest rates to survive. They believe the markets will remain volatile as investors grapple with these two diametrically opposed pressures.

Watch the video archive or read the amended transcription (including slides).


Click here for the amended transcription (including slides).

Click here for slides only (no audio or transcription).

If you have questions or comments about the content of the webcast, don’t hesitate to send us a message or call us at (877)935-5520 extension 4.

For the Top 20 Holdings and performance data as of the most recent quarter-end, refer to the SMA All-Cap Value Fact Sheet.

The opinions expressed are those of Muhlenkamp and Company and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

No File Found

Click here for a printer-friendly PDF of the Memorandum.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

In this Muhlenkamp Memorandum:
Quarterly Letter
The first quarter of 2018 was marked by a sharp market correction and the unraveling of some very popular investment themes. The correction kicked off in February when wage data triggered inflation fears which caused bond yields to jump up and equity prices to drop…

Volatility and the VIX Collapse
At a high level, interest in measures of the change in stock prices really began with the development of Modern Portfolio Theory (MPT) in 1952 by Harry Markowitz…

Register for our Upcoming Webcast
Join Tony Muhlenkamp as he hosts a chat with portfolio managers Ron and Jeff Muhlenkamp. They share their views of the recent market swings and their concern of investors’ margin debt. They will discuss their political and economic observations and what they feel is important to monitor.

Archive Available – February 22, 2018 Webcast
Ron and Jeff Muhlenkamp explained that recent tax cuts and deregulation should help keep the economy moving. Asset markets, on the other hand, could be affected by monetary tightening as the Federal Reserve and other central banks reduce or reverse their easy money policies. Tightening of the money supply could cause bond yields to increase and some market disruptions.

No File Found

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

The first quarter of 2018 was marked by a sharp market correction and the unraveling of some very popular investment themes. The correction kicked off in February when wage data triggered inflation fears which caused bond yields to jump up (bond prices dropped) and equity prices to drop. The rapid drop in equity prices caused volatility to spike up, resulting in massive losses in several exchange traded notes that were short the VIX. [A brief aside is perhaps in order here: Volatility is a measure of how much market prices change on a day-today basis. Current Wall Street practice is to equate volatility with risk, which means there developed a need to measure volatility. The Chicago Board Options Exchange (CBOE) filled this need by creating the VIX index, which is their measure of expected overall market volatility based on options pricing information. Wall Street being Wall Street, they then developed ways to invest in volatility via exchange traded funds (ETFs), exchange traded notes (ETNs), futures, etc. To be “long volatility” is to profit if volatility increases—daily price swings become greater. To be “short volatility” is to profit if volatility declines—daily price swings become smaller.] Several of the affected exchange traded notes folded a week or two later. The unwinding of the short volatility trade just got the ball rolling. Allegations of misuse of data hit Facebook (FB) shortly thereafter, taking 20% out of the stock price over the course of two months, and the pain spread to other members of the FANGs (Facebook, Amazon, Netflix, and Google) which had been market leaders for over a year. President Trump’s tweets against Amazon (AMZN) hit that stock to the tune of 12%. An accident involving an Uber autonomous vehicle in Arizona that resulted in the death of a pedestrian hit NVIDIA (NVDA), Tesla (TSLA), and other companies that are involved in developing autonomous cars. The imposition of tariffs by the U.S. and retaliatory tariffs by China hit a broad swath of importers and exporters in the market.

Market corrections are a fact of life for the investor and, so far, this correction is pretty run of the mill at about a 9% drop from the late January peak. What makes it interesting, and what we were trying to point out in the opening paragraph, is that a number of very popular investments have all found their own reasons to unwind nearly simultaneously. When an investment becomes very popular and everybody is on the same side of the trade, it doesn’t take much to reverse the momentum. We think that’s what happened over the last month or two with these trades and we expect momentum to continue to come out of them. What we don’t know is the longer-term effect on the larger market. There is enough margin debt held by investors that forced selling could exacerbate the decline. We don’t think we’ve seen it yet, but the possibility remains.

We’ve spoken before about the difference between the game of the stock market and the business of investing. We consider betting on price changes of Bitcoin and whether volatility will increase or decrease to be stock market games—the item you are betting on has no value or economic meaning. Most companies produce real products and their stock prices reflect the value they add to their customers in the current investment climate. We consider these stocks as reflective of the business of investing. “FANG” type stocks are a mix. Though the companies and products are real, investing in these stocks at such high current valuations can take on the aspect of a game since their recent stock prices assume success into a far distant future, not based on their current earnings. We prefer the business of investing and generally try to avoid stock market games.

We continue to keep an eye on the economy and it continues to do well. Of all the indicators we watch, the only one that is concerning is the increase in auto loan delinquencies. It looks to us like the economy will continue to grow at around 2% [real GDP growth] for as far as the economic eye can see, but that’s only about 6-9 months into the future. During quarterly earnings conference calls, most companies spoke about the effects of the tax cuts passed by Congress in December. In many cases, management indicated they were passing some of the savings to their employees, using some of it to accelerate business investments and increase capital spending, and passing some along to shareholders as dividends or via stock repurchases. We have highlighted previously that low capital spending was unique to this expansion and a drag on economic growth. We’ll be watching closely to see if managements follow through on their spending plans and what effect it has on the economy. We continue to believe the tax cuts are a net positive for the economy.

The possibility of higher inflation remains a concern of ours and was clearly front of mind for investors in early February. The potential for higher inflation certainly exists, but that’s been true for ten years now, and neither we nor anyone else we’ve read has accurately predicted the low inflation and intermittent deflation we’ve actually gotten. Instead of guessing, we’ll let the facts inform us. Right now, we are seeing inflation on the order of one to two percent.

As advertised, the Federal Reserve has begun to very slowly reduce the financial assets it holds on its balance sheet. We discussed in our last newsletter that we thought this would put downward pressure on asset markets even as the tax cuts and resultant economic activity put upward pressure on the markets. What we’ve seen this quarter, as described in the first paragraph, is a number of areas that were perhaps a bit bubbly, start to deflate. Our expectation of the impact of the shrinking Fed balance sheet is beginning to be realized. What will be important now is whether the declines start to reinforce each other and create a larger, general decline, or not.

We’ve raised a bit of cash recently as several holdings became overly large and/or their price reflected what we believed was the value of the company. As always, we are looking for good companies to invest in and will do so when we find them.

The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.

No File Found

Ron and Jeff Muhlenkamp explain that recent tax cuts and deregulation should help keep the economy moving. Asset markets, on the other hand, could be affected by monetary tightening as the Federal Reserve and other central banks reduce or reverse their easy money policies. Tightening of the money supply could cause bond yields to increase and some market disruptions.

Watch the video archive or read the amended transcription (including slides).


Click here for the amended transcription (including slides).

Click here for slides only (no audio or transcription).

If you have questions or comments about the content of the webcast, don’t hesitate to send us a message or call us at (877)935-5520 extension 4.

For the Top 20 Holdings and performance data as of the most recent quarter-end, refer to the SMA All-Cap Value Fact Sheet.

The opinions expressed are those of Muhlenkamp and Company and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

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