Quarterly Letter, April 2015

By Ron Muhlenkamp, Portfolio Manager and Jeff Muhlenkamp, Investment Analyst and Co-Manager

We’ll start with our views on the U.S. stock market, then briefly touch on some broader U.S. and global issues, then close with a summary of how it all ties together.

In general, we find the market is fully priced. Some sectors appear quite expensive (utilities come to mind), while others are less so (energy). If the market were a new car, you’d be paying the sticker price to buy it today—no incentives, no dealer reductions, nothing—the sticker price. So we’re not very interested in buying the market at today’s price. We keep looking for bargains (we are always looking for bargains), but we’re not finding many. Many of the companies we own are no longer cheap and are no longer “buys,” but we’ve found it profitable over the years to leave well enough alone with stocks that are doing well, watching closely for a change in the price momentum as a signal to sell. That’s what we are doing today. There are reasons to believe momentum may reverse; margin debt, for instance, had been growing for years, but is now holding steady. If it declines, it is likely stock prices will, too. There are also reasons to believe upward momentum may continue. Savers and investors in both Japan and Europe are being punished with historically low, even negative, interest rates and are looking elsewhere for better returns. If their money comes to the U.S. markets, it could well continue to drive prices up for a time. There is no clear market direction right now and we are watching closely to see what develops.

Now let’s talk about some broader topics very briefly.

The U.S. Economy – Coming into the New Year most economic commentators called for 3%+ U.S. GDP (Gross Domestic Product) growth fuelled, in part, by lower oil prices. Most of those estimates have come down steadily over the last 90 days. We continue to expect 2%-2½% GDP growth, repeating the pattern we’ve seen the last few years.

Earnings – There were two big themes in earnings calls this Quarter. For energy companies, the discussion was all about how much (35%-40%) they were going to reduce their capital expenditures in 2015 due to lower crude oil prices. For international companies, the discussion was all about how much the strong dollar hurt their profits as sales in foreign currencies were translated back into dollars for accounting purposes. (Quantities of goods sold in foreign currency may have been the same, and the revenues measured in the foreign currency may have been the same, but with a stronger dollar it translates into lower dollar sales overseas.) Add in some pretty broad-based announcements of wage increases in retail and we expect overall earnings growth this year to be roughly half of what it was last year.

Commodities – Oil prices have been the big news for nine months now as they dropped from $100/barrel to about $40/barrel, then “bounced” to $50/barrel. Now, oil prices are working their way back down because oil inventories, particularly in the U.S., continue to rise. It’ll take some time to get supply and demand back in balance, and we may see new lows in the price of crude oil in the meantime. Hard commodities (iron ore, copper, steel, etc.) continue to get hit hard as the supply brought online to meet anticipated demand from China is now excess and looking for a home.

Central Banks – The European Central Bank embarked on their version of “Quantitative Easing” in the first quarter, immediately driving sovereign rates even lower in Europe and causing the euro to sell off against the dollar. This has been a big part of the strong dollar story and may be a reason for extended momentum in the U.S. markets.

The U.S. Federal Reserve Bank continues to prepare the markets for higher interest rates by wordsmithing their announcements to the nth degree. Higher rates will mean lower bond prices (not a good thing for the existing holder of bonds, or utilities for that matter), but will likely attract foreign capital fleeing negative rates and, thus, reinforcing the strong dollar. Since interest rates are currently below where we think they ought to be for economic reasons, we think rising rates, up to a point, will be healthy for the economy. You’ve heard us say that before.

So, where are we?

We expect continued slow GDP growth of 2%-2½% in the U.S. economy, which is still better than Europe or Japan. Chinese growth continues to slow. Inflation is not a problem anywhere around the globe—deflation is the fear.

European and Japanese central banks have adopted Quantitative Easing (they’re printing money) just as the U.S. Federal Reserve is planning to continue “normalizing” its monetary policy by raising interest rates. (The first step in normalization was the end of our QE program). This has boosted the dollar versus the euro and the yen which, in turn, boosts the purchasing power of the U.S. consumer, but squeezes profitability for American exporters and lowers the dollar earnings of U.S. based international companies.

Crosscurrents anyone?

Meanwhile, stocks are fairly to fully priced, so we’re treading carefully.

The comments made by Muhlenkamp & Company 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.