Quarterly Letter, April 2016

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

In the spirit of our times, when trigger warnings abound, we should probably warn you now that what we’re about to discuss may make you uncomfortable. Continue reading at your own risk. And no, we won’t be discussing politics.

In many ways the first quarter of 2016 was a repeat of the events of late last year. The 10% correction in the S&P 500 Index in January and February closely matched the August–October 2015 correction. Both were immediately preceded by a sharp decline in the value of the renminbi (Chinese currency) versus the dollar, and crude oil prices moved in lockstep with the stock market. During the quarter companies published their 4th Quarter 2015 business results. In the aggregate, both revenues and earnings declined for the top 3,000 U.S. companies on a year-over-year basis. For those of you not keeping your own scorecards, that’s three consecutive quarters of declining revenues, and two consecutive quarters of declining earnings. As before, falling energy prices and a strong dollar accounted for the bulk of the declines. As was true late last year, the Central Banks of Europe and Japan continue to use asset purchases to keep interest rates down in an effort to goose their economies. This year, Japan joined Europe in the use of negative interest rates in pursuit of that elusive goal.

There has been a change in the apparent willingness of the U.S. Federal Reserve to continue raising our interest rates. You’ll recall last year that the Fed spent a lot of time talking about the circumstances under which they would raise rates, and they actually raised them a quarter-of-a percent in December. This year, even though the conditions they outlined last year remain in place, they have indicated they are in no hurry to raise rates further. We believe this is important as the policy differences between our Central Bank and the European and Japanese helped drive the dollar up and oil down. The dollar has weakened since the Fed changed its tone, and, coincidentally, markets recovered and oil bounced. We’ll continue to pay close attention to the central banks.

We were asked the other day what the impact of negative interest rates would be if they came to the U.S. The short answer is negative rates would do more of what low rates have already done—hurt savers. Think of negative interest rates as a tax on assets: some owners will stand and pay the tax; others will run to try to avoid it. Banks would try to pass along the negative rates, which would probably show up in higher banking fees of some sort. Insurance companies, which invest heavily in bonds, would be forced to raise premiums because they’d get lower returns on their assets. Pension plans, many of which are already massively underfunded, would become even more so, requiring greater contributions from the business or municipality that sponsors them. (Guess where a municipality gets funds: from you, the taxpayer.) Money market funds, which have been waiving fees for years to avoid “breaking the buck,” would find creative ways to pass the cost on to their clients or simply close up shop. That was just off the top of our heads. We’ve seen much of that start to unfold in Europe already, and it’s disquieting. We hope our leaders are smarter than that; we’ll see. We also realized that lower interest rates alone have made all of the conventional assumptions used in retirement planning obsolete. We’ll lay out our thoughts on that during the May 12 investment seminar. We hope you can catch that, either live or on the web.

Briefly reprising our list of expectations from last quarter, we expect U.S. Gross Domestic Product (GDP) growth to be in the vicinity of 2% at best with risks to the downside caused by falling corporate revenues and earnings. We have yet to see the full impact of low crude oil prices on the energy sector; we expect more bankruptcies to come with follow-on impacts to the banks. Having said that, high-yield credit spreads have come down a little bit in the last month, which is positive. We don’t expect a rapid rise in energy prices or a rapid decline in the dollar, but both will be driven by central bank policy as indicated above.

We put a little bit of money to work in February and bought some interesting companies at very good prices. We still hold a large cash reserve and continue to look for good places to put it to work. As you know, we like to be buying when others are in a hurry to sell, but we don’t want to be early to that party either.

Until next quarter…

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.

The S&P 500 Index is a widely recognized 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. One cannot invest directly in an index.

Spreads refer to the difference in the number of percentage points or basis points in yield. The level of risk correlates with the
potential for returns.