Quarterly Letter, April 2018

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.