Quarterly Letter, April 2020

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

Before Ron and I start with our normal topics, please allow us to extend our heartfelt wishes for good health and good luck during this exceptional period. Also, our deepest thanks to all of you that are reaching out to help others. We are continually amazed at the many, many ways we see people helping each other and are inspired and heartened by such actions. Thank you.

Additionally, we’d like to reassure you that Muhlenkamp and Company is fully operational and open for business. Our employees are doing a fantastic job working from home continuing to provide the service you’ve come to expect. I’d like to publicly thank Rich Dean, our Operations and IT Manager, for his hard work putting in the systems that allow us to do that. Thanks Rich.

Now, here’s what we’re seeing:

The week of March 9th is when America changed its mind about the novel Coronavirus now called COVID-19. To be sure, the subject had been in the news prior to that, but received little notice. That week, however, the seriousness of the illness caught America’s attention and decision makers at all levels reacted. Like a school of fish that suddenly changes direction with no obvious leader or signal, America shut down its colleges, athletic events, concerts and gatherings, local schools, bars and restaurants, then finally, in many places, anything deemed “non-essential”. I find it really interesting that this change in direction was much more “bottom up” than “top down”.

The stock market reaction was similarly rapid with the S&P 500 Index falling approximately 34% from the peak on February 19th to the trough (to date) on March 23rd. Bond markets tanked as well. Investment-grade bonds as represented by the Markit iBoxx USD liquid investment-grade index fell 18.9% from March 6th to March 20th. High-yield bonds, as represented by the Markit iBoxx USD liquid high-yield index fell 21.8% from February 20th to March 23rd.

Unlike most recessions where the change in economic activity is relatively slow, and even at the trough most businesses have some revenue, this time we shut down many businesses (airlines, cruise ships, theme parks, restaurants, many retail stores, etc.) very suddenly and many of them will have zero revenue for an indeterminate period of time. Businesses and investors suddenly started thinking about cash the way consumers suddenly started thinking about toilet paper: they couldn’t get enough of it fast enough. Companies drew down lines of credit, businesses and investors sold assets to include stocks, bonds, and shares in money market funds. This was not just a U.S. phenomenon. Overseas companies have borrowed heavily in dollars and they too ran for cash denominated in dollars. This sudden dash for cash created enormous stress in the banks and asset markets.

In order to support the continued functioning of credit markets, the Federal Reserve has embarked on a massive buying program of pretty much everything but junk bonds and equities. They’ve also created swap lines with other central banks to get dollars overseas. Their intervention has been huge, fast, and necessary. In order to help small businesses, households, and specific industries remain solvent during this shutdown, Congress passed a $2 trillion support package. It is not yet clear if the Federal Reserve interventions or the Federal Government support will be enough, it’s too early to tell. The speed with which the government acted is noteworthy.

America is intentionally holding the economy down to slow the spread of the virus. The key to letting the economy back up off the mat is: reduce the risk of rapid contagion to a level we can live with. I don’t think we’ll eradicate the virus any more than we’ve eradicated the flu or the common cold. In the long term this will be another chronic condition that we will collectively manage. We think the leading indicator now for economic activity is going to be the change in the acceleration of new corona virus cases. In other words, when will the spread of the virus slow? Our guess, based on the Chinese experience, is that the acceleration will begin to slow 2-4 weeks after social distancing measures really took effect. We are tracking publicly available information to see if our base case is working out, or not. That will give us some idea of the duration of the intervention. The other big unknown is how much damage was done to the economy. We probably won’t really start to understand that until April as companies start to report their quarterly earnings and government data starts to come in. There remain a lot of unknowns.

The United States is not, of course, the only country affected by the virus. China has already been through the worst of it and is recovering. Europe is maybe a week or two ahead of the U.S. in dealing with the virus. Even as China’s lock down affected our supply chains, China’s exports are going to be affected by the shutdowns in Europe and the U.S., two of their biggest customers. These linkages will slow everyone’s recovery somewhat.

It is also possible that the economic stress of dealing with the virus kicks off a self-reinforcing cycle of problems. Cascading defaults on loans are possible which is why governments are pumping money into households and businesses so quickly in an attempt to deal with the problem before it grows out of control. The increase in oil production by Russia and Saudi Arabia, which has collapsed the price of oil to $20 per barrel, is putting enormous stress on energy producers globally, increasing the likelihood of defaults there. Banks are always vulnerable in a recession: reduced credit availability or even bank failures are possible. (The Federal Reserve, in particular, is acting quickly to nip this potential problem in the bud). Finally, this is an election year in the U.S. and the agenda just changed. It’s too early to know what new policy proposals will be put on the table or to hypothesize what their impact will be economically, but a major shift in how the government interacts with all or some of the economy is possible. Europe is also vulnerable to upheaval, and we’ll be watching that.

The selloff in the markets is presenting us with better pricing on companies than we’ve seen in quite a while and we are working hard looking for the best opportunities. Jeff developed a rule of thumb in ’08-’09 that goes like this “When the market is down 30% and the headlines are all screaming ‘Recession!’ the next six months will be a pretty good time to put money to work.” Substitute “Virus” for “Recession” and that is exactly where we are today. We’re not calling a bottom, we really don’t know if we’ve hit the market bottom or not, but we are pretty sure the next six months will be a good time to go shopping, and that’s what we’re focusing on.

With our best wishes for your success and good health!

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.