Quarterly Letter, April 2021

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

The first quarter of 2021 has been pretty good to us. Our homebuilder holdings have benefitted from a very strong housing market that began in May of 2020 and has not seen a letup since. Buyers are occupants not speculators and are putting money down, so the excesses we saw in the housing market early this century are not currently present. Home inventories remain low and rising interest rates do not appear to be impacting demand to any significant degree. Our holdings in financials have benefitted from both an improved consumer outlook (due in part to government stimulus checks) and higher long-term interest rates (which makes it more profitable to lend). Our investments in industrial companies have benefitted from improved business activity. Our information technology companies continue to do well even though some of the upward momentum appears to have come out of the stocks of the biggest companies.

Shifting to the stock market, we’ve observed a rotation out of many of the stocks that have dominated the market the last few years and into stocks that will likely benefit from the re-opening of the economy. That rotation in the market has been to our benefit so far. There are still a lot of overpriced stocks out there, particularly ones tied to popular themes (electric vehicles, renewable energy, artificial intelligence, etc.). We’ve also observed a lot of shenanigans in the market by both amateurs and professionals. The amateurs have used internet forums to coordinate efforts to drive up the stock prices of a number of heavily shorted stocks—you may have read about GameStop (GME) and AMC Entertainment Holdings, Inc. (AMC)—causing acute pain for the institutional investors who sold them short. The professionals have used borrowed money to make themselves financially vulnerable, examples are Greensill Capital (a European financial services company that is now out of business) and Archegos Capital Management, LP (a family office that was done in by margin calls from its lenders). We don’t think any of the above examples will have a big impact on the financial system, but they have been entertaining to watch. We also believe that they are indicative of the mood of market participants (somewhere between confident and overconfident) and are useful as anecdotal indicators of market sentiment.

Expanding our view a little bit, we note that demand for corporate debt remains very strong—no problems there. Interest rates have increased during the quarter and are now almost to the level we saw in January of 2020: the 10 year Treasury Yield on January 2nd 2020 was 1.88%, on April 1st 2021 it was 1.68%, so we are 20 basis points lower than pre-pandemic. Interestingly the rise in interest rates corresponded with a selloff in some of the most popular “growth” stocks. What are the odds that rates continue to rise from here? Our best estimate is 60/40, up a little bit from a few months ago. The primary reason the odds are higher than a few months ago is we are seeing widespread increases in input costs to businesses—raising concerns about higher inflation, which is more often than not accompanied by higher interest rates. Jerome Powell, Chairman of the Federal Reserve, has repeatedly stated that any inflationary pressures resulting from the re-opening of the economy will be temporary. We’re not so sure. On the other hand the abundance of global capital looking for a decent return has not diminished and the “pension feedback loop”* which we believe has contributed to low rates remains intact.

We believe there are incremental reasons to think interest rates may continue to rise but strong, long term reasons to think they may not rise much further, thus our lack of conviction in either direction. We remain pessimistic on the return potential for bonds.

Finally, a brief note about the scale of government COVID-19 relief measures. By our count the Federal Government has approved $5 trillion in COVID relief so far. The first package, $2.2 trillion, was approved in March 2020, the second for a measly $900 billion was approved in December 2020, and the third package, for $1.9 trillion, was approved in March 2021. With a population of 330 million people, the additional spending amounts to $15,000 per person, or roughly $45,000 per household (we have 110 million households in the US). In 2019 the US Federal debt was $70,917 per capita. Thus the per capita Federal debt increased 21% as a result of COVID relief spending. We hope we get our money’s worth as we’ll be paying interest on that debt forever.

As always, if you’ve got questions or comments feel free to write or give us a call. We’d love to hear from you.

*A brief refresher on what we call the “pension feedback loop.” Low interest rates means pensions don’t meet their return requirements and become increasingly underfunded. Current law requires a minimum funding level for pensions, so the plan sponsor (company or municipality) is required to contribute more money to the pension over time. That additional money is partly invested in debt instruments, partly in equities and other assets. The net result is that lower rates create a greater supply of capital that is invested in debt which we believe puts downward pressure on interest rates. Global pensions are the biggest investors in the world, and the math and laws are inflexible. We believe the impact on interest rates of this feedback loop is significant but we have not been able to quantify it.

The comments made in this letter 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.