Quarterly Letter, January 2013

By Ron Muhlenkamp

2012 was a year of mixed results on the economic front, but generally good investment returns as measured by the S&P 500 Index. Some progress was made in Europe and China, and some clarification in direction was made in the U.S.  We presented our thoughts on these topics at our December 6 seminar.

A brief review follows:

The U.S. economy continued to expand, but at a modest rate. Consumer spending is growing moderately at a 2%-3% annual rate; consumer saving is at 3%-4% of income. Consumer confidence has improved since 2009, but is still at the subdued levels seen during the prior recession. Gasoline consumption has declined 5% since 2006, after climbing steadily prior to that. Housing has begun to recover and car sales are approaching “normal” levels.

Business investment and hiring remain subdued as businesses await clarification of the rules on taxes, regulation, and government policy. Business and commercial borrowing are picking up a little. Bank health continues to improve.

The Federal Reserve continues to hold interest rates at artificially low levels, squeezing the returns to retirees and pension funds. The Fed’s balance sheet is no longer growing. The remaining big question in the U.S. is whether we contain government spending, which has been shown to lower economic growth. A major problem is that many think government spending enhances economic growth.

Commodity prices have leveled off, but remain quite volatile. In the energy markets, there remains a huge spread between the price of crude oil and natural gas. In early 2012, the fuel cost of natural gas fell below that of coal, causing many power plants to shift consumption to natural gas. We expect these fuels to remain competitive for the foreseeable future.

While the recent rise in tax rates (and FICA taxes) will serve as a drag on the U.S. economy, we expect the U.S. to avoid recession with modest growth.

In Europe, the crisis of policy seems to have peaked, but much of the continent is reentering recession. We think the probability of Europe’s problems threatening the viability of the U.S. based international banks has lessened.

China appears to have achieved its goal of containing inflation by slowing the economy and is likely to resume Gross Domestic Product (GDP) growth, but at a slower than historic rate and with a focus on the consumer.

During early 2012, we held more than normal cash reserves and remained focused on large, U.S. based companies with strong balance sheets and cash flows. As some of the above-mentioned issues were clarified, we’ve invested most of the cash, some of it in smaller companies.

Our resulting performance, while trailing the S&P500 Index for the full year, has tracked a bit above it in recent months. We continue to seek good companies at modest prices.

The comments made by Ron Muhlenkamp 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.