Quarterly Letter, January 2018

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

If you had told us a year ago that the market would rise 20% in 2017, we would have been skeptical. Yet, here we are at the end of the year and the S&P 500 Total Return Index was up 21.83% for 2017. The S&P 500 Index was up 19.42%. (The difference is the Total Return Index includes dividends.) Technology stocks led the charge; health care, consumer discretionary, and industrials also beat the average. Every other sector delivered below-average returns with energy and telecommunication services posting losses for the year. Our performance was quite close to the S&P 500 Index all year. (Please refer to the 12/31/2017 Fact Sheet for our final performance numbers.) Apple, Inc. (AAPL), ON Semiconductor Corporation (ON), and Universal Display Corp. (OLED) contributed the most to our performance this year, while Teva Pharmaceutical Industries (TEVA), Spirit Airlines (SAVE), and Allergan PLC (AGN) were the biggest drags.

Economically speaking, U.S. Gross Domestic Product (GDP) growth during the first three quarters (4th quarter data hasn’t come out yet) averaged a little over 2.1%, but 1st quarter was the low quarter, and 3rd quarter was the high quarter—so the trend was up (which has been the case since June 2016). Unemployment is generally low, inflation is low, and most of the economic metrics we keep an eye on are looking benign. If you want more detail on that, we’ll refer you to the webcast we did at the end of November.

At a high level, two “big things” are happening. First, the Trump administration and Congress are working to remove legal and regulatory impediments to economic growth. They are obviously not unified in this effort and the process has been, shall we say, contentious. Nonetheless anti-growth regulations have been rolled back to a degree and a new tax law was signed just before Christmas. We think this is the reason Small Business Confidence jumped post-election and remains at a very high level. We think the new tax law and the shift in the regulatory environment are generally positive developments. We think of it in these terms: when businesses are fleeing your borders, it is a HUGE sign that you are doing something wrong. When businesses hire armies of lawyers to avoid taxes instead of simply paying them, it’s a sign you are doing something wrong. It’s been happening in the U.S. for years now, as companies merge with foreign businesses to shift their headquarters to more welcoming tax and regulation locales or create complicated corporate structures and hold cash overseas to reduce taxes. Erecting barriers to exit was the knee-jerk reaction but it never works. Congress is taking action to address the root causes of businesses leaving the U.S. and we think what they’ve done will improve the situation. It’s also happening at the state level, just look at Illinois as businesses move to Indiana. Illinois hasn’t figured this out yet and continues to chase businesses away. Does anybody think Amazon is seriously considering putting its second headquarters in Chicago? We doubt it.

The second “big thing” is the movement of interest rates in the direction of what we think is “normal” and the reduction of assets held by the U.S. Federal Reserve. As you probably know, for two years the Federal Reserve has been gradually raising short-term rates. Allowing rates to rise to where they “should be” relative to inflation is a positive. If they raise rates more than that, it will become a negative. Additionally, this summer the Federal Reserve started executing a plan to gradually reduce the assets they hold on their balance sheet by not reinvesting all of the money they receive when bonds mature. Their plan is to initially reduce their assets by $10 billion per month ramping that up to $50 billion per month over time.

Simultaneously, the European Central Bank has announced a reduction in its bond purchase program beginning in January 2018. The Bank of Japan is the only major Central Bank that has not signaled a reduction in its “print and purchase” program. We believe that all the money printed during the last 8 years helped boost asset prices—stocks, bonds, houses. As central banks start slowly withdrawing some of that money, it may well have a reverse effect on asset prices. The Federal Reserve certainly intends to draw down their balance sheet slowly enough that markets don’t even notice, but they may not succeed in that. We laid this out in greater detail during our November webcast, take a look at that or give us a call if you want to have a fuller discussion of our thoughts on this.

As we look forward to 2018 then, we see two “big things” working in opposition to each other as far as the markets are concerned: prospects for improved economic growth is a plus, while a reversal (U.S) or reduction (Europe) of central bank support is a negative. Each of these forces may get traction at different times.

With that as a backdrop, we will continue to search for investment opportunities and put our money to work when we find them.

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.

Central Bank is the entity responsible for overseeing the monetary system for a nation (or group of nations). The central banking system in the U.S. is known as the Federal Reserve (commonly referred to “the Fed”), composed of twelve regional Federal Reserve Banks located in major cities throughout the country. The main tasks of the Fed are to supervise and regulate banks, implement monetary policy by buying and selling U.S. Treasury bonds, and steer interest rates.

S&P 500 Index is a widely recognized, unmanaged 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.