Quarterly Letter, January 2019

By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers

When we began 2018 we thought the markets would be dominated by two important changes: the passage of the new tax law in the final days of 2017 and a decline in dollar liquidity as the Federal Reserve both raised short-term rates and reduced the size of its balance sheet. We thought the first change would be good for the economy in both the short and long-term and the second change would be negative for most asset markets. We didn’t hazard a guess regarding when the negative influence would start to appear. As a result, we were comfortable holding some cash at the start of the year but also wanted to participate if the economy took off.

As the year unfolded we ended up selling into what was a rising market in the spring and summer—not because of the larger view, but because of changes to the fundamental outlook or the price action of the stocks we owned. We sold some companies because their business prospects changed and no longer met our expectations and sold others that had become fully valued or overvalued and lost their upward price momentum—our normal sell criteria. Since we were unable to find good companies at attractive prices we held onto the cash. As a result, we looked pretty dumb during the first half of the year with our return significantly underperforming a still rising S&P 500. When the S&P 500 began to decline in September and October we didn’t look (or feel) quite so dumb as our cash helped us to outperform on a relative basis late in the year. The outperformance late in the year was not enough to outweigh the underperformance earlier in the year, thus we underperformed for the year as a whole.

As we begin 2019 we are still in a slowly shrinking dollar liquidity environment: the Federal Reserve has indicated it will continue to shrink its balance sheet and consider additional short-term rate increases during the year. Additionally, the European Central Bank (ECB) ended its asset buying program in December 2018, so it is no longer pushing additional euros into global asset markets. Thus, support of asset prices by central banks continues to gradually shift into reverse. This year we cannot identify any big positive change(s) for the U.S. economy like last year’s tax bill. In fact, in October we saw a decline in U.S. housing activity as high new home prices and higher mortgage rates reduced new home sales. We expect the slowdown in housing to continue in 2019 and consider it an incremental negative as we look at the U.S. economy. Additionally, we don’t see a big positive for any other economy around the globe. We are seeing slowing economic growth in Europe, Japan, and China as well. In sum we are seeing slowing economies and shrinking liquidity —a poor environment for good returns on assets.

Our outlook on inflation has shifted a little bit recently. Six months ago we said we were uncertain about whether we would see higher inflation going forward but we thought the risks were to the upside. Since then oil prices have dropped from $75 per barrel to $45 per barrel with many other commodity prices dropping as well. Consequently we no longer think the risks are to the upside and don’t expect higher inflation in the near future.

We also see a couple of wild cards out there. The first is Brexit, which is scheduled to happen in late March. Currently there is no agreement between the United Kingdom and the European Union (EU) to govern relations between them post Brexit and the proposed agreement they’ve been negotiating for two years has yet to come up for a vote in the English Parliament. If Brexit occurs without an agreement (a “hard” Brexit) we expect some volatility, but don’t know how much. It is also possible that an agreement will be reached or that the negotiation process will be extended. The second wild card is the ongoing trade dispute between the U.S. and China. This has the potential to get better or worse and we have no insight into which way it will go. The range of possible outcomes is wide and could impact markets significantly either in a positive or negative fashion.

As the New Year begins we have plenty of cash available to invest but are in no hurry to put it to work. We will continue to methodically search for good investment opportunities and will be patient until 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.

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.

Federal Funds Rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. It is the interest rate banks charge each other for loans.

S&P 500 is a widely recognized, unmanaged index of common stock prices. The S&P 500 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.