The investment objective of the Muhlenkamp Fund is to maximize total return to its shareholders through capital appreciation, and income from dividends and interest, consistent with reasonable risk.
Invest in the common stock of highly profitable companies, as measured by Return on Equity (ROE), that sell at value prices, as measured by Price-to-Earnings Ratios (P/E).
Ronald H. Muhlenkamp, CFA has been active in professional investment management since 1968. He is a graduate of both M.I.T. and the Harvard Business School.
Period: Q4 2012
Portfolio date: 31 Dec 2012
No. of stocks: 46
Portfolio value: $420,851,000
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
The U.S. national election is over. Some of the uncertainty around taxes and regulations is now clarified. We’re likely to get more of each. Attention has shifted to the “fiscal cliff.” Much has been written and commented about the big picture, let’s examine the impact to wage earners and retirees.
As the U.S. tax code is currently written, several changes will take place on January 1, 2013:
1. The payroll “tax holiday” ends, so automatic deductions for FICA (Social Security) taxes will increase by 2% of gross pay for nearly all wage earners.
2. The Bush-era tax rate cuts will expire. We’ve heard that the Bush-era tax rate cuts were for the “rich,” but, in fact, the rates were cut on the order of 3% for nearly everybody. (Refer to the following table for details.)
A Comparison of 2013 Income Tax Brackets
Married Filing Jointly
Taxable Income Bush Tax Cuts In Place Bush Tax Cuts Expired
(tax rate) (tax rate)
$0 - $17,800 10% 15%
$17,800 - $60,350 15% 15%
$60,350 - $72,300 15% 28%
$72,300 - $145,900 25% 28%
$145,900 - $222,300 28% 31%
$222,300- $397,000 33% 36%
$397,000 - 35% 39.6%
Source: Joint Committee on Taxation
Bottom line: For the average wage earner, expiration of the above will raise taxes paid by roughly $2,000 - $3,000 per year.
3. The tax on dividends will go from 15% to the individual’s (couple’s) rate on ordinary income.
4. The tax on capital gains will go from 15% to 20%, plus a 3.8% surcharge for high-income tax payers.
5. The inheritance tax will go from 35% with a $5 million exemption, to 55% with a $1 million exemption.
Consumers, business owners, and investors all focus on after-tax dollars; after all, it’s the only money you can spend or invest.
So the above changes are likely to have the following consequences:
Taxpayers will have less money to spend. If you take a look at your current paycheck and subtract 5%, you’ll get some sense of what your paycheck will look like after January 1. If you recall that the 2009 recession resulted from consumers cutting back on spending (voluntarily) by 5%, you’ll get an appreciation for what may happen when their incomes drop by 5% due to increased taxes
Dividends will be worth less than before. Consequently, stocks will be worth less than before. As the Federal Reserve has concentrated on driving interest rates lower over the past three years, retirees and other people with savings have gone further and further afield trying to find useful “incomes.” We were recently told of a search for “creative sources of yield,” which implies that the search continues, but is running short of ideas…usually a very bad sign.
The higher tax rates on capital gains are likely to result in a rush to realize capital gains through the sale of stocks or businesses before 12/31/12. Those not selling before this date, then, are more likely to allow the tax to be deferred by postponing the realization of capital gains (through the sale of assets) in the future.
Many small business owners pay company taxes at their rate as individuals. With more money going to taxes, they will have less money to pay in wages. When faced with a higher tax bill and more regulation, a greater number of small business owners will choose to retire earlier than planned.
Over the years, we’ve observed that when tax rates exceed 45%-50%, people do strange things with their money to avoid the tax. Remember the tax schemes of the 1970s? Federal income taxes are not currently scheduled to exceed 45%, but estate taxes are. It will be interesting to see what results.
The window for these tax changes to be delayed or further modified is now less than 50 days. This means the decision timeframe for investors to change their actions to adjust for the increased likelihood of higher taxes is closing. (Until November 6, many decision makers waited for the election results, knowing they had 60 days to implement changes after the election.)
For over a year, we’ve been discussing Europe, China, and U.S. Politics as the major drivers of the markets. On September 7, 2012, we published a Market Commentary, headlined “Threat of European Banking Crisis Recedes.” In it, we discuss the Outright Monetary Transactions (OMT) program, introduced by the European Central Bank (ECB). We think this program makes credible the ECB’s promise to do all it can to keep the Eurozone together. And we believe this action mitigates some of the risk of investing in U.S.-based international banks.
As for China, we continue to monitor the country as its leaders turn their economic focus from building infrastructure toward ‘building the consumer.’ We don’t think that China has turned the corner.
We think some of the uncertainty surrounding U.S. levels of taxation and regulation will be resolved when we find out which direction the voters choose for the U.S. on November 6. In the meantime, on September 13, in addition to keeping short-term interest rates near zero until mid-2015, the Federal Reserve announced a third round of Quantitative Easing (QE 3). The Fed has stated it will purchase $40 billion worth of mortgage-backed securities every month until unemployment declines to a reasonable level. We don’t think these purchases will help lower unemployment much, and contend that keeping interest rates low is hurting the retirees/savers in this country. Further, past attempts to reflate the housing market and spur the economy through record-low interest rates and quantitative easing have not been very effective. (Mortgage lending in 2011 declined to its lowest level in 16 years, according to a report from federal regulators.) What we do see is that the Fed’s actions are boosting the equity markets. The DJIA (Dow Jones Industrial Average) hit an annual high after the Fed’s announcement.
We continue to believe the Fed is attempting to fix a fiscal problem (i.e. too much government spending) with monetary policy (i.e. pouring money into the economy). Bernanke, the Fed chief, states “The weak job market should concern every American.” He’s exactly right in this regard, but it’s our belief that hiring will pick up only after the matters of increased taxes, regulation, and healthcare insurance are clarified. (In fact, Bernanke has urged Congress to address such concerns.)
Meanwhile, U.S. Gross Domestic Product (GDP) growth hovers at 1.7 percent. A number of bellwether companies, including FedEx, Intel, and Caterpillar have all revised guidance downwards in the last few weeks. If the automatic tax increases and spending cuts slated for the end of the year occur on schedule, we think it will be a 2%-4% hit to GDP and likely trigger a recession. It is also possible that equity markets, in responding to the latest round of QE, have gotten too far ahead of the economy. If the economy doesn’t follow, we expect the markets to correct.
Threat of European Banking Crisis Recedes
For a little over a year we’ve been telling you that the possibility of a European banking crisis has been one of three macroeconomic situations that we believed were driving the U.S. equity markets. The fear was that a combination of highly indebted countries and highly levered banks holding overvalued assets could collapse in a cascade of bank failures. If realized, this would meaningfully impact U.S. financial institutions that held significant European assets, resulting in large losses or even failures. The likelihood of this occurring is now much less than it was even a few weeks ago due to a new bond buying program announced by European Central Bank President (ECB) Mario Draghi on September 6, 2012. The new bond purchasing program is called the Outright Monetary Transaction (OMT) program. Please allow us to explain.
It’s been our assessment that a high-stakes negotiation has been going on between Europe’s insolvent countries, the ECB, and Germany. On one side of the table are the insolvent countries that need to borrow money cheaply, but are being priced out of the public debt markets. On the other side of the table are Germany and the ECB, which are the two main entities that could lend them money or help keep market lending rates low. The crux of the matter has always been that both the ECB and Germany don’t want to lend to insolvent countries indefinitely. Their demands have been that those countries get their government finances in order and reform their economies to spur growth, thereby reducing the need for further government borrowing.
The ECB and Germany have driven very hard bargains with Ireland, Greece, and Portugal, and the governments of those countries have borne a lot of pain. Both Ireland and Greece threw out the governments that made the initial deal. Greece is now trying to renegotiate the deal, while Ireland is sticking with it (and performing a whole lot better than Greece economically speaking). Spain and Italy have also changed governments in the last year or so and have begun making fiscal changes in the hopes they wouldn’t have to make a deal with Germany and the ECB. But in July 2012, it looked like Spain’s efforts to avoid a bailout were going to be in vain as the yield on 10-year Spanish bonds moved back above 7 percent. We believe that Mario Draghi concluded in July that he had gotten as many concessions out of Spain as he was likely to get and that allowing Spain to experience further pain would be counterproductive. (Capital was leaving Spanish banks; there was increasing talk of the possibility of a breakup of the Eurozone; European economies continued to decline; global markets were reacting negatively, etc.) So Mr. Draghi took action, first with promises during his “Bumblebee” speech on July 26, 2012, and now with a plan of action on September 6. It is also important that Angela Merkel has indicated her support of Draghi’s efforts (without German cooperation the effort would be unlikely to succeed). There is now a path for insolvent countries to follow that enables them to keep functioning for the foreseeable future, thus removing a lot of uncertainty about the immediate future of the Eurozone and the Euro.
The OMT program provides assurance that borrowing rates for Spain and Italy will not become prohibitive as long as the program remains in place. The OMT program and the ECB’s commitment to it are credible. We believe this effort will fail, however, if governments cease working to reform their economies and their finances; that is, if they don’t use the time it buys them wisely. It may also fail if the reforms initiated by governments are rejected by their voters. Greece very nearly did that in May and June with their two rounds of elections; this possibility should not be ignored.
This new bond buying program (OMT) doesn’t mean that the European economies mired in recession or depression will start improving. We don’t think it helps that at all. We do think it means the threat to U.S. banks presented by a European banking crisis is drastically reduced. In response, we have increased our holdings of financial institutions selling at a discount due to their European exposure. Further, it may mean that capital that fled Europe for the “safety” of U.S. Treasuries reverses, allowing Treasury yields to rise a bit.
In sum, one of the three drivers of U.S. markets that we have been talking about for over a year has become much less important, at least for a time. We’ll keep an eye on it to see if Europe finds long-term solutions or if their difficulties increase. This development has no direct effect on the other two drivers of U.S. markets: China and U.S. political economics, which we continue to watch very closely.
Muhlenkamp & Company, Inc., quarterly conference call for advisers.
What’s driving the markets lately? As near as we can tell, the same three topics that we’ve been talking about for almost a year: Europe, China, and the United States—with the current emphasis on Europe for debt and equity markets, and China for commodity markets. We’ll start with Europe.
Spain is now in the European spotlight. Spain has officially requested external assistance of up to 100 billion euros in recapitalizing its banks. The European Community has promised support for the Spanish banks, but the details have not been worked out. Announcements made in the wake of the European Summit last week generated hope that Europe was getting its arms around the problems and prompted a nice rally in the markets on June 29, but were very light on details. How the Spanish banks are bailed out matters at least as much as the fact that they are bailed out. The Spanish government does not want to become Ireland, (sunk by the liabilities of its banks), and is thus reluctant to cosign the loans for its banks. Meanwhile, the Spanish government is diligently trying to get government spending under control in the face of a serious recession and high unemployment. Simultaneously, it is trying to reassure lenders that it will repay its debts, (and hence should be able to continue to borrow at reasonable rates), while trying to avoid angering the voters so much the incumbents get thrown out of office. (Videos of burning tire barricades across Spanish highways indicate at least some Spanish voters are not pleased with what their government is doing.) The Spanish government is walking a tightrope; the balance is getting harder to maintain with every step.
Earlier this spring, Greece provided an object lesson in how hard it is to satisfy both lenders and voters. Voter dissatisfaction with the terms of the second bailout will force the Greek government to re-open negotiations with lenders over its terms. We’ll see where that goes, but it places Greek problems back on the table only a few months after market participants thought they were done worrying about Greece for a couple of years.
Italy has moved out of the headlines. The yield on its 10-year bonds has moved back below 6% to roughly 5.75%, but it, too, has not resolved its long-term problems.
How has the recent European drama affected the markets? The European equity market sold off pretty hard from March through June, while safe havens boomed. German 2-year bond yields went negative as investors moved their money to places they were sure it would be returned. In the U.S., Treasury yields declined for the same reason German yields did, while the equity market gave back much of its gains for the year. Of particular note, the January-March rally in financial stocks almost completely reversed itself from April to June. We expect developments in Europe—primarily Spain and Spanish banks—to continue to influence the bond and equity markets at least through the summer: (June 29 is a prime example of how news from Europe is driving U.S. equity markets.)
We believe Europe has not solved any of its problems and note that forecasts of countries departing the Eurozone are increasing. We’re not trying to predict how Europe’s problems will be solved; we just know they aren’t solved yet. (And it seems Europe is able to accomplish little during the July-August vacation season.)
China is gradually cutting interest rates and relaxing restrictions on its banks in an effort to manage economic growth. On June 7, the Chinese Central Bank lowered the official interest rate at which loans are made. This provides Chinese banks a bit more leeway to deviate from the official rate for both loans and deposits. Allowing Chinese banks more room to set the price of money is a positive development, but it will take time to make a difference, as will the lower interest rate. In the meantime, a slowing rate of growth is hitting Chinese heavy industry particularly hard; Chinese demand for raw materials is dropping. Evidence of this can be seen in the 16% drop in copper prices from April to June; the rapid drop in steel prices over the same timeframe; and, perhaps, even in the 24% drop in crude oil prices from April to June.
Some market commentators expect China to pursue a stimulus program similar to its 2008 stimulus. We suspect if it stimulates its economy in the near future, it will not look like the last one. The Chinese government has stated it wants to encourage consumer spending, not build more highways and bridges. In sum, the Chinese economy is growing more slowly. The Chinese Central Bank has taken its foot off the brake and started to push on the gas, but the Chinese economy isn’t responding yet.
In the United States, economic indicators are softer as we move into the summer. So far, the equity market hasn’t expressed the recession fear that hit late last summer, but nothing in the numbers rules out a reemergence of that concern. There is no more clarity around tax rates, government spending, and regulations than there was a year ago—with the sole exception of health care. On June 28, the Supreme Court ruled the Patient Protection and Affordable Care Act constitutional, removing one source of uncertainty for that industry. The popular press now focuses on the “fiscal cliff” or “taxmageddon” that is anticipated to hit on January 1, 2013 as tax cuts expire and government spending cuts take effect. It seems neither political party is willing to make a significant move pre-election, but waiting until after the election leaves precious little time to do anything meaningful. We don’t expect much change in the economy for the remainder of the year. And we don’t expect to get much clarity on the direction of taxes, spending, and regulation until after the election.
In the U.S., gasoline prices, which hit nearly $4 per gallon in the spring, have pulled back to about $3.50 per gallon and are expected to go lower; that’s good news. Cheap natural gas has prompted electricity producers to shift from coal to natural gas much faster than anyone anticipated, pushing coal prices and electricity prices down. Cheaper energy is probably the biggest positive force in the U.S. economy today. Hopefully, we won’t kill it.
Overall, on the negative side, European debt and banking problems, slowing Chinese growth, and U.S. fiscal challenges keep us cautious. On the positive side, dramatic shifts in energy production and use in the U.S. provide us some very interesting investment opportunities. We expect the summer and fall to remain volatile as Europe continues working through its problems and the U.S. political debate heats up in advance of the elections.
The rally in stock prices which began in the fourth quarter of 2011 carried into the first quarter of 2012. Some called it a “relief rally.” We believe one trigger for the rally was the announcement of the “Long-Term Refinancing Operation” (LTRO) program enacted by the European Central Bank (ECB) which allowed European banks to rollover debt obligations for up to three years. We believe this bought them some time, probably measured in months. This alone does not solve the problems of Europe, but it’s better than prior programs which bought them a few days or a few weeks; (they kicked the can further “down the road”).
There is still no general solution in sight, nor do we expect a general solution. Yet, some countries are dealing with their problems and beginning to improve; e.g. Ireland and, maybe, the U.K. Some countries are treading water; e.g. Italy and France, and some are in decline, e.g. Greece, Portugal, and, maybe, Spain. Europe will probably dominate the headlines and the markets again in the near future.
Meanwhile, the Chinese economy continues to slow; the People’s Bank of China has taken its foot off the brake, but has not yet hit the accelerator. China is also in the midst of a change in leadership; this may delay a clear choice of direction.
In the U.S., the economy continues to expand at a modest rate. Over the 2011 calendar year, nominal GDP (Gross Domestic Product) grew at 3.8% with inflation at 2.1%, for a real GDP of 1.7 percent. The Federal Reserve continues to press for lower interest rates which are now below inflation, putting the squeeze on all savers, including retirees and pension funds. This also makes bonds unattractive as investments.
Along with the promises of more regulations and higher taxes, the uncertainty surrounding Obamacare is keeping businessmen (employers) guessing and reluctant to hire others, so unemployment remains high. Frankly, we don’t expect a clear direction in U.S. policy until after the November elections.
With the recent rally in the U.S. stock markets, we judge stocks, on average, to be fairly priced. We have found a number of good values, which we own in our portfolios.
Citigroup, Pfizer Just Fine, Says Muhlenkamp.
Ron Muhlenkamp, The Muhlenkamp Fund, discusses whether concerns about China will hurt US equities. He likes high quality large-caps with rock solid balance sheet and strong free cash-flow.
Concerns over a U.S. recession peaked in September and began fading by early October. Today, we think the markets are no longer concerned about a U.S. recession—that fear has dissipated largely because the economic data has gradually improved.
In late October we wrote that China had stopped squeezing its money supply and that concerns in the public media of a property bubble bursting weren’t heard much anymore. Last week, China announced it was reducing the amount of money it required its banks to hold in reserve by one-half of one percent, allowing the banks to increase the amount of money they lend. This is the first step towards a looser monetary policy and we think a sign that China is beginning to shift from fighting inflation to promoting economic growth. We believe this is meaningful as it presages increased economic activity, and hence demand, out of China.
Europe has gotten worse, not better, since we last wrote in October. The write-down of Greek debt that was a part of the August–September plan has gotten bogged down in discussions of which debt holders would and would not participate in the write-down. The European Financial Stability Fund (EFSF), which gained the authority to buy sovereign debt and inject capital directly into European Banks, has become nearly irrelevant as efforts to borrow money have failed and the entire facility has been discredited. Italy and Greece have both replaced their prime ministers with “Technocrats” after their parliaments lost confidence in the former ministers’ ability to lead those countries to a solution. (Technocrats are technical experts placed in authority by the ruling party in Parliament without an election being held.) Italian 10-year bond yields broke 8% in mid-November in spite of ongoing purchases of Italian bonds by the European Central Bank (ECB) now led by Mario Draghi. (Jean-Claude Trichet’s eight-year term as ECB President ended in October.) Those yields have pulled back a bit in the last week or so, but remain worryingly high.
The biggest news recently is the reduction in interest rates on dollar swaps to other central banks—this makes dollars available to European banks (through their central bank) at cheaper rates and helps relieve some of the near-term dollar funding pressure they had been experiencing. Announcement of this coordinated central bank action on November 30, 2011 prompted the S&P 500 to jump over 3% that day. While helpful in reducing near-term stress on European banks, this action doesn’t resolve the underlying issues. Probably more important was Mario Draghi’s address to the European Parliament on December 1, 2011 in which he suggested additional ECB assistance might be forthcoming if greater fiscal union (and enforceability of budgets) were rapidly achieved in the Eurozone.
This is the crux of the matter. Germany and the ECB do not want to lend money to Italy, Spain, Greece, etc. in perpetuity—they want those governments to get their spending under control so any loans made now don’t have to be repeated in the future. Their negotiating tactic is to withhold further assistance until market pressure (unaffordable borrowing costs) forces governments to agree to enforceable fiscal discipline. This is a high stakes negotiation that will probably continue for a while.
It remains possible that events may force the participants’ hands: European banks continue to struggle to access short-term funding; they remain undercapitalized and are reducing lending and selling assets to correct the problem. Overt default by a sovereign state would force them to mark their bonds to market and some banks would be shown to be insolvent. Finally, the Eurozone is heading into a recession which will stress government budgets further. While a European recession wouldn’t reduce demand for U.S. products very much a banking crisis would affect our banks and global financial markets: the magnitude of the effect is difficult to estimate but is the reason for our continued interest in Europe. Europe’s drama will continue to induce volatility in the markets and could still turn out very badly.
The reduction in the likelihood of a U.S. recession and the shift in stance of the Chinese Central Bank give us more confidence in buying companies we believe will do well going forward. Ongoing events in Europe continue to keep us a bit cautious. We continue to try to strike a reasonable balance between taking advantage of the investment opportunities we see and avoiding losses if events in Europe get worse.
Ronald Muhlenkamp, founder and president of Muhlenkamp & Co., talk about Federal Reserve policy, the U.S. economy and investment strategy.
As always, the best market commentary around, courtesy of Mr. Ron Muhlenkamp of Muhlenkamp & Company.
We don’t think investors care much whether U.S. debt is rated AAA or AA+. The U.S. Treasury market is still the largest and deepest market in the world, and the likelihood of getting the promised payments (in nominal terms) remains very high. From an investing perspective, the downgrade is irrelevant. From a political perspective, it may be very significant. Mohamed El-Erian, (CEO of PIMCO), has stated the silver lining of the downgrade is the clear and unambiguous message it sends to policy makers. We hope he is right. What we do know is that yesterday, U.S. Treasury bill interest rates fell dramatically as investors rushed to buy U.S. government debt—not what you’d expect if they were worried about getting paid back.
We think what is driving the sell-off in equity markets and the move into “safer” bonds is concern over European debt problems led by Italy. You’ll recall that, for most of the summer, the European Union was wrestling with the problem of Greece’s debt, and, about three weeks ago, it reached an agreement to expand the authority of the European Fiscal Stability Facility (EFSF)—in both size and authority—to address the problem. The new agreement must now be ratified by European parliaments, which are on vacation until September; (I’m not kidding). While that debate was going on, the market was steadily increasing the cost of lending money to both Spain and Italy, currently charging a bit over 6% for those countries to borrow for 10 years. 6%-7% is about the level where Italy’s debt no longer becomes affordable; the Italians can no longer afford to borrow money to pay old debts and other government expenses, so its crunch time.
So sovereign debt problems and the possibility of a European-led banking crisis are, once again, the focus of the markets, and investors are pulling back because effective action isn’t being taken. You see this in the velocity of money, which has fallen dramatically, and the move into U.S. Treasury bills, bidding their prices up and creating the negative yield mentioned earlier. Banks are having difficulty making money on depositors’ funds—and must pay FDIC insurance fees on them—so they are passing those costs along to their depositors; (at least, Bank of New York Mellon is). I suspect yesterday’s decline was accelerated by some margin calls on leveraged hedge funds, but the essence of it is that the market is concerned about Europe.
The context in which this is taking place is also important. In the U.S., many economic indicators, from the Purchasing Manager’s Index to unemployment, are weakening; GDP growth is still positive, but 1st and 2nd quarter numbers were revised downward last week. These data points are creating renewed concern that the U.S. is moving into another recession. The recent debate over the U.S. debt ceiling was frankly discouraging and exhausting to watch—whether you liked the outcome or not.
The outlook for the next month or so isn’t good either. Europe has major problems and the parliaments are all on vacation. If this develops into a full-blown liquidity squeeze or banking crisis, it will get ugly. I expect European leaders will be unable to get ahead of the problem for at least six weeks. I think the problems in Europe will impact the decisions of businesses, consumers, and investors in the U.S., and make a recession more likely in the near term, not less. In the last week to ten days, most of the CEOs we listen to during quarterly earnings calls are very cautious when they talk about the second half of the year; so we’re seeing businesses react already. We see a lot of good companies selling at prices we like, but if investors start selling without regard to price—either because they have to meet margin calls or because they are scared—value won’t matter for a while.
We suspect the companies that do the best going forward will be different than the ones that outperformed the last few years.
The following essay by Jeff Muhlenkamp, Investment Analyst, is based on Ron Muhlenkamp’s May 3, 2011 presentation of the same title, and research by the Muhlenkamp & Company Investment Team.
The ever-insightful and value veteran, Ron Muhlenkamp of Muhlenkamp Fund, discusses current market valuations. He likes F, PM, ORCL, PFE, UNH:
In the U.S., the economy continues to expand at a modest rate as consumers continue to save a greater proportion of their incomes. This increased saving by the consumer, however, is nearly offset by increased borrowing by the government. While the headline’s focus has been on the federal government borrowing, it is state and municipal borrowing that is likely to trigger the next financial panic. Many states and municipalities have made pay and pension promises they simply cannot keep. The resulting pressures are now surfacing in Wisconsin, Ohio, and other states. Meanwhile, companies have been reluctant to hire because, for most of the year, the costs of employing people had been scheduled to go up, particularly for taxes, regulations, and health insurance. Since the November elections, present tax rates have been extended which should help increase employment.
In 2010, the shocks to the markets and the financial system came from Europe. Since the adoption of the euro currency in 1999, a number of countries have taken advantage of low interest rates to spend money well beyond their tax receipts. In 2010, the “chickens came home to roost.” Greece, in the spring, and Ireland, in the fall, required bailouts by other members of the European community. Much of the sovereign (country) debt is held by European commercial banks across the continent, which likely forced these banks to sell other assets. We do know that, recently, markets in Europe, the U.S., and elsewhere declined when the sovereign debt problems came to the fore.
Many European countries are adopting budgets that rein in government spending, (much like Canada did in 1995), but it is not yet clear that their citizens will accept the budgets instead of rioting in the streets. So the European crisis is not over.
The swing member of the international community is now China. While China amounts for only 9% of world GDP (Gross Domestic Product), it is over 40% of the GDP of “emerging markets.” After the meltdown of the fourth quarter of 2008, when many governments (including the U.S.) adopted plans for economic stimulus, China stimulated more than others. Much of its stimulus went into useful infrastructure, but a lot also went into real estate of a bubble character. (If you want to see a beautiful ghost town, look up Ordos, China on Google Maps.) Adding stimulus is easy, removing stimulus is tricky; China has now begun removing stimulus.
I have outlined above the major bearish arguments. The main bullish argument, as always, is based on 2-3 billion people in the world who go to work every day in order to feed their families. In doing so, they build personal and family assets and, coincidentally, business and national assets. As investors, we try to align ourselves with these efforts by investing in companies that aid people in the wealth-producing process and, thereby, benefit from it. Today, we find the best values in large, international companies (usually U.S. based) with rock-solid balance sheets and healthy cash flows. (We expand on this in Muhlenkamp Memorandum, #97, available on our website at www.muhlenkamp.com.) While the risks mentioned in the first part of this letter are likely to create volatility in the markets in 2011, we think peoples’ efforts in adding value and creating wealth will add value to the companies we own. Over time, their value will be reflected in the prices of their stocks.
The following essay, Where is the U.S. Economy Today? Are We on the Road to ‘Japan’ and A Lost Decade?, is adapted from a presentation Ron Muhlenkamp delivered at the Muhlenkamp & Company investment seminar in November 2010. Supporting figures are updated through October 2010...