Updated Market Commentary from Ron Mulhenkamp

Yesterday, (August 18), was another down day in the U.S. markets with the Dow Jones Industrial Average (DJIA) losing 3.68 percent. This continuing market volatility reflects the central banks’ efforts to redirect their economies in the three largest economies in the world. (This was discussed in my Quarterly Letter, published in Muhlenkamp Memorandum #99; July 2011.)


We said ten days ago that the debt crisis in Europe and the potential for recession in the U.S. were driving the markets; we believe they still are. In regards to a U.S. recession, we have gotten an additional week’s worth of economic data which was net negative, increasing the odds of recession. We think the markets are pricing that in. Regarding Europe, there are two new data points. Last week, the European Central Bank (ECB) started buying Italian and Spanish bonds, keeping both countries in the public debt markets for the time being and forestalling a bailout. That positive development was offset by renewed concerns about European banks’ ability to borrow, along with doubts about the approval of the Greek bailout as Finland and other countries look for collateral to secure their loans to Greece. So, while we have a bit more data on the U.S. recession question, no one has any more certainty on the European question and probably won’t for at least several weeks.


To recap our thoughts on the various efforts by central banks to alter the trajectory of their economies:


In response to the 2008 recession, the U.S. Federal Reserve Bank tried to stimulate economic activity by lowering short-term interest rates to zero, and injecting cash into the markets through bond purchases. The consumer, however, was interested in reducing his debt and increasing savings—and has continued to do so—in spite of the Fed’s attempts to encourage more borrowing and spending by making credit cheap. It appears to us that low interest rates were insufficient incentives for new purchases; for example, home sales remain depressed, as do auto sales. So, the benefit of low rates, (increased spending), has been less than its costs, (near zero returns for savers and a lack of confidence in the economy), for a net negative effect on the economy. In short, the Fed used the tools at its disposal to increase economic activity and failed. We are now seeing that reflected in economic indicators, including the Business Outlook Survey, published yesterday by the Philadelphia Federal Reserve Bank.


Similarly, the ECB in 2008 and 2009 lowered interest rates in order to cushion the impact of the recession. Unlike the U.S. Fed, the ECB began to raise rates in 2011—the only major central bank to do so—in order to fight what it saw as the early stages of inflation. (Unlike the U.S. Fed, which has a mandate to maintain price stability and encourage full employment, the ECB only has the requirement to maintain price stability.) The latest round of economic data out of Europe is pretty weak; e.g. Germany’s second quarter GDP growth is only 0.1 percent. This creates a dilemma for the ECB: does it raise interest rates to keep inflation under control and risk a liquidity squeeze, or does it lower rates to try to generate GDP growth?


China has the opposite problem. Massive loan growth as a part of its stimulus package during the 2008 recession has generated worrisome inflation. In response, China’s central bank first started raising bank reserve ratios, and later started raising interest rates, to get inflation under control. These efforts have not yet been effective and China continues to squeeze its money supply. Because monetary tools are blunt instruments, there is a risk China triggers a greater economic slowdown than it intends. It would not surprise us if we get bad news out of China before its central bank quits squeezing.


In all three cases, the struggle between what the central banks are doing and the pre-existing trajectory of their economies is the source of the volatility and uncertainty in the markets. Investors are sometimes encouraged by central bank action and, at other times, concerned at the lack of results when the methods used don’t get the desired results. On top of this titanic struggle, you have the uncertainty around European debt; specifically, what actions will Europe agree upon and will they work? Further, will the agreements made by the governments be supported or rejected by their constituents?


The answers are not clear; we don’t expect them to clear up anytime soon. We have largely maintained our cash position, but have reduced our exposure to companies we consider cyclical and moved into more defensive stocks. The companies we own are strong enough financially to survive the worst case scenarios, but are also in positions to profit and prosper if disasters are averted. We are ready to generate more cash if the worst case scenarios become more likely.


Here is the link to the original article:


http://www.muhlenkamp.com/upload/pdf/MarketCommentary_20110819.pdf


Here are the top ten holdings of the Muhlenkamp fund as of last quarter end:


Top Ten Holdings