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Muhlenkamp: European Deleveraging Could Kill Confidence

Jason Stipp

Jason Stipp: When you look at your fund you have an excellent longer-term record, a 15 year record, very, very good. The last three to five years very poor record, and I think that that does sort of speak to time horizon. If you can tell us a little bit about the experience of the fund over those different time periods, and how that has informed how you're running the fund today?

Ron Muhlenkamp: Okay. If you read what we've read and this is in a book among other things, but what we've always tried to do is invest to some extent on the business cycle, we used to get a recession every three to five years, the last couple have been 10 years apart.

So, we've always told people that you needed a minimum of a three to five year horizon to kind of cover the business cycle sort of things. We did poorly in late '07 and in '08, and frankly part of the reason we did poorly was, the Fed which was raising interest rates every recession we've had, since World War II has been triggered by – not necessarily caused by, but triggered by the Fed raising rates on purpose to slow the economy down, usually to keep inflation under control.

And when they – and typically they would raise rates until somebody went bankrupt. They would squeeze the system till they broke something, and when that happened then they start loosening up. And what we said in – I may be off a little, but in '05 and '06, was – this time, they squeezed, they raised rates to 5.25, and we said, gee, they're not pushing it far enough to break something, we might get away with a soft landing.

I was wrong. What Wall Street could have said from this was, they've very short rates, and historically a major trigger was when they raised short rates above long rate levels, it gave us "inverted yield curve" and that's a great sign to look out for a recession. While this time they raised it to 5.25, and Wall Street instead of saying they have narrowed the spread on borrowing and investing money, we should back off. What Wall Street said was they have narrowed the spread, if we just double our leverage, we can keep the returns. Carlyle Capital actually said publicly at one point that to make a deal look good they had to go to a 30:1 leverage.

Well, hindsight is better than foresight, but if you can go to 30:1 leverage to make a deal look good, it ain't a good deal, and nevertheless, that's what's happened. So the Fed didn't cause the bubble, but they allowed it. And that's what Wall Street did. And I read it somewhat wrongly to say that it looks like they are loosening up and you want to be moving back in, when this occurred in '05 and '06, and Wall Street took that narrowed spread, they leveraged it up and broke themselves. Wall Street has nobody to blame but itself; I have nobody to blame but myself, but that's what was going on, the singles were misread, things have been so good so long that we pushed that until we broke it, and we did break it.

Stipp: And when they broke themselves, they broke themselves in a big way.

Muhlenkamp: Yes, they broke themselves in a big way. Now what we know is in '08 of course the word went out to hedge funds to deleverage, and what leverage had been and what it is I don't know, but I know that Goldman Sachs and Morgan Stanley which had been a 30:1 leverage went to a 10:1, and they're going to stay there because now they're voluntarily banks.

So, our question became could we get a second round of this, and probably not in this country, but there is some room for that coming out of something like the European banks. The odds I think are less than 50% nevertheless if we were to get another round of that, you'd probably kill the confidence in – certainly in equities. People sort of forget that bonds got killed in '08 as well, but they did, but you do a major, major damage to the confidence of investors. So this year we're a little bit on the cautious side. People asked us what we do different, we're a little quicker to raise cash. We're a little quicker to pull some money off the table than what it has been, and we're trying to monitor that. And again, it's hard to get good numbers on them.