2011 was another year of economic crosscurrents and mixed results. We began Ronald H. Muhlenkamp photothe year with some confidence that the U.S. was gradually on the mend and that Europe was beginning to deal with its problems. This actually worked out through mid year (June/July). In August it became apparent that not much was being accomplished by the leadership in Europe or the U.S., and both world and U.S. markets got hit hard. By yearend, the large cap U.S. indices (the DOW and S&P 500 Index) eked out gains for the year; the small cap indices (Russell 2000) did not. European and emerging markets (MSCI Indices) closed down 20%-25% for the year. Our focus was on large, U.S.-based companies, but we still were down for the calendar year.  Going forward, we believe large, U.S.-based companies remain the place to be.

The issues which we have been discussing with you continued with some progress in a few areas and a frustrating lack of progress in others. We presented a review of these issues at our November 7 investment seminar, (which has been revamped in an essay in booklet form), and in a number of market commentaries since mid year. These materials are available on our website at www.muhlenkamp.com.

A brief review follows:

The U.S. economy continues to expand, but at a modest rate. Consumer spending is growing at 2%-4%, with savings now at 3%-5% of income, down a bit from the 5%-6% of income saved in 2009-10. We believe restrained growth in consumer spending will continue.

Businesses continue to run lean and to husband cash. They are reluctant to increase capital spending and employment, largely due to low utilization rates of existing capacity, along with increased regulation and uncertainty about tax rates.

U.S. banks continue to rebuild their balance sheets and have begun to lend more to business; (commercial and industrial lending is now increasing). We think the credit crunch in U.S. banks is pretty much over. The major remaining risk to U.S. banks is a contagion from European banks.

The U.S. Federal Reserve continues to put downward pressure on short- to intermediate-term interest rates in an attempt to stimulate consumer spending. We believe lower interest rates have encouraged retirees and near retirees to spend less, not more. Thus, the interest rate stimulus has been largely ineffective.

Congress and the Administration have extended the 2% FICA (payroll) tax cut to give employees greater after-tax income—but low consumer confidence and the temporary nature of the cut have encouraged saving, rather than spending. We believe that the U.S. populace is being offered the choice of continuing down the path to a European-style welfare state, or a return to a greater reliance on free markets and private enterprise. This choice deserves a year’s discussion, which we are now in. We don’t expect clarification on the choice until the November 2012 election.

Some states and municipalities are making strides at getting spending under control, many others are not. This will be a gradual process.

The growth of the Chinese economy continues to slow in response to the tightening credit conditions their leadership imposed several months ago. We anticipate that they will loosen credit at some point, but not yet. A number of other “emerging” countries, including Brazil and India, are on a similar path.

The primary source of recent headlines and markets fears has been Europe. A number of European countries have promised their citizens welfare state benefits beyond their capacity to pay for them. Until now, they’ve borrowed the difference, but have exhausted their credit. For well over a year now, European leaders have been in a series of discussions, trying to appease lenders on one hand, and the voting publics on the other. And the voting publics in different countries have responded in different ways. So far the leaders have bought a bit more time, and a bit more time, and a bit more time…but the issues have not been resolved.

In response to these pressures, we’ve held more-than-normal cash, and focused on companies with strong balance sheets, earnings, and free cash flow. We continue to look for turning points in China, Europe, and the U.S. We expect these turning points in 2012.