Every year around this time, I head up to "Bear Country" with my family. Usually, the financial markets are a bit tamer when we travel, and the only signs of bears are in Glacier National Park. This year, rumors of a bear sighting on Wall Street have left many investors uneasy. When you see a bear in nature, especially a grizzly bear, there is no mistaking the animal and its awesome power. But, a Wall Street bear is harder to identify.
Know Your Bear
In Glacier National Park, the rangers explain how to avoid bears and how to survive should a bear cross your path. "Carry bear spray and wear bells on your shoes," they advise. "Make a lot of noise to avoid surprising the bear." And, they say, if the bear spray fails and you find yourself face-to-face with a bear, you need to figure out what type of bear you're dealing with—quickly, very quickly.
Identifying the type of bear you've encountered is critical to your survival. The wrong approach can lead to ugly results. If you come face-to-face with a grizzly bear, you are in a heap of trouble. Do not run. That only makes the kill more fun for him. Instead, lie on the ground in a fetal position and protect your head with your arms. Keep your knees close to your chest to protect your vital organs. Then, pray! With any luck, while you are playing dead, the grizzly will get bored and meander on.
However, should you meet a black bear, the proper reaction is quite the opposite. These bears are more timid and generally not interested in a fight or an exciting kill. In this case, fight back and make yourself as threatening as possible. Yell as loud as you can. Throw things. This should convince a black bear to go away.
Wall Street bears are tougher to identify than the Montana kind, but no less dangerous to your health—your financial health, that is. Yet, just as in nature, encounters with different types of Wall Street bears call for different survival strategies. If this current market correction is the beginning of a grizzly attack, then take no risk (go to cash), play dead (turn off the media) and cover your vital organs (your savings). But, if this correction is a black bear attack, then get aggressive (add to equities) and attack the bear.
Signs Point to a Less Severe "Black Bear" Attack
So, how can you tell the difference between the grizzly and black bear on Wall Street? The good news is that grizzly attacks have been rare, occurring only every generation or so. Black bear attacks—corrections of 10% or so—have been more frequent, generally every few years. And, while they may be unsettling, these black bear attacks are a necessary evil because they help to shake out the weak stomachs or the highly levered in the financial markets.
Let's consider the strength of the economy and general economic principles, which we believe provide the best clues as to whether Wall Street is facing a black bear or a grizzly. When you consider that oil prices have been on the rise and the Federal Reserve has been removing the monetary stimulus for two years, it is remarkable that the equity markets have not experienced a correction of 10% or more (a black bear attack) since 2003.
Although many factors prompt concerns about the health of the U.S. and global economies, there are many positive influences that should not be overlooked. Signs of excess are present, but so are signs of strength and moderation. In general, we believe what we're seeing today is a black bear attack in a bull market.
One would expect some degree of stress as the Federal Reserve and other central banks become less accommodative. The Fed has expressed concern about rising inflation pressures and has responded by raising the federal funds rate, possibly beyond the neutral level. The ever-elusive goal of the Fed is to find neutrality once its stated mandates have been met. These mandates include keeping core inflation low, around 2%, and seeking full employment, at approximately 95%. In the past few years, these goals have been achieved but the Fed has continued to raise the fed funds rate in an effort to slow growth and reduce inflation.
We are not in the camp that believes growth causes inflation; instead, we believe that excess money is the culprit. Milton Friedman said "inflation is too much money chasing too few goods," and maintained that inflation—everywhere and at all times—is a monetary event. Twenty years of managing money and studying the markets and economy lead me to believe that Freidman is correct. Over that time, we have experienced one of the best growth periods in history, with inflation trending lower for nearly the entire period. Strong economic growth does not cause inflation; excess liquidity results in high inflation. Although growth may cause temporary or even sustained inflation in some products, other products will experience price declines as the growth phase offers economies of scale and new business opportunities; these in turn create competition and alternative products.
If inflation is a monetary phenomenon, then it should show up in a weak U.S. dollar as excess money creates a dilutive effect on the currency. Inflation should also show up in oil prices, given that all oil transactions occur in dollars. Ultimately, foreign producers recognize that they are getting paid in a currency that buys them less than in the previous year, leading them to raise prices to offset the dilution. Finally, excess money will flow into hard assets that have been a store of value or a currency of last resort—such as precious metals and especially gold. Today, we see prices surging in the stores of value and in oil while the dollar is weak. So, is the Fed worried that growth has caused inflation, or is the Fed not taking responsibility for inflation that it caused?
If inflation has been minimized by the liquidity drain of the past two years, which we think it has, then what is the Fed up to? The Fed expressed concern about the amount of leverage in the economy and markets; and is therefore raising interest rates to squeeze the excess out. Businesses and consumers who intelligently took advantage of the 40-year lows in interest rates and easy access to credit should not be harmed by the more recent interest rate hikes. Many homeowners and corporations locked into very low long-term interest rates; these borrowers should weather a rough patch just fine. In contrast, the highly levered borrower with the adjustable-rate loan is going to feel the squeeze, as will market participants who borrowed short to purchase long. The carry trade is over and the housing market is slowing. Similar to the events of 1994, the Fed—with support from Continental Europe and Britain—seems to be attempting to initiate a market cleansing to shake out the leverage and excess.
The average homeowner and the average corporation are looking at interest rates of approximately 2.0 to 2.5%, after taxes and inflation. Corporate profit growth has been remarkable and corporate liquidity is excellent. Household net worth is near all-time highs and unemployment near all-time lows. Wage and salary hikes are helping to offset the impact of higher energy prices on consumers. We see strength in the fact that high energy costs have not caused consumers to cut back on consumption or otherwise change their behaviors. Global economic growth is enjoying some of the best years in a generation, even though Japan and Europe have yet to participate fully.
"Bear Spray" for Long-Term Investors
Volatility in financial markets is quite normal, and may be providing a needed correction. It is therefore imperative that apprehensive individuals revisit their financial plans, review why they invested in the market, and then stay the course. This back-to-basics approach may serve as the most useful bear spray for the black bear attack.
Let us return briefly to grizzly bears on Wall Street. Unlike black bear attacks, grizzly bear attacks occur when conditions penalize growth and economic freedoms, such as free trade, private property rights, a credible legal system, low taxation and regulation, accounting transparency and a stable currency. These are the principles that drive living standards and wealth creation. They also have proven to be the best grizzly bear spray for Wall Street.
At Calamos Investments, we watch the markets and economic forces closely. We follow a general model that favors capitalism and improving living standards. When we see significant changes in these critical factors, we become more defensive. For example, we reacted in advance of the technology and telecom bubble in 2000, divested and rode out the market. In the same way, we anticipated the energy excess of the late 1970s and the high yield market crises in the past two recessions.
We're Moving Forward with Confidence
As we strike out on our wilderness path, we are ready for black bears. Given our experience in distinguishing between the grizzly and his more docile kin, we feel confident that there isn't a grizzly along our path. Instead, we see reasonably valued markets at 15 times next year's earnings, coupled with a respectably strong global economy.
