Commentary

2006 Market Review

Throughout our commentaries in 2006, we shared our view that the economy—while remaining fundamentally strong—was entering a period of mid-cycle slowdown. By the end of the year, we believe this outlook was affirmed. Growth in gross domestic product was respectable, albeit more tempered than it was during the recovery phase. Corporate earnings were strong overall, and balance sheets solid. Merger-and-acquisition and private capital trends were favorable as well. Consumer spending lost some steam, but has by no means plummeted: declining gasoline prices in the fourth quarter, along with increased wages, provided an additional boost to consumers—and the markets. Inflation concerns cast a persistent shadow, but in the end, core inflation remained quite tame. Unemployment continues to be low. Although the yield curve inverted, liquidity and credit remained ample. The housing market retreated from its stratospheric heights but did not fall below a reasonable level; in fact, it showed signs of stabilizing during the fourth quarter.

Despite a particularly choppy patch from May through July, equity markets continued their march forward, with the S&P 500 Index gaining 15.79% and the Dow Jones Industrial Average breaking past 12,000. Yet, rather unexpectedly given the climate of mid-cycle slowdown (which has historically seen a shift in leadership from cyclicals to growth), value securities led and growth lagged.

Convertible securities once again proved their mettle, providing downside protection during the more choppy periods of the equity market while participating in its upswings. Within the convertible universe, speculative-grade securities beat their higher-quality counterparts for the year. Meanwhile, solid economic fundamentals and low default rates contributed to a positive backdrop for the high-yield market and spreads stayed tight. Here, too, lower-rated issues outpaced higher quality.

Global economic growth provided continued support for the international markets; gains in both developed and emerging markets surpassed the healthy return in the U.S. market. Among developed markets, Japan continued to show signs of economic improvement, including gross domestic product growth, easing deflationary pressures and increasing retail trends. In developed Europe, economic growth was better than many expected. Germany, for example, saw improvements in employment, business and consumer data. Moreover, interest rate increases by the European Central Bank and a strengthening euro did not dampen market sentiment; corporate restructurings also bolstered confidence. In the emerging markets, expanding economic freedoms, greater stability, and corporate innovations provided an ongoing catalyst; India serves as a prime example. A less favorable environment persisted in much of Latin America, with governments such as Venezuela's moving to curtail economic and trade freedoms.

Outlook for 2007

The backdrop for the performance of the financial markets is anticipation of future economic activity. After 17 Fed rate hikes, surging commodity prices and an abrupt end to the housing boom, the economy is slowing. What does this mean for the markets in 2007? Does this mid-cycle slowdown morph into a full-blown recession, with its obvious negative consequences for the equity markets? We don't believe this is the case. In fact, we are positive on the equity markets—around the globe—for the coming year. We are positive on the convertible market and selective on high yield opportunities.

Corporate earnings and interest rates are among the important factors that will influence the year's outcome. Corporate earnings growth has been nothing short of remarkable, with 18 straight quarters of double-digit growth. We expect this string of double-digit growth to be broken in 2007. Profit margins appear to be near a cyclical peak, so we would not be surprised to see corporate earnings revert closer to the mean. That said, this realistic view of corporate earnings and profits does not equate to a bearish mindset.

Significantly, past profit margin peaks did not foretell a top in the equity markets. After past peaks, the equity market on average offered 10.2%, 18.7% and 30.1% additional upside over the next one-, two- and three-year periods, respectively.

Percentage Change in S&P 500 Index After Peaks in Profit Margins
Historically, peaks in profit margins have not curtailed solid gains in the equity markets.
% Rise in S&P 500 Index*

Moreover, as we have discussed in previous commentaries, mid-cycle slowdowns such as this one have not signaled the demise of the equity market. In fact, in the 1960s, 1980s and 1990s, the equity market served as a leading indicator, forecasting the slowdown. Then, as the economy—as measured by GDP—was slowing, the equity market was advancing. In 2006, we believe the May through July market downturn served to forecast the current slowdown.

Our analysis "Mid-Cycle Slowdowns and Market Rallies" considers in greater depth the relationship of GDP to equity market performance.

Interest rates are another important barometer of the health of the economy and markets. With Fed hikes from June of 2004 through June of 2006, short-term rates are now higher than longer-term interest rates. Yet, as we have noted, credit is ample and liquidity has not been negatively influenced. The market seems to be growing comfortable with an inverted yield curve. The real cost of debt is quite reasonable and debt spreads have remained in normal range for this economic mid-cycle. These are important factors in the financial markets remaining robust.

A Rotation to Growth in 2007

We believe the stage is set for a rotation into growth companies, both in the United States and globally. While every cycle is different, previous rotations have been swift and sudden, with sharp spikes. In fact, you could say that when growth comes back, it's almost with a vengeance.

We believe 2007 could see such a dramatic rotation, with spikes caused by P/E expansion. Our 2007 outlook reflects our long-held view that, ultimately, valuations trump everything—including momentum. When we consider the marketplace today, it seems to us that momentum has pushed value and cyclicals too far. Meanwhile, there's a very compelling story in the valuations of traditional growth companies. Many large-cap growth companies are trading at prices we believe to be extremely attractive, based on earnings growth and cash flow generation.

Recession in 2007?

We don't believe a recession is imminent, given the current economic landscape. With solid corporate earnings and a good level of productivity and low unemployment, the U.S. economy, in our estimation, is fundamentally healthy. Of course, risk always exists. So, what would change our outlook from mid-cycle slowdown to recession?

We're of the view that good economies—like ours—never die a natural death; something kills them off. We believe that a healthy economy could be killed off by a Fed policy mistake, for example, if misguided inflationary fears prompt rate hikes. (That said, we think there is a more likely prospect of a Fed rate cut in 2007.) The U.S. government could also push the economy toward recession by repealing tax legislation or advancing new taxes that would curtail revenues and in turn, economic growth. Given that ours is a synchronized global economy, disruption to trade and liquidity flows (for example, increased trade protections, a significant decline in the U.S. dollar and competitive devaluations, and monetary mistakes by major countries) could cause significant corrections to the financial markets, and shift the economy from mid-cycle slowdown to recession. And, of course, geopolitical terrorism is a factor that could change the landscape dramatically.

Many point to the U.S. trade deficit as a harbinger of recession. We, however, view the deficit in a broader context, and do not believe a large trade deficit will send the U.S. economy and markets spiraling downward. We've had a trade deficit for many years, but the U.S. remains the global superpower, a leader in innovation and productivity, and the reserve currency for the world. Additionally, it's important to remember that one contributor to the trade deficit is foreign investment. Investors around the world continue to seek out the U.S. market for its stability and opportunity, which we believe is a significant positive. As we've discussed in the past, capital markets measure profits, not deficits: as long as the stock and bond markets are in good shape, we are not worried unduly about the deficit.

Investment Strategy Review and Positioning

Below, we review some of the factors that drove the performance of our strategies in 2006 and how we've positioned them for 2007.

Equity

In 2006, we expected a change of market leadership from cyclicals and value investments to traditional growth. Historically, periods of mid-cycle slowdown have been accompanied by a shift from a pro-cyclical market to a more growth-oriented market. In each, the value and cyclical stocks that led during the early phase of the bull market were replaced by more traditional and stable growth stocks in the next phase.

Because we seek to position our portfolios ahead of market turns, we sought companies whose growth is not completely dependent on economic growth, volatile commodity prices or access to cheap capital. While we're never averse to buying great companies at good prices, the continued success of cyclicals and what we consider to be lower-quality names meant that we were early. This showed up most in our more aggressive portfolios, where we tend to make changes more quickly and hold more significant industry and sector overweights and underweights. For example, our growth strategy underperformed benchmarks and peers because of its bias to large-cap quality growth and away from commodity-based opportunities.

Entering 2007, our U.S. equity strategies emphasize larger, high-quality traditional growth opportunities. The market's preference for cyclical companies in 2006 created an opportunity for us to invest in many premier growth companies at prices we believe to be very attractive relative to the broad market and historical values. Many of the companies in our portfolios have seen substantial earnings growth that has not been reflected in their security prices, while also offering high return-on-capital, low debt-to-capital and reliable cash flows.

From a sector perspective, consumer staples, health care and technology are well represented. Each of these areas is positioned to benefit from long-term secular trends. For example, the competitive global economy creates a favorable environment for information technology goods and services, while changing global demographics should support long-term demand for health care innovations.

In contrast, we are underweighted in materials, commodities, autos, REITs, transportation and industrials. Of course, to maintain appropriate diversification and manage event driven risk, we do hold allocations to cyclical sectors. Here again, though, we stay true to our core investment rationale. Within energy, for example, we are favoring drillers and suppliers as they are less tied to fluctuations in the price of oil.

Global and International

Because we apply a consistent philosophy across our strategies, our global and international portfolios reflect the same principles as our domestic portfolios. In 2006, we emphasized large-cap, higher-quality companies in anticipation of our view of market rotation. From a country perspective, we favored countries that support economic freedoms, such as democracy, abiding by the rule of law, property rights, openness to foreign investors and transparency in accounting and regulations. This led us to developed markets such as Japan, as well as to emerging markets such as India and Mexico. In contrast, we avoided much of Latin America and China.

Select names in information technology and consumer staples were among those that were most beneficial during 2006. While our strategies performed very well in absolute terms, relative performance was hindered by a growth bias, as well as by our stake in Japan. Performance was also tempered by dollar exposure in the second quarter.

As we noted earlier, our positive outlook for growth-oriented equities in 2007 extends across the global marketplace. We have positioned our global/international strategies to pursue the highest relative growth opportunities. This leads us to maintain sizable allocations to sectors such as information technology. To reduce cyclical vulnerabilities, we have pared exposure to materials and natural resources.

Although Japan delivered lackluster performance in 2006, we see considerable long-term opportunities in Japan, where valuations are particularly attractive versus other developed markets. Waning deflation, increasing corporate profits, strengthening retail and consumer trends are among the factors that we believe should provide strength in the Japanese market in 2007. Of course, we are monitoring closely developments under Prime Minister Abe, to ensure that the progressive economic reforms of his predecessor maintain—and gain—traction.

We have increased our allocations to Europe as well, in companies with strong free-cash flow, including a number of consumer staples companies. We are maintaining exposure to local currencies in order to enhance the diversification benefits of our strategies for client asset allocations.

Convertible

We believe that convertible securities will continue to offer the thoughtful investor with a valuable means of enhancing returns and managing risk—and particularly when convertibles are judiciously blended with other asset classes.

Convertible securities saw their valuations improve in 2006, but we believe that current environment provides additional upside against the backdrop of a rising equity market. Moreover, we believe the current interest rate environment may contribute to brisker issuance and more choices for convertible investors in 2007. Now that interest rates have risen from their historic lows, companies seeking access to capital may find it more affordable to issue convertible debt rather than "straight" (non-convertible) bonds.

Consistent with our overall view of the economy, we are favoring convertible issuance of higher-quality traditional growth companies with solid balance sheets and reduced cyclical exposure. Convertible securities, as hybrids, provide a combination of equity-market participation and fixed-income characteristics. The blend varies by issue. Based on our view that the equity markets will move upward, we are biased towards convertibles with greater equity sensitivity and are avoiding "busted convertibles." (Busted convertibles trade essentially as straight bonds and offer very little equity participation.)

High Yield

While we don't believe signs point to a recession in 2007, we believe recessionary fears will interject a new level of risk and volatility into the high yield market in 2007. To be clear, however, we are not seeing signs of—or attempting to forecast—a spike in spreads typically commensurate with a financial shock or a recession that ushers in bear market in equity and credit-linked debt. Rather, the current risk/reward trade-off is no longer as attractive as it has been.

Over the past five years, we have been bullish and constructive on the high-yield market and on the corporate market overall. We have justified the narrow yield spread based on the strength of the economy, excess liquidity, strength in corporate balance sheets and support from private markets and hedge funds. But things have changed. Most notably, the economy is slowing and complacency may have set in. We have seen remarkably low levels of corporate and equity market volatility, low inflation, low default risk and stable growth. The lack of negative surprises and the low volatility in asset classes has manifested itself in more leverage and debt build up and in tight credit spreads.

Despite this added caution, we believe in the merits of the asset class, particularly given our highly selective, rigorous bottom-up security selection process. We are favoring the higher-quality tiers of the high yield universe and avoiding truly distressed issues.

Closed-End Funds

We are enthusiastic about the prospects for our closed-end funds in 2007. In these portfolios, we seek to dynamically and strategically blend asset classes to manage risk and enhance return potential. These portfolios include enhanced fixed income (primarily convertible securities and high-yield bonds), defensive equity and defensive global equity (equities, convertibles and high yield). The potential of these strategic allocations was validated by the distribution rates and total returns of these funds in 2006. Among the strategies that enhanced returns was our use of interest rate swaps, which protected the funds' income streams in a rising rate environment. In a period of mid-cycle slowdown, we have a high degree of conviction in the potential of these portfolios to help investor pursue their long-term financial objectives.

Learn more about Calamos Investments' closed-end funds.

Conclusion

Investing can often feel like a horse race: Daily, weekly, monthly, quarterly, semiannual and one-year returns are measured and compared. On a certain level, it is understandable: every day the media has to fill space and air time; and the rating services need revenue. Yet, this is a short-term trap, and investors and investment managers must be extremely diligent in avoiding it. It is the long term that matters most.

Wealth is built over time, through multiple market environments—including bear markets. We recognize that investors choose Calamos Investments because we follow a clearly stated discipline and refuse to fall into a short-term mindset. We build portfolios for the future and for full market cycles—and that means more than the next 12 months. As we enter 2007, we look forward to pursuing the long-term opportunities of an exciting global marketplace.