Q. What's your assessment of the overall market?
If you look at the short-term metrics, those that are fairly reliable one to six months out, the market looks healthy. Just about every index was above its 200-day moving average at quarter end, and many indices had hit all-time highs, so clearly things look strong. A case in point is the S&P 500 Index, which rose 4.2% for the quarter, and had its best first quarter gain in seven years. This rally was broad-based, with nine out of ten major sectors within the S&P 500 Index finishing in positive territory. From a sector standpoint, Telecommunication Services was the top performer for the quarter, up 13.4%, followed by Energy, which gained 8.6%. Utilities and Health Care were the worst performers, down 2% and up 0.9% respectively. Small-cap and mid-cap stocks outperformed large-cap stocks, with the Russell 2000 Index2 up 14% and the Russell Midcap Index3 up 7.6% for the quarter. Among large caps, Value bested Growth, with the Russell 1000 Value Index4 up 5.9% and the Russell 1000 Growth Index5 gaining 3.1% for the quarter.
Market Valuation From a valuation standpoint, the market looks quite attractive. The S&P 500 is trading at around 15 times 2006 earnings, and if you capitalize those earnings using the 10-year bond rate, the market appears to be about 30% undervalued. Furthermore, we're seeing greater opportunities among larger and especially mega-cap companies, as they tend to outperform during a more moderate growth phase of the economy. This outlook has shaped our equity portfolios' positioning for a number of quarters and is reflected in our higher average market cap relative to earlier in the market cycle.
Taking this a step further, we like to look at the earnings yield. The inverse of the PE on the market is about 6.5% and earnings have grown at about a 7% annualized rate since the end of World War II. The market also has a dividend yield of about 2%. Think of the market yield as a bond yielding 6.5% and the coupon payment growing about 7% per year. In general the market earnings yield has been close to the yield on 10-year Treasury bonds. Today, with 10-year bonds at 4.9%, the market implied fair value is about 1700 on the S&P 500 Index or more than 30% higher than today's value. So, the market is not expensive and valuation should not hinder upside potential. And, we believe there is even better news on the horizon because when the Fed stops raising rates (and we believe the day is at hand), the market has the potential to rally significantly.
Bond Markets are less exciting because they already reflect a low inflation environment and credit spreads show a continuation of a healthy economy. Therefore, the upside potential is limited in the bond markets and it may be best to keep fixed-income investments on the shorter end of the curve since taking on the additional risk of longer-term bonds doesn't pay off right now.
High-Yield/Convertible Markets However, if you look at the high-yield and the convertible markets, there's the equity tie-in that makes for a more attractive tradeoff between risk and reward. These asset classes do best when the economy's in good shape, as the convertible market demonstrated first quarter. Although convertibles suffered in 2005 from the hedge fund sell off and the decline in implied volatility in the marketplace, they roared back first quarter, actually besting a large chunk of the equity market.
Global Markets The global equity markets have been a great place to be in the past few years and we believe still afford opportunities. It looks as if both Japan and Europe are done dipping their toes in the pool and are finally going to dive in and participate in global expansion. Their leading indicators are all pointing that way, and their equity markets are serving as the vanguard.
From a monetary perspective, the European Central Bank did raise rates and the Bank of Japan has moved to a more restrictive policy as a precursor to raising rates. So, global liquidity is going to ice over a bit. At the same time, however, we see global M&A activity going strong, corporate balance sheets improving dramatically across Europe and Japan and declining excess capacity.
Although markets around the world are no longer as cheap as they once were relative to the U.S. market, we're excited about the many overseas opportunities that still exist.
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Index Definitions:
1 The S&P 500 Index is an unmanaged index generally considered representative of the U.S. stock market.
2 Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $664.9 million; the median market capitalization was approximately $539.5 million. The largest company in the index had an approximate market capitalization of $1.8 billion.
3 Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index. As of the latest reconstitution, the average market capitalization was approximately $4.7 billion; the median market capitalization was approximately $3.6 billion. The largest company in the index had an approximate market capitalization of $13.7 billion.
4 Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
5 Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
6 The CSFB High Yield Index is an unmanaged index of high yield debt securities.
7 The Merrill Lynch All U.S. Convertibles Index (VXA0) is comprised of approximately 500 issues of convertible bonds and preferred stock of all qualities.
8 The Merrill Lynch All Investment Grade Convertible Index (VXA1) is comprised of approximately 200 issues of only investment-grade convertible bonds and preferreds.
9 The Merrill Lynch All Speculative Grade Convertible Index (VXA2) is comprised of approximately 300 issues of only speculative-grade convertible bonds and preferreds.
Index returns assume reinvestment of dividends and, unlike Fund returns, do not reflect any fees or expenses. It is not possible to invest directly into an index.
Performance data quoted represents past performance which is no guarantee of future results. Current performance may be lower or higher than the performance quoted.
The views and opinions expressed by John P. Calamos and Nick P. Calamos are as of the date of the article, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be considered investment advice.
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