"The only thing we have to fear is fear itself"
-Franklin Delano Roosevelt, Inaugural Address, 1933
The credit crisis and mounting fears of a global recession continued to send shockwaves through the markets during the third quarter. The U.S. government intervened to prevent the collapse of Freddie Mac, Fannie Mae, and AIG. Lehman Brothers joined the ranks of the once-formidable and now bankrupt, while Washington Mutual and Wachovia sought protection in mergers. Regulations were re-written, changing the future of investment banking. As the government's $700 billion bailout package stalled, the Dow saw its worst single-day point decline. Abroad, conditions were equally difficult—growth slowed, housing markets slumped, markets tumbled and recessionary pressures intensified.
We recognize that these are very difficult times for investors. In the following Q&A, we share our view on the markets, the bailout plan and the credit crisis. We also explain how we are navigating through these challenging times.
Q. Many investors are extremely concerned about the string of bank failures. What is your perspective on events in the banking industry?
A. The entire financial system is based on trust; not a single bank can survive if it must prove liquid immediately. Fear and a rush to liquidity can cause even a perfectly solvent institution to collapse. The function of our banks, investment banks and broker dealers is to provide capital access and liquidity. This allows the financial markets to operate day-to-day. To fulfill these functions, lenders trade short-term liquidity for long-term assets and earn the term spread. They assume risks through their willingness to take assets into inventory for a fee (or spread) and then hedge the asset until a buyer can be found.
Fear and requiring "liquidity for all" creates bank runs which no lender can survive. The hedge funds know this and are adding as much fuel to the fire as they can by shorting stocks, bonds and anything else that pushes the regulated financial institutions into the abyss. Why not? In the new world order, large hedge funds are emerging as the liquidity providers, while the private equity firms are taking an increasingly important role as capital providers. Meanwhile, Goldman Sachs and Morgan Stanley have been restructured to become banks. Left unchecked, the large hedge funds will take the investment banks place in our financial musical chairs.
The reality is that capital has moved to the dark corners of the financial world— places that escape the SEC, value-at-risk models, bank examiners, Sarbanes- Oxley and FASB 157 regulation. Ironically, the push toward transparency has moved capital to the less transparent places, because as we are now witnessing, transparency breeds attacks from competitors. How many of us would play a high-stakes poker game if we would be playing against someone who would be allowed to see our hand? (If you would, please call us to set up a game.) Yet, this is what is happening today—public companies and financial institutions must provide transparency, but the hedge funds and private equity firms do not.
Q. How did the markets and economy get into such dire straits?
A. We have a case of Gresham's Law— "bad money forces out good money"—in action. That is, bad investments have been forcing out good ones. For many years, capital was cheap and widely available. Without a doubt, this was a catalyst for the current crisis. Bad loans are always made when excess capital is available at very low usury rates. These bad loans have taken down over-levered financial institutions, and we do not believe we've seen the end of this.
But in many cases, other factors are at play: Loans that are perceived to be "bad" may not be, if the housing market soon bottoms. Because of the aforementioned policies and lack of sensible regulations, the system is now rigged to force a cascade of failures even before the economics are a reality. And unfortunately, the financial markets have the power to create negative economic outcomes.
Many investors are concerned about what lies ahead. We believe re-regulation and new regulation of financial market players will come about soon. The crisis will pass, and we'll feel good again. But, as with most regulation, we believe there will be some other unintended consequences, which could start the next crisis brewing.
Q. Will the U.S. Treasury's $700 billion "bailout" plan work?
A. We don't know if the Treasury Department's $700 billion plan provides enough money or if it is directed in the right places. We do believe that it is a significant move in the right direction. This is a large amount of money (5% of GDP) that has been targeted for purchasing distressed assets, and for shoring up the credit markets and financial institutions' balance sheets.
We encourage individuals to remember that this current "bailout" is not a bailout of banks only, but one for the entire economy. It is not a sunk cost (that is, a cost that cannot be recouped). It is very likely that purchasing assets at these price levels and selling them later will result in gains.
We would have preferred a plan that used the $700 billion to inject equity capital directly into financial institutions' balance sheets via a convertible preferred security. Financial institutions would then have the opportunity to stop selling assets. Such a plan would also put the onus on the institutions to decide what is worth holding at these distressed levels. Just as important, the equity injection would also provide leverage that would have an impact of 8 to 10 times the size of the $700 billion, because bank equity represents between 8 and 10% of assets. The banks of course would have to pay a dividend or interest payment on the capital provided by the Treasury along with an equity participation payment.
We believe strongly that the plan should include a change in the FASB 157 mark-to-market accounting. As we have discussed many times in the past, mark-to-market accounting has sped the downward spiraling of valuations and fuelled panic in the market. Investors sell as prices go down, driving prices down further and forcing more selling.
Q. Why is there so much controversy about mark-to-market accounting?
A. We agree that transparency is important. To properly value and understand a company's assets, it's necessary to mark some assets to the market. However, there are assets that are less liquid but solvent. For these, mark-to-market accounting demands a reality check, because cash-flowbased valuation or model-based estimates can significantly impair the valuing of these assets.
For example, if you had to estimate your home value each day based on the price you received in a bidding process, you may not be too pleased with the results and the volatility would be unbearable. Let's assume your mortgage was $300,000. One day, you receive a bid for $500,000; the next day, $100,000; and the next day, nobody bids at all.
On the first day, your mortgage company would determine that at $500,000, your mortgage of $300,000 is well covered with $200,000 in equity, especially since all your payments have been on time for the last 10 years and you are gainfully employed. You have no problems with the mortgage company. But the next day, you get a home price bid for $100,000 and the equity value of your home is now negative $200,000. Forget your purchase price or your excellent payment history—the mortgage company would need to write down your loan and call your loan unless you could come up with the $200,000.
Because homes tend to have a low level of liquidity— meaning you may only get a few offers each year—the forced valuation approach is disconnected from economic reality. A better approach would be to use appraisers and to value the home based on the last sale in the area, even if that occurred one year ago.
FASB Level 3 accounting treatment is a similar asset value treatment used to value less liquid assets. As you can see, it can create significant and undeserved problems for the holders of the assets.
Q. If most of the problems are in the financial industry and credit markets, why are all stocks declining so much?
A. The bursting of a credit bubble causes a significant amount of de-leveraging. Declining asset values force additional selling to meet margin requirements, debt covenants and reserve requirements for various financial companies. As financial institutions and debtors sell to reduce leverage they often have to sell what is most volatile and liquid. In this case, stocks rank high on the list. Hedge funds are selling stock to reduce leverage, as are some insurance companies, and of course, individual and institutional investors.
Stocks are generally good as a leading indicator for the economy. But, they tend to be more volatile than the economy as a whole. (As many have said, stock prices have predicted eight of the last four recessions.) Stocks have already discounted a more-severe-than-normal recession. Many stocks have plunged to levels that are discounting a very extended recession and virtually no recovery in the next decade. We believe this is not the most probable scenario. No doubt stock prices are reflecting some degree of economic reality, but we believe they have succumbed to a degree of panic valuation as well.
Q. Are conditions so bad that investors should take their money and sit on the sidelines until things improve?
A. No one knows for sure, but the odds are that the economy can adjust to this as it has in the past. The credit markets need a sign that a bottom has been established in the mortgage debt market; then, some confidence will be restored.
We believe that making important financial decisions during a panic is never a good strategy. If you don't need liquidity, stay in longer-term assets. Liquidity and high quality is at a premium. Yields on three-month U.S. Treasury Bills hit a 54-year low of 0.03% in late September. If you can keep a longer-term perspective of three years or more, we believe bargains are showing up all over the financial markets.
Q. How will the economy and the stock markets respond in 2009?
A. The contraction in credit, combined with the decline in asset values, almost ensures a slow-growth economy in the near future. During periods of credit contraction, such as we are experiencing today, the economy slows and inflation rates fall. If the credit contraction is large enough, then deflation becomes a real concern, as Japan has experienced for the past 18 years.
Now, however, the Fed and world central bankers seem to be coordinating globally to fend off a deflationary scenario, with liquidity injections occurring on a consistent basis. We would expect additional injections of liquidity in the near future. Then, in the more distant future, we expect the Fed will aggressively try to sop-up the excess liquidity provided during this period of contraction.
As we have discussed in past quarterly outlooks, the velocity of money is slowing and will most likely slow further. Meanwhile, consumers' propensity to save will increase, furthering the consumption slowdown. We would expect inflation to fall in the next 12 months, while the economy slows concurrently. Oil prices have declined from $140 per barrel in July to under $95 per barrel today, and commodity indexes have experienced similar dramatic declines. This helps reduce inflation pressures and provides a small degree of relief for consumers. We expect the slowing economy will also be accompanied by a decline in corporate earnings and a reversion to the mean in profit margins.
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Q. If you expect further slowing of the economy and declining corporate profits over the next year, then why should I remain invested in stocks now?
A. It is true that GDP growth, corporate earnings and the stock market all are very closely related over the long term. However, in any year, the correlation is low and in many cases, inversely related. As Figure 1 shows, in years when corporate earnings are down, the equity markets generate positive returns on average. This makes intuitive sense because the equity markets are forward looking and discount future earnings streams, not the past earnings. (The past earnings are reflected in the corporation's retained earnings and capital base and represent a portion of the company's value, while a portion of the value generally is reflected in the expected earnings the company will generate into the future.) |
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| Figure 1: S&P 500 Earnings and Stock Prices 1960-2007 |
| Average Returns During Negative Earnings Years |
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| Source: Bloomberg and Standard & Poor's. | |
Q. The Calamos growth equity portfolios had no exposure to Fannie Mae, Freddie Mac or any of the banks or thrifts that went to zero. If you avoided this toxic area, why did these portfolios decline so much?
A. Our portfolios emphasize growth stocks of companies that we believe are positioned to benefit from long-term secular trends. Meanwhile, we have avoided the commodity and energy sectors. Many growth stocks have been re-valued by the market for a "no-growth" economic scenario. In this environment, our growth discipline has faced considerable headwinds.
As a result of the recent sell off, many quality companies are trading at valuations below their sustainable growth levels and are reflecting a prolonged period of global weakness. Overall, in fact, the P/E of the market (as measured by the S&P 500), excluding financials, is around 11x.
Q. Convertible securities have declined significantly in value. Is this because of hedge funds' selling activity?
A. The decline in the stock and corporate bond markets has hurt the convertible market. But as a result of deleveraging by hedge funds, convertible bonds have declined more than they should. Hedge funds have a significant footprint in the convertible market because convertibles offer a high correlation hedge with positive cash flow characteristics. The convertible market for hedging has become very competitive over the past eight years. As yields have declined and the arbitrage opportunity narrowed, the hedge funds used more leverage to juice up the narrow yield and spread opportunity. We are now seeing the opposite; as the hedge funds sell to reduce leverage, the convertible market is experiencing a large deviation from theoretical fair value.
Q. How are you positioned in this difficult environment?
A. We believe that as the global economy contracts, investors will seek companies with visible earnings and the ability to sustain their growth without accessing the capital markets. We are emphasizing companies with solid balance sheets, ample cash flows, strong global brands and diversified revenue streams. We continue to favor technology companies, as these are at the forefront of many secular trends, such as enhancing productivity in a highly competitive global economy. We have also found opportunities among stable growth companies, such as those in the health care and staples sectors.
Conclusion
Although we believe investors should be prepared for more volatility and uncertainty in the near term, we encourage long-term perspective. We assure our clients that we are working diligently to assess the risks and opportunities in the market, and that our interests are clearly aligned with those who have entrusted their wealth to us. We have invested through many periods of turmoil before, and we have seen fundamentals ultimately prevail. We maintain confidence in the long-term resilience of the markets and global economy.
We opened with a famous quote of Franklin Roosevelt, and would like to close with one as well. In that same inaugural speech, he noted, "this great Nation will endure as it has endured, will revive and will prosper." Indeed, in these difficult times, it is important to remember that the U.S. and global economies have experienced many—and varied—periods of uncertainty and turmoil. Often, the path was uncertain and unknown, but through creative problem solving and entrepreneurial spirit, the right course emerged.