Commentary

The World Series is fast approaching, and the ballparks in Chicago are quiet. As a Cubs fan, I have grown accustomed to the silence.

For sports fans, team loyalty is often a badge of honor and tradition. Allegiances are frequently passed through the generations. My great grandfather passed along his Cubs loyalty to me. I, in turn, am guilty of passing it along to my sons.

While such loyalty in sports often defies logic, a far better case can be made for having a steady investing discipline. The market is cyclical, after all. Investment styles, fads, and asset classes move in and out of favor. Because it is impossible to predict the exact shifts, we at Calamos Investments caution strongly against market timing and short-term thinking—the "fair weather" approach to investing.

That said, it is not necessary or wise to be as patient and loyal as Cubs fans when it comes to most matters, including evaluating investment performance. In recent commentaries, we've discussed the market's current bias to cyclical and value stocks. So, the next question is, when does the market turn?

Mid-Cycle Slowdowns and Market Runs

To us, it appears likely that the economy will experience a mid-cycle slowdown, much like the slowdowns experienced in 1965, 1985 and 1986, and 1995. Each of these slowdowns was preceded by Fed rate hikes that appeared to be early or directed at some excess building in the real economy or financial markets. In each case, the market reacted to the slowdown before the gross domestic product (GDP) reflected it—in other words, the market was a leading indicator.

In 1984, the Fed was raising rates and the S&P 500 Index began the year at 169. By mid-July, the index bottomed at 148 (a 12.4% correction), and then rallied to end the year at 166 for a -1.77% price return. Once the slowdown showed up in the GDP figures in 1985-1986, the market rallied in anticipation of a slowdown and more controlled growth. From January 1, 1985, to December 31, 1986, the market rallied from 166 to 247, a nearly 50% rise. By August of 1987, the index was at 328, representing a price rise of nearly 100% from when the Fed stopped raising rates. Half of the market move occurred during the mid-cycle slowdown.

Once again, in the 1990s bull market, the economy experienced a mid-cycle slowdown; and again, the slowdown was preceded by the Fed raising rates in 1994 with a GDP slowdown occurring in 1995. The market came into 1994 at 464 and closed the year at about 460 for virtually no price return. But during this same year that economic slowdown occurred and the Fed rate hikes stopped, the market began a huge sustained bull market that peaked at 1525 in March 2000—a 229% move.

Changes in GDP Growth and the S&P 500 Index
March 31, 1965 - December 31, 1969
March 31, 1983 - December 31, 1987
March 31, 1993 - December 31, 1997
Source: Bloomberg, LP. The S&P 500 Index is an unmanaged index generally considered representative of the U.S. stock market. Unmanaged index returns assume reinvestment of any and all distributions and, unlike fund returns, do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index.

Today, after officially pausing in August, the Fed may be near or at the end of its rate hikes. The market appears to be discounting a mid-cycle slowdown, treading water even in the face of very strong corporate earnings and solid GDP figures, much like the mid-cycle market run in the last two bull markets. Many times in the past year, we have said we believe the market will get back on track when the Fed is done raising rates. We believe this change is near.

Changes in Leadership?

Unlike the Chicago Cubs who have waited generations for a World Series victory, we believe growth could soon see the tide turn. One of the significant changes that occurred in past mid-cycle slowdowns was 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. We believe this will happen again.

At a certain point in every economic cycle, top-line growth, pricing power and high utilization rates create a perfect storm, spurring eye-popping earnings growth rates for cyclicals. During these periods, earnings growth rates of more than 100% are not uncommon. But, the same forces that brought about the very high growth rates also shift and bring about huge negative swings in the earnings growth of cyclicals.

Early signs that a shift is underway include the changed fortunes of housing stocks. Down 50% from the earlier highs, housing stocks are once again priced as cyclical companies and not as secular high-growth companies. We believe that other cyclical "growth" stocks will follow suit, and may soon be re-priced by the market. Growth stocks, on the other hand, have significantly underperformed value stocks and cyclical stocks. The leadership change from cyclical to growth is generally followed by a dramatic—downward—change in the forward earnings-growth for the cyclical companies, while the more stable growth companies continue generating more of the same, steadier earnings growth.

Several catalysts favor a sustained shift toward growth: an end to Fed rate hikes, moderation of energy prices, slowing in the growth of housing prices, an increase in market volatility, moderation in consumer spending (especially high-end spending) and a decline in commodity prices. Most of these are present today; so if history is a reasonable guide, we should expect a change in leadership.

In fact, since early August, the leadership has begun to change as many of the cyclical stocks that led the market in the first half of the economic expansion have considerably underperformed the more stable growth stocks.

We acknowledge that the market does not always follow the same pattern every economic cycle; and it could be different this time. It seems that the real risk in this cycle is the possibility of inflation not moderating, and instead taking hold at higher levels, much like it did in the 1970s. If this were to occur, the economy would be weaker.

We feel inflation is moderating and is not a large risk at this time. Although commodity prices and energy prices have had a huge move since the beginning of the expansion, the much larger bond market valuations indicate that inflation is not a threat. It has been said that anything China is buying is going up in price, and anything China is selling is going down in price. I think this speaks to many of the mixed signals that have made investors anxious this summer. China is a large buyer at the margin of all commodities, as well as of government bonds and U.S. stocks. The country is also a large seller of consumer household goods, clothing and other consumer products. This relationship appears to be intact, but as the global economy slows, the pricing pressures subside. When we adjust commodity purchases from dollars to units, we believe that much of the buying pressure has subsided and the slowdown has already begun.

In our view, the risk of a slowdown favors a shift to stable growth companies. The risk of higher inflation, on the other hand, could cause the Fed to continue raising rates, and the resulting stagflation would also favor a shift to more stable growth companies. The continuation of more of the same would favor cyclical investments, but it appears that the economy has changed. If it has not, our view is that we are merely early in our assessment of the leadership change.

At Calamos Investments, we've taken a determined stand against the "fair weather" fan approach to investing. We believe strongly in positioning our portfolios ahead of market turns, and have maintained our discipline through short-term and saw-toothed market conditions. As a result, the Calamos portfolios are invested in what we believe are some of the world's premier growth companies. Many of these companies are trading at discounts to the market and historical values—despite average returns on invested capital exceeding 20%, balance sheets with less debt than the average company and revenue growth that far exceeds the market.*

Historically, high-quality growth at a discount comes around only once every decade or so. Accordingly, we believe that now represents a compelling time to increase allocations to growth-oriented investments.