Commentary

Even if the economy continues to struggle, the equity markets may have already put the worst behind them.

We don't believe investors should run for shelter. Instead, think about what's changing and how to potentially benefit from those changes.

The debate continues as to whether the U.S. economy has entered a recession and how bad things could get. Recession or not, the market has already discounted a large portion of an economic downturn. Past recessions translated into an equity market decline of about 20% on average. The S&P 500 Index has dropped 17% from its October 2007 high.

The extent of a decline in equity markets generally correlates to the extent of the decline in corporate earnings and to the overvaluation of the market going into the decline. If we first look at the situation from an earnings perspective, we may not be in for a major market decline. Corporate earnings were down 3% overall in 2007; but excluding the financial industry, earnings were up about 11%. We expect 2008 will be a more difficult year, likely with earnings growth in a range of plus or minus 5%. Although we're at odds with the general consensus of analyst bottom-up estimates, which forecast a rise of 17%, our earnings outlook is far from catastrophic. Secondly, the equity market is not as extended in value as it was before the recessions of 2000 and 1973. Realistically, we don't see valuations levels fueling the fire for a significant correction.

Is the Financial Sector Poised for Rebound?
During the S&L debacle and recession of 1990, banking stocks fell 41% before beginning a rebound. In the wake of the subprime crisis, we've already seen a similar decline, suggesting to us that much of the negative news may be priced into the sector already.
Source: FactSet/S&P.

A Normal Correction or Something More?

The collapse of the housing and credit bubbles should result in less credit expansion, reduced equity withdrawals and increased savings. Nonetheless, most of the economy is still in good shape. If the integrity of the financial system can be maintained, the U.S. economy should soldier ahead.

While we hope that a more significant decline in the economy and market can be averted, precedents indicate the U.S. economy is in for a normal correction and recession. The economy may muddle along and the stock market may be stuck in a trading range until some clear path is revealed for the economy and the credit markets. We believe the Fed's recent decisive actions will be more successful than "pushing on a string," but not as effective as the liquidity injections of years past. The lowering of interest rates should benefit bank balance sheets and spur more refinancing of home mortgages. Lower rates may even help sustain lending to commercial and individual borrowers. But banks are likely to remain in a more conservative mode and be much less aggressive in growing their balance-sheet leverage.

Fiscal policy stimulus should support the Fed's monetary stimulus, but here again we expect limited impact. This is a one-time, election-year giveaway stimulus and therefore not likely meaningful to the economy on an ongoing basis. The economy will still need a long-term solution that supports job growth, capital flows and global business competitiveness.

As we've discussed in the past, the bursting of the housing bubble and the ensuing credit crisis have left a significant amount of questionable credit in the economy, but some of the juice that fueled the economy during the past five years is gone already. The economy benefited greatly from home equity withdrawals; in fact, since the end of the last recession, the withdrawals may have generated as much as half of the economy's growth. Home equity withdrawals are no longer the stimulus they once were.

GDP Growth With and Without Mortgage Equity Withdrawal (MEW)
Sources: Real GDP numbers obtained from the U.S. Department of Commerce, Bureau of Economic Analysis (www.bea.gov); Mortgage equity withdrawal gross cash out figures obtained from a model built by Alan Greenspan and James Kennedy. The data was downloaded from Trackback URL: http://blogs.wsj.com/economics/2007/06/12/homeequity-extraction-bounces-back/trackback/.

One or two sectors carrying the economy for a long period, as the housing market has done, is not uncommon. Economic expansion from 1994 to 2000 was carried primarily on the back of the technology sector. In years past, the old adage was that "as General Motors goes, so goes the economy." But when the sector that provided much of the growth falters, another must take its place. Today, much of the hopes are pinned on export growth, business capital investment and global infrastructure build-out.

The Integrity of the Financial System: A Large Risk

Global trade will continue to drive world economies, but the trade mix will change. This creates opportunities and problems for all markets.

The actions of the Fed and the financial markets indicate the need to support banks' balance sheets and the monoline bond insurance industry. (Monoline insurers insure fixed-income securities, in contrast to multi-line insurers that insure a variety of assets.) Temporary government support for bond insurance agencies may be necessary. Bond insurance industry defaults could cause mass credit downgrades and should be addressed before the slowing economy causes an increase in bond default rates.

We would be most favorably disposed to a solution akin to the Resolution Trust Corporation which provided government relief when the Savings & Loan crisis came to a head in the early 1990s. If similar support were put in place for bond insurers, we believe the passage of time—combined with a normal-shaped yield curve and capital infusions—will heal the banking industry. If the monoline bond insurance industry fails, then we would expect renewed selling pressure on many bonds, collateralized debt obligations, leveraged loans and structured debt. Falling credit ratings could trigger a significant round of asset deflation.

As we mentioned, banks will likely be slow to expand balance sheet risks. Given the credit market meltdown of 2007, we believe a more cautious approach is both prudent and necessary. Banks should evaluate the risks of swaps and other derivatives with an eye toward building proper reserves against losses and gaining more meaningful understanding of the levered risks.

The integrity of the credit markets is a global concern. A slowdown in the United States will have an impact on other nations. Although non-U.S. consumers contribute more to global spending than in the past, the United States remains the largest consumption engine for most export-driven economies. The United States is not exporting dollars at the same rate as it was a year ago as the current account deficit is declining. Although many experts expected the large trade deficit would lead to higher-costing U.S. government debt, the interest rate on U.S. government debt has fallen even though the trade deficit exceeds 5% of GDP.

Navigating the Road Ahead

Can the United States overcome slowdowns in credit expansion and consumer spending? We believe so. Creativity and supply-side innovation, shifting resources to more productive parts of the economy, and exports to emerging-consumption economies are powerful catalysts for long-term prosperity. Also, government policies—including interventionist regulation, bureaucracy and taxes on capital—create waste and discourage innovation. Removing, or at least lessening these burdens, could spur further economic growth.

As we noted earlier, we believe the correction has run much of its course. Given the continued evolution of the global economies, the markets may take a while to gain a sound footing. From 2001 through much of 2007, global liquidity and the velocity of money increased. Now, global liquidity and the velocity of money are on the decline, presenting a very different environment. Global bank lending is slowing, and Asian economies are recognizing that artificially low currencies pegged to the dollar may create inflation, and at the same time, cap internal consumption. Because economic growth in the United States and Europe may be slowing, policies from Asia could shift, focusing less on subsidizing exports and more on stimulating internal consumption. Should this occur, low-cost capital would decrease and liquidity constraints would increase. Additionally, the United States is hoping for an export-led recovery, while Asia needs an internal consumption plan to extend economic growth. These shifts are significant and could cause some interesting opportunities and challenges in the next few years. The current run-up in Asian currencies and a waning fortitude to hold U.S. reserves indicate a change is occurring at the margin already.

Strategic Positioning: Calamos Portfolios

So, then, what opportunities are emerging from the market correction and the changing liquidity and credit environment? Within the equity markets, large-cap U.S. growth stocks with a substantial degree of global revenue continue to be very attractive to us. The credit markets are still in the early innings of what may be a few years of stress and reassessment. Bankruptcy rates are likely to rise, and credit spreads have widened to levels very near to those seen during the last recession. As risk is more appropriately priced into the credit markets, we expect more opportunities among below-investmentgrade credits. We may shift the credit risk in our high-yield and convertible portfolios to more aggressive holdings over the next few quarters.

We believe that long-term secular trends, such as increasing global prosperity, will continue to provide a catalyst for many companies. Accordingly, the Calamos portfolios include significant exposure to non-U.S. consumers and capital investment. As the global economies adjust to the changing conditions, we believe emphasis will serve the portfolios well. We expect to focus much of our search for growth opportunities on the Asian consumer and infrastructure export industries.

We are slowly adding to our financial exposure. In the wake of the recent sell off, valuations in the sector are near an 18-year low. We believe this provides us with a timely opportunity to increase the portfolios' substantial underweightings. (The domestic portfolios hold about half as much in financials versus the U.S. market indexes, while our international financial exposure is even less.) High-quality stable growth stocks in other sectors are also near 18-year valuation lows. The technology sector has come under more selling pressure than the market as a whole, and we believe the markets have overshot on the downside. Global competition and infrastructure build-out are highly dependent on technology investments that support communication, information sharing, product innovation and consumer demand.

We have not invested actively in housing stocks during the past two years. Now that many stocks in this area are down 50 to 80%, we may find some attractively valued opportunities. U.S. health care and consumer staples stocks typically respond well during the correction phase of the market, but as we discussed, we believe much of the decline has occurred already. Although we are finding select companies in these sectors, we do not intend to significantly overweight them due to concerns about the political nature of the health care industry during an election year and the slower growth prospects of the consumer staples area.

Conclusion

We encourage investors to stay in the markets and focused on the long-term. Just as market corrections have tended to be very swift, so too have rebounds. History has shown that market timing is a very difficult, if not impossible, strategy for the long term.

We believe the U.S. economy and the capitalist system will prevail, continuing the remarkable wealth creation track that has increased living standards for Americans for nearly a century.

For more than 30 years, Calamos Investments has dedicated itself to helping investors build and protect wealth. We have tested our discipline through many difficult market environments. We believe the global marketplace continues to offer abundant opportunities for long-term investors, and we look forward to drawing upon our experience to pursue these evolving opportunities.