Commentary

Bet on the economy, not the vagaries of short-term market price swings

In terms of improving living standards and the quality of life for its people, the United States can lay claim to being the most successful economy in history. Over the past 100 years, per capita income expanded at an astonishing rate of well over 11,000% (from $390 in 1907 to $46,040 in 2007), while GDP soared more than 2,200% (from $489 billion to $11,524 billion) during the same period (Figure 1). The U.S. economy has proven remarkably resilient in the face of world wars, terrorism, natural disasters, banks crises, double-digit inflation, and other problems. Indeed, the economy has demonstrated it is a formidable force, even in the face of nerve-racking month-to-month equity market price swings (Figure 2).

Figure 1: U.S. GDP Growth Real GDP (Billions of 2000 dollars), log scale Source: www.measuringworth.org

Figure 2: U.S. GDP Growth and S&P 500 Index Performance Despite equity volatility, an upward trajectory for GDP growth 1947 Q1 - 2008 Q3 Source: FactSet

The stock market is fraught with price swings driven by fear and greed; but over the long run, the stock market reflects the strength of the economy. Just eight years ago, we experienced the incredible excess optimism priced into technology and telecom stocks. Today, we are experiencing the polar opposite in the markets— extreme pessimism. Today's panic is grounded in a great deleveraging cycle that will be difficult to stomach for months to come. The fear is fuelled by concerns that we

may be following a path similar to that of the last large debt unwinding of the Great Depression. However, there are significant differences between conditions today and those that set the stage for the Great Depression. The Great Depression started with a tight monetary policy, a 33% decline in industrial production, and trade tariffs that ground the economy to a halt—all before the banking crisis even hit. Today, the economy is more diversified and benefits from additional safety nets and insurance that did not exist during the 1930s. Because of such factors, we can be confident that the economy will react differently this time, although how differently may be anyone's guess.

What can we expect from an economic standpoint?

In our July 2008 commentary ("If you're not confused, you don't know what's going on", www.calamos.com), we stated the credit crisis would have a negative impact on the economy and a recession was likely. We explained the velocity of money was declining and the monetary base was not expanding enough to offset the decline. We cited the monetarist equation for GDP, which explains the change in GDP as MV=PQ.

In a monetary context, Milton Freidman developed the GDP equation that money (M) multiplied by velocity (V) is equal to price (P) multiplied by quantity (Q) produced. [Ultimately, the total amount of money spent on purchases (MV) = the total amount received by sellers of output (PQ).]

In today's terms, we are going to continue to see less velocity of money as the banking credit-creation process or multiplier declines. We are also witnessing a decline in monetary growth as the United States deals with a weak dollar and inflation concerns. Therefore, we would expect a period of slow growth bordering on recession over the next few quarters or years. Unfortunately, very slow growth will reveal other weaknesses and will probably push the economy over the brink into a recession. The economy does not function well at very low growth rates; historically, low growth has led to no-growth as businesses suffer, default rates climb and new job creation drops.

This was a quick way to understand how the credit crisis might impact the economy. We had no way of knowing how much the velocity of money would decline, so we observed the factors and logically assumed a negative overall impact on the economy. The monetary base was not increasing enough to offset a decline in the velocity of money; therefore, a recession was likely.

As it is now obvious that we are in a recession, we can use another equation for GDP that may help us understand the extent of the impact the financial markets crisis may have on GDP.

GDP = Government spending + consumer spending + business investment + (exports - imports)

We expect government spending to increase as fiscal stimulus is encouraged. Indeed, spending will increase if President-elect Obama's plans to rebuild our infrastructure through a 1930sstyle jobs program come to fruition. However, an over-extended budget and the negative impact of raising taxes on an already burdened economy will constrain a spending increase.

Consumer spending presently accounts for about 70% of GDP and has been instrumental to the success of our economy during the past 40 years. Yet, deteriorating home values and financial assets have caused consumer net worth to drop sharply. We believe consumer spending will decline as consumers increase savings to rebuild net worth. Figure 3 shows the inverse relationship that exists between savings and net worth. In general, higher consumer net worth translates to a lower need for out-of-pocket savings, and vice versa.

Figure 3. Personal Savings Rate and Ratio of Net Worth to Disposable Income 1951 Q4 - 2008 Q3 Sources: Personal saving and disposable income: Bureau of Economic Analysis (BEA); household net worth: Federal Reserve Board.

We estimate declines in housing and financial wealth have dropped the net worth-to-income ratio to around 5.0, down from a high of more than 6.0. The decline in this ratio should have a dramatic impact on consumer savings. Historically, when the net worth-to-income ratio reached 5.0, the corresponding savings rate was roughly 8%. However, the current savings rate is only 2.5%; therefore, we expect the consumer will reduce consumption by approximately 5.5%—although a portion of the decline in consumption will be in the form of debt reduction. Increases in wages, financial assets or housing will also offset some of the consumption decline. Even so, with consumer spending declining 3.0% to 5.5%, the impact on GDP could be a 2.0% to 3.5% annual decline!

Can government spending offset the reduction in personal consumption? Government spending represents 20% of GDP. To offset the consumer spending decline, government spending must grow at a rate of about 15%, annually. However, since 1955, the government spending growth rate has been closer to 3% and has generally been below 10% year-over-year (see Figure 4). With already-large deficits and growing national debt, it would be difficult for the government to be the sole driver of the economy.

Figure 4. Government Spending Growth Rate December 31, 1947 - December 31, 2007 Source: Bloomberg LP

To what extent can business investment and export growth make up for the shortfall in consumer spending?

We expect business investment spending to be additive to GDP, but at a very low rate since the current mode of the business sector is one of caution and preservation of capital. Business investment spending is likely to be tight because access to capital is difficult and a weak economy has caused business executives to re-evaluate growth plans and reduce risk.

The other part of the GDP equation is related to export growth, net of imports. In the past few years, exports have added to GDP as the U.S. dollar declined, effectively offsetting most of the housing market impact. In the past few months, the dollar has staged a remarkable rally—the result of a flight to quality and the unwinding of a global carry trade that was short the dollar. The positive impact on GDP from exports will be muted if the dollar remains strong. Because of this and the slowing global economy, it is unlikely that we will see a significant contribution to GDP from exports.

As a result of this confluence of factors, we expect a weak economy for the next year or two, with housing price movements and broad financial market price moves adding to, or reducing, the depth and length of the recession.

What should investors expect from the markets over the next year or two?

Stock and bond markets have declined dramatically and appear to be expecting a significant recession—not just a couple of years of slow-growth or no-growth. It is difficult to determine what the next year or two may bring, but the markets generally recover before the economy does; and we are at extreme valuation and sentiment levels today. We believe that both equity and bond markets offer very attractive returns at these levels, although the road ahead will be bumpy and may challenge one's conviction and sense of security.

Convertible securities, for example, are trading at historic— indeed, unprecedented—levels of undervaluation. In our recent commentary, "How Attractive are Convertible Securities Today?", we analyzed how inexpensive the convertible market has become, even though much of the undervaluation could be captured with a hedge that is quite highly correlated and economically viable.

Meanwhile, investment-grade bonds are trading at a spread of approximately 550 basis points to Treasury bonds. Figure 5 shows the history of the spread and the recent exceptional widening. Historically, investment-grade debt that default have had a recovery rate in excess of 55%. The historical default rate since 1920 has been only 0.145%! A quick way to evaluate the implied default rate is to compare the stripped Treasury or zero-coupon risk-free Treasury to a zero-coupon corporate with the same 550 basis-point spread. This is a simple method for viewing the opportunity, minimizing the impact of coupon reinvestment and discounting the cash flows on a periodic basis.

Figure 5. Corporate Bond Yield Spread* * Moody's BAA Corporate Bond Yield Less 10-Year Treasury Yield Source: Wells Capital Management November 2008 Economic and Market Perspective

Consider:

• A 10-year zero-coupon government bond with a 3.7% yield would cost $695.
• A 10-year corporate zero coupon with an 8.2% yield (450 basis points over the Treasury) would cost $454.

We could establish a zero-cost hedge in the following manner:

• Short 1,000 government bonds for $695,000.
• Purchase 1,528 corporate zero-coupons for $695,000.
• • In year 10, the government bonds would be worth par (or $1,000,000).
  • With no defaults among the corporate bonds, the long corporate investment would be worth $1,528,000.

What default rate could we have and still breakeven with the short Treasury position?

• With a nearly 35% default rate and no recovery in any of the bankruptcies, we would breakeven!
• With a 50% recovery rate, we could see nearly a 70% bankruptcy rate and still breakeven.

The spread is discounting a depression! Clearly, the spread includes a wide liquidity premium; but overall, the economics are very attractive.

What is the implied default rate for belowinvestment- grade debt?

Using the same simple logic, high yield bonds offer a spread over Treasury bonds of 1,300 basis points, or a yield to maturity of about 16.7%.

• Therefore, a zero-coupon equivalent would cost $213.
• A zero-cost hedge against the 1,000 bond Treasury strips would allow you to purchase 3,263 high-yield bonds for $695,000.
• • With a 70% default rate and no recovery in any of the bankruptcies, we would breakeven on the highyield bonds.
  • With only a 20% average recovery rate among bankruptcies, the market would be discounting a breakeven default rate of over 80%!

Over the next year or two, the high-yield investment world may prove to be very unnerving, but not to the extent that we believe the market should be discounting a complete economic disaster.

Why are corporate bond prices indicating such a dire future?

We believe the markets have overshot economic reality, and that valuations are largely attributable to forced selling in the financial industry and hedge fund arena. The investment banks and hedge funds are liquidity providers, and during normal times act as efficiency capital to allow markets to function smoothly. Because the liquidity providers are themselves under extreme duress, the entire financial industry is suffering from too much debt and a crisis in capital access and liquidity. There is an abundance of sellers, but buyers are only stepping in at very distressed prices because most have limited capital and in most cases, are net sellers. In addition to large default rates, credit spreads are also reflecting substantial liquidity spreads. Today's credit markets include a large liquidity premium. Capital and liquidity providers are experiencing a severe recession in the financial industry. As a result, a huge spread has been built into the price of securities that are dependent on liquidity providers to keep markets efficient.

For example, imagine if you wanted to sell a used car, but 50% of the auto dealers had gone out of business and the remainder held excess inventory that they had to sell quickly to stay solvent. A dealer would only pay a price that would allow it to earn an extremely high return on the purchase. The price for selling the car immediately would include a steep liquidity discount—one that would likely make you feel as if you were being cheated severely.

The corporate bond markets are experiencing this sort of significant liquidity premium. However, we believe this environment offers buyers an excellent long-term opportunity to earn high returns on capital.

How much of the large credit spread is due to the liquidity premium and how much is due to bankruptcy predictions?

It is difficult to estimate the exact premium built into spreads for bankruptcy potential and liquidity, but it is likely that a significant discount is related to liquidity because the equity markets are not discounting a depression scenario while it appears the debt markets are, if you ignore the liquidity premium. The difference, we presume, is because equity markets remain more liquid and, therefore, the liquidity premium is not necessary.

For long-term investors, are stocks as attractive as corporate bonds?

Equity valuation is a bit more elusive because it is more subjective. Bond valuation is based on certain cash flows and terms to maturity. In general, a bond's coupon and maturity date are known factors. An investor has to determine the creditworthiness, or discount rate, to assign the debt; an estimated inflation rate over the life of the security; and the likelihood of payoff of all principal and interest.

Equity valuation is similar to bond valuation except the "coupon" or cash flows the company generates must be estimated into perpetuity along with an estimated discount or risk premium. The equity also offers no principal payment and is the last claim on business assets. Approaching the equity market like a perpetual bond may shed some light on the current valuation. The charts in Figure 6 are histograms that use our proprietary stock valuation model to determine the intrinsic value of each stock we follow. The bands are indications of valuation based on historical references regarding industry growth, return on capital and weighted cost of capital. As you can see, the valuation has changed dramatically in the past 12 months. Today 75% of stocks are undervalued or very undervalued, as compared to only 20% one year ago. Some of the models used to estimate the equity valuation work with earnings per share (EPS) yield relative to a discount rate. It may be helpful to normalize EPS in an attempt to smooth the earnings trend and to do the same for the discount rate. Figure 7 compares market P/E for the median stock in the S&P 500 Index, and currently indicates the lowest P/E since before 1990.

Figure 6. U.S. Companies, categorized by Economic Profit (EP)1 Based on EP, the majority of U.S. companies are currently very undervalued—a striking contrast to September of 2007. Figure 6a. EP Band Ranks as of 10/20/08 Figure 6b. EP Band Ranks as of 9/30/07 Source: Calamos Advisors LLC. 11Economic Profit (EP) is a calculation of profits remaining after the costs of a company's capital (both equity and debt) are deducted from operating profit. Source: investopedia.com.

Figure 7. S&P 500 Index Price/Earnings Multiple2
2 Median Company Price to Forward 1-Year IBES Mean Earnings Estimate Source: Wells Capital Management November 2008 Economic and Market Perspective

Another way to evaluate the relative valuation of the equity markets is to compare the combined market capitalization of the market to nominal GDP (Figure 8). Think of this as a price-to-sales measure. In 1999 and 2000, the market peaked at about 180% of GDP. Looking back since 1950, the trough was about 40% of GDP, occurring during the 1975 to 1980 period. Today the ratio is down to 60% of GDP, indicating a bad recession, but not a depression.

Figure 8. U.S. Equity Market Capitalization as a Percent of Nominal GDP 3
3 Last data point based on actual nominal GDP data through Q2 2008 and an estimated market capitalization adjusted for the total return of the Dow Jones Wilshire 5000 since the end of Q2 2008 Source: Wells Capital Management November 2008 Economic and Market Perspective

The debt markets are pricing in a huge liquidity premium in the spreads over Treasury bonds, but are not pricing a depression. Rather, they are pricing an extremely illiquid environment. Domestic and global equity markets are pricing in a prolonged recession—and this extreme pessimism may create a favorable environment for long-term investors. From a historical perspective, equity market P/E ratios are in the second decile. As Figure 9 indicates (courtesy of Leuthold Group), returns over the next three- and 10-year periods should be very favorable for equity investors. According to the Leuthold Group's work, three- and 10-year annualized returns were in excess of 15% when P/E levels reached this point!

Figure 9. Median Annual Compound Total Returns From Historic P/E Deciles, 1957 to date
Figure 9a: Median Three-Year Annual Compound Total Returns Three Years Out
Figure 9b: Median 10-Year Annual Compound Total Returns 10 Years Out
Source: Leuthold Group Interim Memo, October 10, 2008

Looking forward

Over recent months, there has been an unprecedented amount of monetary reflation and global coordination to address the current credit market crisis. The U.S. monetary base has exploded (Figure 10), and it is likely that this will have a stimulative impact on the economy, without increasing shortterm inflation pressures. The U.S. industrial production rate of change is highly correlated with changes in the monetary base growth rate, and the current base growth has been off the charts. We should expect some signs of recovery in the next six to 12 months.

World governments are attempting to move from a potential deflationary economic collapse to a mild inflationary recovery. The main tools at their disposal are expansive monetary and fiscal policies; and at this point, the monetary faucet is wide open. Fiscal stimulus may be the Keynesian economic prescription—arguing for heavy government spending and leaving deficit concerns for some future decade. Politically speaking, fiscal stimulus gives

Figure 10. Real Monetary Base and Industrial Production January 1973-October 2008 *SA: Seasonally adjusted; NSA: not seasonally adjusted Source: Monetary Base data from Federal Reserve Bank of St. Louis which was adjusted for inflation with CPI data from Bureau of Labor Statistics. Industrial Production provided by Federal Reserve.

Figure 11. Bear Market Performance and Recoveries: S&P 500 Index Figure 11a. 2006-Current Figure 11b. 2000-2005 Figure 11c. 1972-1977 Source: BCA Research Global Investment Strategy, Weekly Bulletin, October 17, 2008; page 2

government more power to concentrate capital allocation where it chooses. In contrast, classical economic theory would advocate stimulating the economy through tax cuts and letting consumers decide how to spend the capital. The economy is also benefiting from lower oil and commodity prices; these act as a tax cut of sorts, by providing a buffer to consumers and businesses. Most of the bank write-downs have been recapitalized, and short-term credit indicators are all improving from extreme crisis readings to more normal recessionary levels. Banks will still need to recognize losses on consumer and commercial lending portfolios. That said, much of these losses appear to be recognized by the market, given the very low stock valuations afforded to banks and financial stocks. And as we noted, forced selling by overleveraged hedge funds may have caused financial markets to overshoot reality. Accordingly, it may be possible that we have a severe financial industry recession, while the economy as a whole experiences something closer to a "normal recession." Historically, sharp corrections of the magnitude we have recently encountered have been followed by a strong rebound within a year. Figure 11 shows the few periods since WWII when the market has severely corrected and the corresponding rebounds. Certainly, it is our hope that the markets find a bottom soon and repeat what has happened in the past. In the meantime, we believe the financial markets may be presenting an excellent long-term opportunity for those brave enough to remain in a fear-stricken environment.