The "Fix Is In" — But Will It Last?

2008 Review

In 2008, the global financial crisis caused a near collapse in global economies. Shocked by the financial asset implosion, most consumers and businesses stopped spending. Commerce ground to a near halt in the last quarter of the year and panic took over. Throughout the past few years, we have discussed how the markets have been good predictors of future economic activity. We have also noted that the markets have become so large and leveraged that they can cause economic collapse, not just predict it. We are in the midst of a financial-market-induced collapse that has been fueled by cheap debt capital and 10 years of chaotic monetary policy at the Federal Reserve.

A recent study by Professors Carmen M. Reinhart and Kenneth S. Rogoff entitled "The Aftermath of Financial Crises" looked at the severity of recessions caused by financial crises in the past century. Reinhart and Rogoff studied the impact and duration of unemployment, equity markets and GDP in various economies. The results are unsettling, to say the least. On average, recessions caused by financial crises have been much worse and longer lasting than recessions caused by excess inventory, oil shocks or excess capacity.

When recessions were caused by financial crises, the study found that unemployment increased an average of 7 percent, with elevated unemployment lasting an average of four years. Output dropped an average of 9 percent from peak to trough, and the downturn lasted an average of two years. Government debt exploded an average of 86 percent, while equity markets dropped an average of 56 percent with downturns lasting about 3.4 years. The study also found that real housing prices declined an average of 35.5 percent from peak to trough with an average duration of about six years. This may indicate that the bottom of the real estate cycle is yet to come, as the U.S. real estate market has fallen about 25.4 percent and is about 2.5 years into its correction (Figure 1).

Undoubtedly, the government's economic think tanks, the Federal Reserve and other experts know much of this data and are acting quickly, so the"fix is in." But, this is all a grand experiment, even if it is being guided by the best minds in government and by world monetary leaders. To end the pain and suffering caused by the economic and financial turmoil, they are taking a no-holds-barred approach to reflate the debt cycle and rekindle the spending spree. This experiment reflects an expectation that quick and aggressive measures will result in a much shorter recession and a less severe asset price correction than those experienced during other economic cycles driven by financial crises. So far, things are better than the averages in the Reinhart and Rogoff's study. For now, we can hope the masters of the universe have engineered a real turnaround.

Figure 1. Perspectives on the Downturn: Current Conditions in the U.S. Economy vs. Global Historical Averages
Sources: Global historical averages for GDP, unemployment, equity prices and home prices: "The Aftermath of Financial Crises", Carmen M. Reinhart, University of Maryland, NBER and CEPR and Kenneth S. Rogoff, Harvard University and NBER, December 19, 2008. Current U.S. GDP: Bureau of Economic Analysis (BEA.gov). Current U.S. unemployment: Bureau of Labor Statistics (BLS.gov). Current equity prices: FactSet. Current home prices: S&P/Case Shiller Home Price Index (www. standardandpoors.com).

Outlook

We will get a response from the extraordinary global monetary expansion. Money will make its way into the economy, financial markets and hard assets. We cannot be sure of the impact on each, however. It seems likely that initially, monetary expansion will cause financial and hard assets to rebound as new money makes its way around the globe. Near-term, excess global manufacturing capacity and heavy debt loads will likely keep spending down as savings activity increases. Until spending resumes and excess global manufacturing capacity is utilized, inflation at the consumer level is unlikely.

We expect 2009 will be a difficult year for the economy, with rising unemployment and bankruptcy rates. That said, the financial markets should rebound because, after all, the fix is in. It may be a fix that is rigged and one which only prolongs a further debt cleansing cycle while ushering in high inflation— but that's for another time and other politicians to deal with.

Opportunity Amid Turmoil

We are experiencing the worst stock market collapse in more than 75 years. Many have also said that we are headed for another depression or something close to it. Quite understandably, many investors question why they should remain in risk assets.*

We encourage investors to remember that price and value are not the same. We believe that the prices of stocks and nongovernment bonds do not reflect the true value of these assets. At today's prices, we believe that stock and bond market prices offer attractively valued opportunities to earn above-average returns in the next decade. In our view, long-term investors should hold—or if possible, accumulate—these assets at the current discount values.

These stock and non-government bonds have gone into a freefall that reflects extreme selling pressure and a liquidity crisis. Prices in these markets assume a no-growth environment with high business failure rates over the next decade—a level of pessimism that we believe overshoots reality and overlooks corporate fundamentals. We believe that corporate bond prices are reflecting a crisis with the bond buyers (hedge funds, investment banks, banks and insurance companies), not a significant problem with the issuer of the debt.

In contrast, government bonds are significantly overvalued. As a result of investor panic and a rush into highly liquid and no-risk investments, the 10-year Treasury yield dropped to just over two percent. The three-month T-bill rate has been at zero and even negative yields several times in the past few months—meaning people are paying the government to hold their money!

The Importance of Long-Term Perspective

It is true that there are many economic problems, and it may seem like the end of prosperity is coming. But, trying to predict the future is a hazardous game. Almost nobody has done it correctly over the short term, and no one has done it well for long periods. Just a few years ago, virtually no one would have predicted the depth of the recent market collapse. Yet now, so many investors believe they can correctly predict the future— and that it will be bleak.

We believe that rather than trying to time the market, investors should stick with a well-diversified asset allocation and add to asset classes on a consistent basis, to realize average prices that take advantage of the market's volatility.

In our experience, investors have been better served by considering the long-term history of the markets and economy. Historically, the markets and economy are cyclical. We believe they will continue to be, and that the future will once again look brighter.

Questions & Answers

The Economy and Markets

Q. Do you believe the government's near term-solutions could open the door to longer-term problems?

A. The end of an era may be upon us, but no one knows for sure. The U.S. consumer needs to build savings and reduce debt levels. Although recent energy price declines should help soften declines in consumer spending, the resulting consumption drop off may create future headwinds in the economy. There are clear indications that the U.S. government will attempt to fill this spending gap with increased spending of its own. Companies in troubled industries may become increasingly nationalized, resulting in lower margins and slower growth. The financial sector is already going through some major changes that will result in lower leverage, higher regulation and government direction—and lower margins and growth. The auto, health care and energy sectors can probably expect some heavy government involvement in the next few years.

Unfortunately, an economy controlled by government intellects has yet to be anywhere close to competitive with the capitalist system. As President Reagan observed, "The most terrifying words in the English language are: I'm from the government and I'm here to help."

The economy has too much debt and assets are in a freefall. The stage is set for a more hands-on government in Washington to attempt to pave the road to economic growth by spending. To offset the debt deflation cycle, the government solution will likely be to reflate the economy by printing money and taking on debt. However, common sense tells us that printing money and increasing the debts of an already heavily indebted economy is not the road to prosperity. We can only hope that consumers and debt-burdened home owners are given tax relief as part of the stimulus plan!

Looking out, we are concerned that the newly elected administration will adopt policies that emphasize government over business, penalize successes and reward failure, discourage risk taking and allow the government to plan the economy. The economic crisis could become an excuse for more government involvement; and the worse the crisis appears, the more control the government could get. Quick sharp restructurings and market clearing actions are generally very distressing, but then the economy can resume again. Unfortunately, the government's response—both monetary and fiscal—may prolong the pain and leave the economy in a state of malaise for many years.

We did not stray from our growth discipline. We chose to stay with large- and mid-size growth businesses that offered relatively stable cash flow streams, strong balance sheets, and products and services that have been in high demand or have commanded a premium in the marketplace.

The rationale for the aggressive monetary policy response can be seen in the chart showing the sharp decline in the velocity of money (Figure 2). Through monetary policy, the government has tried to do whatever it can to avoid a deflation cycle and to reaccelerate the velocity of money. However, the Fed cannot create the business environment that is necessary to stimulate risk taking. Only fiscal policy and regulatory, tax and legal restructuring can create the proper "risk taking environment" that will allow the velocity of money to increase without the risk of dollar devaluation and inflation. The monetary response is a quicker fix because it does not require Congress pass legislation that would create a more supportive environment for risk taking and business development.

Figure 2. A Sharp Decline in the Velocity of Money
Monetary Base Velocity Growth	M2-to-Monetary Base Ratio, United States
Sources: Monetary Base Velocity Growth: Federal Reserve Bank of St. Louis, "Monetary Trends," January 2009, page 10; M2-to-Monetary Base Ratio: BCA Research, "The Bank Credit Analyst," December 2008, Vol. 60, No. 6, page 5.

Q. What factors support risk taking and job growth—and in turn, the acceleration of money velocity and creation of wealth?

A. We believe that economic freedom drives economic prosperity. Below, we list several of the guiding principles of economic freedom, along with potential threats to each.

Q. If the current actions and policy discussions could lead to problematic outcomes, why should investors remain in risk assets?

A. The financial markets are pricing in most of the malaise and anti-entrepreneur, anti-business dogma. During the six months before the election, the Obama ticket led the polls while the market plummeted. Even government and Federal Reserve actions have had little success in stoking a rebound. If the markets were more optimistic about the long-term prospects of the newly-elected administration, we would expect to see improved sentiment. Markets dislike uncertainty, and presently, uncertainty is running high—about what's been done so far and the ability of the newly elected administration to enact lasting economic change. We believe that concerns about the potential for increased business and investment taxes, government bureaucracy and new regulation are reflected in U.S. market sentiment.

Remember, the market is apolitical, and only searches for places where money is treated best and the economics support the prospects for success. The market will be a good barometer of global fiscal and monetary policy actions. Therefore, to some extent, we believe the market will force corrections to the policy decisions that are often made with multiple constituents to please.

Also, we are confident in the ambition and creativity of the American people. In the face of past challenges, this entrepreneurial vision and determination have helped our nation develop new solutions to economic challenges. We believe this will continue, and that the U.S. economy will find a way to grow again.

Investment Opportunity

Q. Historically, major market changes have created opportunities for investors. What opportunities have emerged from the current financial market collapse?

A. Some asset classes have dropped to valuation levels that have not been seen in generations, while others offer attractive cyclical pricing opportunities. Below, we outline some areas where we believe valuation discrepancies exist, including areas where we see long-term excess return opportunities (undervalued assets). We encourage investors to consider these within the context of their long-term asset allocations.

Growth Equity Performance Analysis, 2008

Q. In the past, the Calamos Growth Strategy performed very well relative to the broad market during severe market declines. Why did the growth strategy decline more than the markets during the 2008 market crash?

A. This has been a different type of market correction. Virtually no area of the market was unscathed by panicked selling and deleveraging. Even quality assets were severely penalized as investors sought liquidity at any cost. In contrast, during past market declines, the panic and selling activity was less indiscriminate. In 1990 and again in 1994, an investor could move to high-quality corporate bonds, high-quality stable growth equities or other high-quality assets to avoid a negative return. During the technology and telecommunications mania of 2000, an investor could have protected assets by moving to equities in the non-technology and telecommunications sectors. We have adjusted well to environments that have provided a place in the equity markets to protect assets from market corrections.

For the past 18 months, we have been cautious and concerned about the economy and markets (for more, see our commentaries authored in 2007 and 2008). We thought that during market dislocations, access to capital would falter and companies with strained balance sheets would suffer. We also felt that cyclical companies presented a high level of risk. Our analysis indicated that most had been priced as if a recession would not occur for the next decade. We believed that any weakness in the economy would expose profit margins to normal corrections.

We did not stray from our growth discipline. We chose to stay with large- and mid-size growth businesses that offered relatively stable cash flow streams, strong balance sheets, and products and services that have been in high demand or have commanded a premium in the marketplace. We believed that if an economic correction occurred, it would cause a flight to quality, and that companies with quality cash flows and high return on capital would hold up best. Although quality growth equities were caught up in the frenetic selling, we believe that they will be rewarded in the marketplace as more normal conditions emerge.

Warren Buffett has famously encouraged investors to choose stocks that they would be comfortable holding if the markets closed for a period of years. Many of our core holdings are companies that we believe we could comfortably hold even if the stock market closed for three years. These include Apple, Google, Nike and Gilead Sciences, to name a few. We believe these companies should weather an economic storm very well, thanks to their high-return-on-capital businesses, strong balance sheets and strong market positions.

Q. Why did the market penalize high-quality, highreturn- on-capital growth companies?

A. As extreme fear and pessimism took over, investors rushed to securities that offered the liquidity and the highest degree of safety. Nothing else mattered. The only buying activity occurred in U.S. Treasury bills and notes. The market became unwilling to pay anything for growth. As a result, virtually any company that needs capital is now considered an impaired asset, or at least is priced to reflect the valuation of an impaired asset. Most other companies are priced as if they will not grow—or worse, will shrink—over the next decade. According to our analysis, only one group, the mega-cap consumer staple stocks, are not priced for a collapse. (Included here are select companies in the soft drink, fast food, household products and discount retailing industries.) On a sector level, the more-defensive consumer staples and health care sectors fared the best in 2008, though still falling -17.4% and -22.8%, respectively.¹

Q. If the economy is faltering and GDP is declining, doesn't that mean that growth stocks will suffer more than value stocks?

A. Historically, the cycle for growth stock investing has not been correlated with economic growth. Figure 3, page 6 shows the outperformance of growth and value stocks since 1975. Historically, the growth stock cycle has been influenced by the relative valuation differences between growth and value stocks. Today, the valuation gap favors growth stocks over value stocks by a significant margin.

Figure 3. Growth Stock Performance and Economic Growth
Large-Cap Growth vs. Large-Cap Value
Source: Leuthold Group

Conclusion

Even though it seems like all of the rules are being re-written, we believe that the U.S. and global economies will endure, and there will continue to be opportunities for wealth creation. These extraordinary markets have not shaken our faith in the ability of individuals to develop innovative solutions to complex challenges. These solutions may take time—and trial and error—but we believe a stronger global economy will ultimately emerge. Today, the solution is monetary expansion, infrastructure building and direct government investment in corporations. This outcome of the grand experiment remains uncertain, but we expect that the current fix will probably require other fixes over time.

Even so, we encourage patience, not the extreme pessimism that abounds today. We draw lasting confidence from the remarkable resilience of global economy and markets in the face of past challenges, including the downturns of the 1960s and 1970s, and even the Great Depression.

As we discussed in this commentary, we believe there are unprecedented opportunities across asset classes—in quality growth stocks, in convertibles, and in corporate bonds. That said, we expect significant market turbulence to continue over the near term. Now more than ever, investors will need discipline and long-term perspective.

In this difficult time, we wish to thank our clients for the trust they have placed in us. We do not view our responsibility to you lightly. As we have for more than 30 years, we will continue to rely on long-term perspective and rigorous research as we seek to capitalize on the unusual conditions of today's market.