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American Dream Alive and Well Under Mel Watt

By Chris Mashia, CFA

October 28, 2014

We are pleased that FHFA Director Mel Watt has indicated meaningful progress in reaching an “agreement in principle” with mortgage lenders around regulations that deal with representation and warranty risk for lenders. Watt’s encouraging comments came in his October 20 speech to the Mortgage Bankers Association.*

Last month, in “Why Are Mortgage Standards Still So Tight?,” we discussed rep and warranty risk as the key impediment preventing borrowers with lower FICO scores from obtaining conforming loans—that is, loans that a government-sponsored entity (GSE) would purchase from loan originators. In that post, we also noted that significant steps would likely be taken to address rep and warranty risk, given the desire of Watt and the Obama Administration to work with lenders to expand credit availability.

Notably, Watt addressed life-of-loan exclusions in his speech. Current life-of-loan exclusions allow GSEs to “put back” a loan to its originator for a relatively wide range of violations, at any point during the life of a loan—even if the loan satisfied the 36-month statute of limitations often referred to as the mortgage sunset provision. This extended window of liability and the lack of consistency and clarity around loan putback criteria discourage lenders from extending credit to potential home buyers.

Watt noted the GSEs intend to more clearly define the language around life-of-loan exclusions within six categories: (1) misrepresentations, misstatements and omissions, (2) data inaccuracies, (3) charter compliance issues, (4) first-lien priority and title matters, (5) legal compliance violations, (6) acceptable mortgage products.

Moreover, under the planned changes, originators must demonstrate a pattern of abuse before a loan could be put back to them under a life-of-loan exclusion. This pattern would be based on a minimum threshold set by the FHFA. The FHFA also plans to establish a “significance requirement” to determine if a loan would have failed an automated underwriting system had the loan information been accurate at origination.

In our view, making a distinction between a pattern of abuse versus one-off violations and relatively minor loan defects will have a meaningful impact on credit availability.

In the days following Watt’s speech, we spoke to several of the largest mortgage lenders in the U.S. and detected a palpable sense of optimism that these changes would be a step in the right direction. Major lenders and regulators have discussed rep and warranty issues for much of 2014, and these proposed rules appear to balance the FHFA’s need to ensure the safety and soundness of the GSEs with a desire among all parties to expand credit to borrowers in a responsible manner that considers their ability to repay.

The next few weeks will likely yield little new information, as lawyers hash out the details that we believe will come to define the next era of mortgage lending. However, in November, we expect to receive more information around the final regulations, with the optimism we have sensed from mortgage lenders becoming more widespread.

Importantly, we believe these changes to rep and warranty language will lead to a measurable expansion of mortgage availability to qualifying borrowers with lower FICO scores and lower down payments. In our view, these policy changes can produce a tailwind for mortgage insurers, residential real estate brokers, and homebuilders alike.




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Whither the Consumer? Part 1

By Stephen Roseman

October 27, 2014

Over the past several quarters, much has been made over lackluster U.S. consumer spending. Excluding autos, retail sales growth has averaged 3.3% annually since 2012 but only 1.9% through late 2014. Over recent years, there have been sea changes in consumer behavior and store traffic trends, many of which are complicated and nuanced. Our focus is on understanding these trends and their implications for companies’ growth and profits.

Before we go any further, we believe the U.S. consumer is in a better position to spend this year. Our confidence reflects:

    1. Recent non-farm employment numbers were near all-time highs
    2. Home values have largely recovered to their pre-crisis highs
    3. While volatility has been top of mind these past weeks, consumers have benefited from a five-and-a-half-year bull market
    4. Consumer confidence, highly correlated to consumer spending, has been rising, steadily but choppily, since the 2009 bottom

So what gives? In a series of blog posts, I’ll be taking a look at the ranging influences shaping consumer activity and the implications for companies. In Part 1, I’ll focus on taxation.

Taxes Have Changed the Consumer Landscape
There’s a solid body of economic research that points to taxes as a primary driver of reduced consumer spending. Prior to 2010, the correlation between consumer spending and taxation was low or non-existent, but this relationship has become solidly inverse since 2010.

As the graphs below show, the decline in consumer spending is coincident with the new U.S. tax schedule. We believe the 460-basis point difference (from 35% to 39.6%) in the marginal tax rate for the upper-range of filers is having a real and measurable difference—$128 billion, in fact.

Decreased Spending Followed an Increase to the Top Marginal Tax Rate

Source: Piper Jaffray, “Multi-Brand Retail & Specialty Commerce: Conquer Mobile, Win the Consumer,” August 13, 2014, using data from Bureau of Labor Statistics Consumer Expenditure Survey and Piper Jaffray & Co. Research.


Taxes Have Taken a Toll on Retail Activity

Source: Piper Jaffray, “Multi-Brand Retail & Specialty Commerce: Conquer Mobile, Win the Consumer,” August 13, 2014, using data from Bureau of Labor Statistics Consumer Expenditure Survey and Piper Jaffray & Co. Research. TTM: Trailing 12 Month.

Lest readers believe the changes in tax rates only affect more affluent households, the increase in the Social Security portion of the payroll tax is two percentage points—from 4.2% to 6.2%. This affects everyone with a paycheck.

What does this mean for stocks of consumer companies? Few of us believe that higher taxation is a positive. While many companies will suffer from higher taxes, those that are secular growers may be better positioned to navigate the taxation headwind.

When consumers have less money to spend, a company must be that much more competitive in terms of its products, how it distributes them and how it engages with potential shoppers. We believe the stocks of companies with differentiated product offerings, brands that can be leveraged into new categories, and those that control their distribution will continue to win and are likely to be less hindered by the increased taxation burden on consumers. To wit, we believe we are now in a growth stock regime as we enter the late stage of the economic cycle (for more on this, see Global Co-CIO Gary Black’s recent posts).

While the reality is that there are many influences that are potentially impacting consumer spending, in my next post, I’ll focus on how the internet is transforming consumer activity and creating a new landscape for retailers.




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October’s Correction: Likely a Pause that Refreshes

By Gary Black

October 22, 2014

Last week, we showed that the S&P 500 Index had fallen through its 200-day moving average just five times since the bull market began in March of 2009:

  Decline from peak Key factors
July 2010 -16.0% Flash Crash (May 6), euro zone debt crisis
October 2011 -19.4% Downgrade of U.S. government debt, euro zone debt crisis
May 2012 -9.9% Anxiety about Spain and Greece, slowing U.S. economy
November 2012 -7.7% Fiscal cliff looms
October 2014 -7.4% Europe deflation concerns, Ebola

Past performance is no guarantee of future results. Source: Bloomberg.

Past performance is no guarantee of future results. Source: Bloomberg.

We posed the question as to whether the current pullback is more like the July 2010 and October 2011 corrections, or more similar to what we saw during the two corrections of 2012. In 2010 and 2011, the pullbacks led to 15%-20% declines that lasted three to four months before reversing. In 2012, the pullbacks lasted just weeks, acting as pauses that ultimately refreshed the bull market.

We continue to believe that this is more like the 2012 pauses, and consistent with those brief pullbacks, the market has already pushed back through its 200-day moving average amid indications that:

    1. The ECB, having already embarked on “QE light” (covered bond buying), will move on to true QE to stimulate growth, German objections notwithstanding.
    2. Ebola concerns should ease as the 21-day incubation periods for individuals in the U.S. roll off, without significant additional cases outside West Africa.
    3. Fed officials have signaled they are open to pushing back expected interest rate increases to 2016 and even to providing additional QE if the global economy weakens.
    4. September quarterly earnings have been generally positive to date, and with quiet periods now ending, share buybacks can resume in earnest, with earnings yields (E/P ratios) significantly above corporate borrowing costs, which makes buybacks very accretive.

Against this backdrop and given that U.S. stock valuations are at highly attractive levels versus the 10-year U.S. Treasury yield as well as inflation, we continue to believe that this bull market has more room to run, led by technology, health care, financials and consumer discretionary.





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A Tale of Two Companies

By Jeff Miller

October 22, 2014

It was the best of management; it was the worst of management.

I recently visited two specialty retailers in San Francisco. Retailer A operates a number of brands, predominantly in the U.S., a few of which have had some sales weakness recently. Retailer B also operates a number of brands, predominantly in the U.S., some of which have had some sales weakness recently. Retailer A recently hired a new head of merchandising. Retailer B recently hired a new head of merchandising. Retailer A thinks that the new product lineup from its new design team will revitalize sales at its flagship brand. Retailer B also thinks that its new design team’s lineup will revitalize sales at its flagship brand. To a person reading a summary of the two meetings, it would appear that the two companies are on similar paths to recovery in their primary brands and that a turnaround is imminent at both.

Nothing could be further from the truth, and the reason is management. Retailer A’s CEO and CFO both spent over an hour and a half in an open dialogue at the meeting with the investors, discussing all of the company’s weaknesses as well as its strengths. They were honest about their past mistakes and the amount of time it would take for them to be rectified. The CEO was engaged in every facet of the turnaround, and in addition, knew quite a bit about the strengths and weaknesses of the company’s competitors. Despite being fairly new to the company, the CEO was well versed in the details of the business and had a clear vision for how to move the company forward after a few years of lagging growth.

Retailer B’s management, on the other hand, was a caricature of a bad interview. The CEO skipped the meeting at the last minute, to the surprise of everyone in attendance, leaving the interim CFO and head of strategic development to spend the next 90 minutes playing dodgeball with questions. Rarely have I been in a meeting where management was more defensive and evasive, as well as simply not honest about what everyone knew were obvious issues in the company’s product and marketing. Clearly the company is going through a rough patch, but its management team did itself no favors by avoiding questions and failing to have a plan to rectify the problems.

We do not necessarily avoid companies facing near-term challenges—but we do avoid those companies that won’t admit they have a problem in the first place. An investor who simply looks at the financials of each company and listens to the scripted conference calls from each quarterly earnings release would not pick up on the significant difference in management. Companies are managed by people, and the ability of those people to own their mistakes, find solutions to them, and then put a plan into action is vital in a world in which consumers have endless choices immediately available on their phones and tablets. Failing to meet these challenges can quickly put a company out of business. Conversely, a new management team has a unique opportunity to seize the day and move the company forward.

While both of these companies are facing similar challenges with similar causes and similar potential solutions, I am certain that in a few years Retailer A will be, if not thriving, at least surviving and moving forward, and will be a decent investment. Retailer B, on the other hand, will likely continue to struggle, and be unlikely to turn around its fortunes, while managing a debt burden that it is having a hard time servicing, and vendors may soon get nervous and tighten terms. When it comes to investing, management matters. Sometimes it is the difference between a great investment and one that goes to zero.




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Technicals Bearish, But Fundamentals Haven’t Changed

By Gary Black

October 14, 2014

Much has been made about the S&P 500 Index breaking through its 200-day moving average yesterday. This appears to have happened five times now (including yesterday) since this bull market began in March 2009. The first two times, in May 2010 and August 2011, the S&P 500 corrected -16.0% and -19.4%, respectively, before reversing and going to new highs. The last two times, May 2012 and November 2012, the S&P 500 dropped by more moderate amounts of -9.9% and -7.7%, respectively. Through yesterday’s close, the S&P 500 is now down -6.8% from its peak.

What worries me more than the magnitude of the current correction is its similarities to the August 2011 decline. Since 2011, we’ve had a series of higher lows—until last Friday, when the S&P 500 finished at 1906, slightly below its previous higher low of 1910 from August. With yesterday’s S&P 500 close of 1875, the three-year string of higher lows has been broken, as the chart below shows.

S&P 500 Breaks Technical Barrier in the Face of EU Growth Concerns and Ebola Fears
October 14, 2009-October 13, 2014

Past performance is no guarantee of future results. Source: Bloomberg.

I continue to believe the very public fight between ECB President Mario Draghi and Deutsche Bundesbank President Jens Weidmann about the ECB’s proposed €1 trillion quantitative easing program leaves the ECB hamstrung, creating huge uncertainty about whether Europe can avoid recession. This uncertainty and news of the first two Ebola cases transmitted outside of Africa have given investors a real case of the jitters. Both concerns need to be overcome for the bull market to resume its five-year run. I believe this week’s earnings announcements from key bellwethers can relieve some pressure, but it sure would be nice to see Draghi and Weidmann holding hands and singing “Kumbaya.”

While we are concerned by the breakdown in technicals, we believe not much has changed on the fundamental side. We believe the equity markets will shrug off these renewed growth concerns and move to new highs. We are still looking for 3%+ GDP growth in the second half of 2014 and 2015, inflation remains virtually non-existent, and the plunge in oil prices gives central banks more room to maneuver. Corporate profits are likely to be 6% to 7% in 2015, although the strong dollar could clip that by a point or two. As I’ve discussed in past posts, M&A and buybacks continue to put a floor on this market. Any sharp drop in stock prices is likely to precipitate more deals and more buybacks. U.S. equity valuations remain in their cheapest quartile over the past 65 years, with the S&P multiple now at 15.1x (6.6% earnings yield) and the 10-year Treasury yielding 2.2%.





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5% Corrections Have Been Normal in this Bull Market

By Gary Black

October 10, 2014

Yesterday’s S&P 500 close of 1928 marked a 4% correction since the index peaked at 2011 on September 18, 2014.

Let’s keep this in perspective: If the market falls another 1% to 1910, it would mark the fifteenth correction of 5% or more since this bull market began in March of 2009. On average, there have been two 5%+ corrections per year since the bull market began in 2009. The most recent was the 5.6% correction in January, which also resulted from concerns about slowing global economic growth.

Past performance is no guarantee of future results. Source: Bloomberg.

This correction feels no different than others: We’ve had a spike in volatility to around 19 off of July’s record low of 11 (as measured by the VIX) as the market has gyrated from worrying about too much growth leading to an early Fed rate hike to worrying about too little growth as European Central Bank President Mario Draghi and German finance officials disagree about the efficacy of quantitative easing.

In the end, we believe this correction and spike in volatility will end when investors conclude the upward trajectory of corporate earnings will continue. With expected S&P 500 2015 earnings growth of 6%, the S&P 500 could earn $124 in 2015, which implies a 15.5x P/E multiple, or a 6.4% earnings yield. Relative to today’s 2.3% 10-year Treasury yield, equities remain in the cheapest quartile of valuation relative to bonds over the past 60 years. Furthermore, corporate buybacks and M&A—which remain at their highest levels since 2007—put a floor on the equity market. If stocks fall further, we believe corporations awash in cash and able to borrow at some of the lowest rates in decades will continue to buy either their own or someone else’s stock. For most companies, both actions are highly accretive and will likely continue as long as borrowing costs remain low and/or earnings yields stay high.

We believe the 3Q earnings season, which moves into full swing next week, combined with greater unity by European officials on how to jump start economic growth, and additional soothing comments from our own Fed about keeping short-term rates low for a considerable time, should allow this correction to dissipate without incident, propelling the five-and-a-half year bull market to new highs.





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Why We Believe the Market Will Go to New Highs

By Gary Black

October 3, 2014

Today’s +248K jobs growth number and the August revision to +181K suggest recent worries that the U.S. economy was falling backward were misplaced. Over the past two weeks, the 10-year Treasury yield had fallen from 2.6% to 2.4% and the S&P 500 Index lost roughly 3% on fears about slowing global growth. But the combination of today’s strong U.S. employment data, indications of dissipating Hong Kong unrest, and no new Ebola cases put many of those no-growth fears to rest.

We can’t help but be bullish: In our view, U.S. GDP growth for the second half of 2014 continues to run at 3%+; 2015 corporate profit growth is likely to be 6% to 7% with S&P 500 earnings expected to reach $125; global monetary conditions remain extremely accommodative; inflation remains almost non-existent; and U.S. equity valuations remain in the cheapest (least expensive) quartile over the past 65 years. As Figure 1 shows, with today’s 10-Treasury yield of 2.5% and an E/P ratio of 6.3% (inverse of 2015 P/E ratio of 15.9x), the spread is 3.8%. For stocks to be viewed as fairly valued relative to historical levels over the past 65 years, the 10-year Treasury yield would have to rise to 4.3%, or the S&P 500 P/E would have to rise to 22x.

Meanwhile, for the first half of 2014, M&A and buyback activity were the strongest since 2007, providing an effective floor on valuations, since any weakness in stocks would encourage companies to buy back their own or someone else’s stock. With the Fed unlikely to raise short-term rates until mid-2015 and European investors pushing down U.S. long-term yields in a quest for income, we expect M&A and buyback activity to remain robust, with the spread between S&P 500 earnings yields and corporate debt costs near levels not seen since the late 1970s.

FIGURE 1. EQUITIES REMAIN CHEAP RELATIVE TO BONDS

Past performance is no guarantee of future results. Source: Empirical Research Partners using Standard & Poor’s, Corporate Reports, Empirical Research Partners Analysis. Estimates are indicated by “E.”

After five years of what has largely been a value regime and the considerable defensiveness during the first half of this year (when large-cap growth stocks lagged value stocks by some 200 basis points), we believe indications are that we have moved into a growth regime. As Figure 2 shows, this generally happens as we enter the latter and most robust part of the business cycle. The last such growth regime occurred from 2005 to 2007 and before that, we had a growth regime from 1996 to early 2000.

FIGURE 2. GROWTH STOCKS HAVE ALMOST ALWAYS OUTPERFORMED DURING THE LATE CYCLE

Past performance is no guarantee of future results. Source: Empirical Research Partners Analysis. Equally weighted data used for the lowest two quintiles of price-to-book ratios compared to growth stocks.

Growth regimes are characterized by several conditions, according to Empirical Research Partners, which has done considerable work on the topic. Those conditions include:

  • A flattening in the yield curve (off already low rates)
  • Narrowing in the percent of companies generating margin improvement
  • The market rewards companies with high capital spending and cash reinvestment
  • The market rewards higher-volatility names
  • The valuation spreads between growth and value is narrow (for more on this, see John P. Calamos’ recent blog).

On this last point, large-cap growth stocks now trade at 1.2x large-cap value stocks, versus a long-term average multiple of 1.4x and vs. the peak reached at the height of the 1999 tech bubble of 3.0x.

FIGURE 3. THE OPPORTUNITY IN GROWTH STOCKS

Past performance is no guarantee of future results. Source: FactSet (1989-6/2012) and CapIQ (7/2012-present)

Our view remains that technology, health care, financials, and consumer discretionary stocks will continue to lead the market higher in an environment of low-inflation and 3%+ GDP growth. We believe the Fed will keep short-term rates low for an extended period to make sure the geopolitical risks and weak economies around the world do not cause the U.S. to fall backward. Our 12-month price target on the S&P 500 remains in the 2150 to 2200 range, based on S&P 500 earnings of $125, and the normal multiple of 17.5x that has been associated with 3-4% long-term interest rates.





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Is Your EM Allocation Vulnerable to Index Vagaries?

By John P. Calamos Sr.

September 29, 2014

Recently, global index provider FTSE announced it has reclassified Morocco from “emerging market” to “frontier market” and Argentina from “frontier market” to “unclassified.”* These changes will impact the composition of FTSE’s emerging market and frontier market indexes in mid-2015.

Such constituent shuffling happens more often than many investors might realize. What’s more, I believe shifts between categories will occur with greater frequency as emerging markets follow divergent growth/contraction trajectories, due to different economic policies, political systems and geopolitics.

There is no single definition for “emerging market” and therefore for “emerging market investing.” Indexes use different criteria to classify countries. As a result, one index’s emerging market is another index’s developed market. South Korea is a case in point. While Standard & Poor’s and FTSE classify South Korea as a developed market, MSCI places South Korea in its emerging market index, where it represents more than 15% of the benchmark.

Similarly, FTSE and Standard and Poor’s consider Greece to be a developed market, but MSCI counts it among the emerging economies—for now, at least. Greece has hopped between MSCI’s categories, moving from emerging markets to developed markets in 2001 and then back to emerging in 2013.

Figure 1. Even Experts Don’t Agree on What Constitutes an Emerging Market

Source: MSCI Inc., S&P Dow Jones Indices LLC, FTSE Group as of June 30, 2014

In my view, the fluid nature of EM indexes illustrates the need for an active approach to EM investing. Passively managed strategies are subject to the vagaries of index reshuffling. What’s more, speculation about what’s in or out of a particular index could lead to volatility within emerging markets as passive strategies must sell or buy en masse to accommodate constituent changes.

We continue to believe fundamentals and top-down views provide the best criteria for deciding whether or not to invest in a company or market. When portfolio construction is dictated by the vagaries of a third-party index provider, I believe the potential for unnecessary downside risk increases significantly.

In a passive ETF strategy, investors end up with a static approach punctuated by abrupt and wholesale changes driven by index shifts rather than company fundamentals. In contrast, an active approach can adapt and capitalize on market opportunity.

As our international team has discussed in posts, our team emphasizes countries moving toward increased economic freedoms and companies with attractive growth fundamentals that are participating in long-term secular growth themes, such as the megatrend of global middle class expansion. As a result of our active management, our EM strategies may look quite different from an EM index—in our view, that’s good for investors.




*For more, see “FTSE Drops Argentina, Demotes Morocco: Mind Your ETF Index,” by Dimitra DeFotis, Barrons.com, September 25, 2014







The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.

Indexes are unmanaged, do not entail fees or expenses and are not available for direct investment. The S&P Emerging BMI captures all companies domiciled in the emerging markets within the S&P Global BMI with a float-adjusted market capitalization of at least US$ 100 million and a minimum annual trading liquidity of US$ 50 million. The S&P Developed BMI is a comprehensive benchmark including stocks from 26 developed markets. Source: Standard and Poor’s, as of 7/11/14. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The FTSE Emerging Index includes large and mid cap securities from advanced and secondary emerging markets, classified in accordance with FTSE’s Country Classification Review Process.

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Why Are Mortgage Standards Still So Tight?

By Chris Mashia, CFA

September 24, 2014

As the housing recovery continues, stubbornly tough mortgage underwriting standards have often been cited as impeding the pace of the rebound. Despite soaring housing prices in many U.S. markets, a steadily improving job market, and an expanding U.S. economy, mortgage lenders remain extremely selective about extending credit beyond wealthy borrowers with pristine credit.

In our view, this is a rational response to what has been a draconian regulatory environment. Large-cap banks have paid staggering penalties for mortgage missteps, in addition to absorbing billions of dollars of “mortgage putbacks,” related to loans sold within both agency and private-label mortgage backed securities (MBS).

Since the onset of the financial crisis, many of the mortgage industry’s woes have stemmed from the legal responsibilities assumed from the acquisitions of now-defunct organizations (Washington Mutual and Countrywide). Even so, the surviving players in the banking industry bear a good amount of responsibility for the financial-crisis fallout. Consequently, we believe regulators are justified in holding the industry accountable, as a deterrent to future bad behavior.

However, the process most people face today to secure a mortgage suggests the pendulum has swung too far. Too-lenient lending practices have been replaced with arduous requirements for borrowers and lenders alike, creating an impediment to a properly functioning mortgage market. In our view, the root cause of this is the banks’ lack of confidence that an appropriately underwritten loan, once sold, will not come back to haunt them as soon as it as goes delinquent.

Importantly, the aftermath of the financial crisis has proven to banks that they have little to no leverage when negotiating with the U.S. government and bank regulators. To borrow a phrase from The Godfather, when it comes to previously sold delinquent mortgages, banks often find themselves confronted by “an offer they can’t refuse.”

Meanwhile, the Federal Housing Finance Agency (FHFA), the regulator to Fannie Mae, Freddie Mac and the 12 Federal Home Loan banks, as well as the conservator of Fannie Mae and Freddie Mac faces its own dilemma: How do you simultaneously punish the banks for bad historical behavior, while at the same time encouraging them to extend credit to borrowers across the credit spectrum?

This has proven a complex undertaking. As I will discuss, we are encouraged by developments we believe can benefit banks and consumers alike—such as a move toward better defined underwriting criteria and mortgage sunset provisions. However, regulatory hurdles remain substantial.

A Rule Book for Lending—With No Surprises

Banks need to be confident that if they follow the rules, they won’t be left with disproportionate penalties if a borrower defaults. Well-defined underwriting and documentation standards can go a long way in rebuilding banks’ confidence about extending mortgage credit. In January 2013, the Consumer Financial Protection Bureau (CFPB) first defined criteria for a “qualified mortgage” (QM); these guidelines are also known as “the ability-to-repay” rule. QM rules, which became effective in January 2014, established underwriting standards that offer mortgage lenders a degree of legal protection should a sold mortgage become delinquent. Features of a QM include:

  1. No interest-only loans, negative-amortization loans or balloon payments
  2. No terms beyond 30 years
  3. Debt-to-income ratios that do not exceed 43%
  4. Points and fees that do not exceed 3% of the loan value
  5. Ample financial documentation (8 items at a minimum, including credit history, employment status, current income and assets)

Depending on their levels of compliance with the guidelines, banks are entitled to legal protection at either the higher standard of “safe harbor” or the lower standard of “presumption of compliance.”

While the QM guidelines provide some legal protections to mortgage originators, it also sets a barrier to loan originations outside of the enhanced criteria. Furthermore, the penalties for minor missteps have proven so draconian that the banks have responded with tighter mortgage standards that go well beyond QM in order to ensure compliance.

Who’s Keeping (FICO) Score?
Conforming mortgage loan standards require a minimum FICO score of 620, but as Figures 1 and 2 show, originations drop sharply for individuals with FICO scores between 620 and 700.

FIGURE 1. SO-SO CREDIT, SO-SO CHANCES
SHARE OF PURCHASE ORIGINATIONS BY CREDIT SCORE

Source: ATR/QM Standards: Foundation for a Sound Housing Market, October 2013 using data from CoreLogic, June 2013. Note: Purchase Originators.

FIGURE 2. A HIGH BAR FOR GSE OR FHA LOANS
FICO AT ORIGINATION FOR PURCHASE MORTGAGES

Source: Goldman Sachs, U.S. Housing Monitor, September 2014, using data from Black Knight, Goldman Sachs Global Investment Research. GSE: Government-sponsored entity.

As the banks would be quick to point out, some of the drop-off in lending in this segment is because many of these prospective borrowers do not satisfy increased documentation requirements or debt-to-income thresholds. While this is a contributing factor, we still believe banks are overly restrictive in originating conforming loans for borrowers with lower FICO scores, largely because of experiences with agency mortgage put-backs during the financial crisis. More specifically, loans within previously sold agency MBS (guaranteed by Fannie and Freddie) can be “putback” to mortgage originators if the originators are found to have violated any underwriting criteria (“representation and warranty”), as detailed by the government-sponsored agencies.

Agencies justify putbacks for a number reasons related to charges of fraudulent mortgage documents that misrepresent a borrower’s creditworthiness or the appraised value of the property serving as loan collateral. Some of these items are easily-documented facts, such as a borrower’s employment status and current income, but others, like the appraised value of a property, are open to more interpretation.

To address this uncertainty and risk, mortgage originators have responded by requiring credit overlays that go beyond Fannie’s and Freddie’s conforming loans standards. Credit overlays for Federal Housing Authority (FHA) loans are even more onerous. FHA-insured loans, which are sold and securitized through Ginnie Mae, represent an effort to expand home ownership to lower income Americans. FHA-insured loans allow for down payments as low as 3.5% and minimum FICO scores of 580. Similar to conforming loans, the banks have endured massive mortgage-fraud lawsuits related to FHA loans, post crisis. Indeed, after paying treble damages for $200 million in FHA loans, one large-cap bank threatened to leave the FHA business completely on its 2Q14 conference call.

Two Steps Forward, One Step Back
When former Democratic Congressman Mel Watt was appointed director of the FHFA in December 2013, the industry viewed this as a particularly positive sign the Administration was serious about taking steps to reduce put-back risk, providing banks incentive to ease mortgage underweighting standards, and attracting more private capital to the mortgage market.

Watt cut to the heart of matters in his May 2014 speech at the Brookings Institution Forum: “Lenders believe that too much uncertainty still exists in [the area of repurchase risk] for them to ease credit overlays. Ultimately, this undermines the goal of improving access to mortgage credit for creditworthy borrowers.”

Watt then noted a strengthened mortgage sunset provision that would lessen the risk assumed by banks for a sold mortgage. Under the new provision, if a loan sold to Fannie Mae or Freddie Mac were current after 36 months with no more than two instances of delinquency, it would no longer be eligible to be put-back to mortgage originators.

Unfortunately, not all the news has been this encouraging. In July 2014, the FHFA surprised the market with capital standards for private mortgage insurers that were more onerous than expected. The implications of this—for consumers, banks, and the government—are far reaching, given how many U.S. borrowers aren’t able to provide the 20% down payment required for a “conforming” mortgage (i.e., one that Freddie or Fannie will buy). Accordingly, these higher capital standards should increase borrowers’ reliance on the FHA and government capital. Fortunately, based on our discussions with industry participants, we are optimistic there will be meaningful relief from the initial proposal for capital standards, likely announced in late 2014.

Private Sector Participation Has Remained Elusive
The Obama Administration has highlighted a number of provisions it wants in a housing reform bill, including:

  1. Positioning private capital as the first backstop to mortgage loan losses, with government agencies maintaining a catastrophic guarantee behind private capital
  2. Preservation of the 30-year fixed mortgage, to provide stability to homeowners and the broader economy
  3. Continued government support for lower-income and military borrowers through the FHA and VA programs
Despite the oft-stated objective of reducing the amount of government capital at risk, the opposite has occurred since the crisis (Figure 3). Private mortgage originations and in particular, private MBS issuance, have dropped meaningfully. Additionally, private mortgage insurance has lost a substantial share to the FHA, although this has been reverting back toward more normal levels in the past few years (Figure 4).

FIGURE 3. U.S. GOVERNMENT REMAINS PRIMARY BACKSTOP FOR THE MBS MARKET
THE VALUE IN GROWTH

Source: Citi Research Equities, “Outlook on U.S. Housing Finance,” January 6, 2014, using data from Citi Research, Federal Reserve Flow of Funds, FDIC, SIFMA, Haver, FNMA and FRE filings as of 3Q2013

FIGURE 4. U.S. GOVERNMENT: PRINCIPAL PLAYER IN MORTGAGE INSURANCE
THE VALUE IN GROWTH

Source: MGIC, Barclays Global Financial Services Conference, September 8, 2014 using Inside Mortgage Finance and Company Data, not including HARP. Q2 2014 is an estimate from Inside Mortgage Finance. MI: Mortgage insurance. PMI: Private mortgage insurance.

The sharp increase in profitability at Fannie and Freddie over recent years further complicates matters. Both have benefited from an improving housing market and meaningfully increased pricing for credit protection through higher guarantee fees (g-fees) and loan level price adjustments (LLPAs). We suspect this strong profitability may make it difficult to attain the political will to dissolve these cash machines. Also, FHFA Director Watt appears considerably less interested in limiting the role of Fannie and Freddie than his predecessor Ed DeMarco.

Large-scale housing reform will need Congressional approval, which is perhaps unrealistic in today’s highly partisan environment. Nonetheless, we believe the present system has the potential to function normally in its current state, even if Congress doesn’t act.

Why Lending Standards Matter So Much
After a still-challenged job market, we believe tight lending standards represent a major hurdle to a more robust U.S. housing market. After extensive discussions with mortgage lenders, mortgage insurers and regulators, it is clear that all parties recognize that greater access to mortgage credit depends upon banks receiving more clarity and assurances that a properly underwritten and documented mortgage can be effectively sold without putback risk.

We believe this can be accomplished, while at the same time implementing underwriting safeguards that ensure the vast majority of borrowers can comfortably repay their debt. There is still considerable uncertainty around housing reform. Perhaps the largest unknown is whether or not such reform will dismantle Fannie Mae and Freddie Mac, agencies that touch the majority of mortgages originated in the U.S. Nevertheless, it does appear likely the U.S. will continue to implement reforms that will loosen excessively tight mortgage underwriting standards—albeit at a slower pace than many would like.

Against this backdrop, we continue to monitor the regulatory developments around credit availability and housing reform. Despite the regulatory hurdles that have yet to be fully addressed, we maintain a cautiously optimistic view of the housing recovery. Importantly, progress in mortgage finance reform and improved credit availability have positive implications for several industries, including private mortgage insurance, residential brokerage and homebuilders. Furthermore, we believe there is an opportunity to identify attractive investments on a bottom-up basis that leverage our belief that a housing recovery remains intact.




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Why Growth Stocks Now?

By John P. Calamos Sr.

September 9, 2014

After five years of a strong bull market, I believe there’s still room for stocks to advance. Growth stocks look especially attractive. At 1.23, the premium for growth over value remains lower than the historical average of 1.44. Even when we omit the tech bubble from the long-term average, the 1.23 premium for growth is lower than that 1.37 average.

FIGURE 1. THE VALUE IN GROWTH
THE VALUE IN GROWTH

Source: FactSet (1989-6/2012) and CapIQ (7/2012-present). Past performance is no guarantee of future results.

While growth stocks’ prices are low relative to value, their earnings prospects are significantly better. The 5-year forward EPS growth rate for the Russell 1000 Growth Index is 14.76%, versus 8.77% for the Russell 1000 Value Index (Figure 2). As investors move from the "bad news is good news" mindset to "good news is good news," we believe that growth stands to benefit.

FIGURE 2. BRIGHTER EARNINGS PROSPECTS FOR GROWTH
THE VALUE IN GROWTH

Past performance is no guarantee of future results.Data as of July 31, 2014.

As we’ve discussed in our previous commentaries (including our most recent outlook), we believe that the market has entered a growth regime, and that this current economic expansion cycle will likely be longer than typical—providing a favorable backdrop for growth stocks. Accommodative monetary policy seems set to continue: Last week, the European Central Bank surprised the markets with a rate cut and Friday’s anemic job numbers suggest that the Fed is unlikely to accelerate the pace for a rate increase. But when a rate increase does eventually occur, P/Es are likely to go up as well. History has shown that P/Es go up when interest rates are moving up from abnormally low levels.

No doubt, there will be volatility from economic reports and geopolitics, with Ukraine and the Middle East looming largest today. Active management and a long-term perspective will make the difference in taking advantage of the short-term choppiness that is likely to occur.




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¡Viva La Reforma! Part II

By Nick Niziolek

September 3, 2014

In my December post "¡Viva La Reforma!," I discussed how economic reforms were contributing to an increasingly favorable top-down view of Mexico. Fast forward eight months, and we remain bullish on Mexico for several reasons. Most importantly, President Enrique Peña Nieto has continued to advance the "Pact for Mexico," with a broad reform agenda that has touched the energy, financials, public, and educational sectors. Additionally, we believe Mexico’s strong ties to an improving U.S. economy can also provide economic tailwinds to companies in a range of sectors.

As I recently discussed in Barron's (August 23, 2014), we're seeing better property-right protection for creditors and improved transparency. Other promising reforms are focused on reduced judicial process and a closing of loopholes that discouraged foreign investment. Energy sector reforms also continue to progress. Expectations are that Mexico’s state-owned petroleum company proceeds with its first farm-out agreements early next year and that round one, which will permit private company bidding, begins in mid-2015. Meanwhile, regulations in the financials sector should improve competition—for example, by fostering increased mobility of deposits and loan choices, improving access to credit information, as well as by eliminating bundled financial products and services. In a further demonstration of the government’s commitment to transparency, nominations or dismissals for the boards of state-owned enterprises must now receive approval from two-thirds of the country’s senate.

We believe reform policies have the potential to add more than 200 basis points annually to GDP growth by 2018. Energy and financial reforms should have the most immediate impact, likely felt beginning in 2015 and more fully in 2016, while telecom and fiscal reforms are also expected to provide a tailwind to economic growth. Education sector reforms designed to root out corruption and improve accountability have proven more challenging to implement, but should provide longer-term economic benefits to the Mexican economy.

The most difficult aspect of investing in Mexico today is balancing the optimism about future growth prospects with the subdued growth environment that currently exists. Reflecting these crosscurrents, we have focused on identifying companies that are not only tied to the long-term potential of the Mexican reform story but that also benefit from near-term catalysts and reasonable valuations.

For example, this dual focus has led us to a materials company positioned to capitalize on domestic infrastructure investments (the long-term potential) that is reaping balance sheet improvements from strong ties to the U.S. economy and housing market (the near-term catalysts). Similarly, there are a number of financial companies that we believe can leverage reforms, including one that can benefit from an expected ramp-up in investment spending in the years to come but in the interim has expanded its domestic consumer base and implemented efficiency programs (near-term growth catalysts). Within financials, we also have identified opportunities in real estate, an industry benefiting from a stable and improving economy, low rates, and attractive affordability levels compared to other global and regional markets.

Although we believe reforms in the energy sector are further along than those in other sectors, there are fewer direct investment opportunities, given the sector’s high level of nationalization. As a result, we have instead sought global companies that stand to profit from increased demand from Mexico for their products and services, such as large oil and service providers.

Year to date, the emerging market rally has been led by optimism for change via election cycles and/or reforms in several countries (India, Indonesia, Brazil, China) and has been less dependent on near-term fundamentals and growth. As we look forward, we believe the market will shift its focus to countries that have successfully implemented reforms and to companies that are directly benefiting from the improvement in economic growth and sustainability. While Mexico has lagged the broader emerging markets year to date, we’d expect investor interest to return as economic growth accelerates during the second half of 2014 and more significantly in 2015 and beyond, as the impact of these reforms is felt more fully.

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The More Things Change, the More They Stay the Same

By John McClenahan, CPA, CFA

September 2, 2014

Back in the beginning of April, I wrote a post about how the stock market can be divided into four areas of economic sensitivity:

  1. Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. These tend to be in the consumer staples, health care, telecommunications, and utilities sectors.
  2. Late-stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.
  3. Early-stage cyclical stocks: Stocks that perform well when the economy is starting to accelerate. These tend to be in the consumer discretionary, financials, industrials, and technology sectors.
  4. Secular growth stocks: Stocks that perform the best when the economy is growing at a steady pace but neither accelerating nor decelerating. These tend to be in the consumer discretionary and technology sectors.

At the time of this earlier post, defensive had taken the lead as investors responded to Janet Yellen’s interest rate comments. What happened to these four areas since then? Well, first there was more backtracking on Yellen’s “six months after QE” line, and then there was bad 1Q economic data, with GDP growth coming in at -2.9%, versus an estimate of -1.8%.

People started thinking: When will this end? Could all of this economic decline be due to weather? As you would expect, late-stage cyclicals and defensives led the market.

Then in July, 2Q advance GDP growth was released at 4.0%, versus an estimate of 3.0%, and 1Q GDP contraction was revised upward to -2.1% from -2.9%. The market initially declined as these revisions raised fears that the Fed would raise rates sooner than expected. But once Yellen showed she was still dovish at Jackson Hole, secular growth returned to the forefront with early cyclicals close behind.

More recently, early cyclicals outperformed even secular growth (4.9% versus 3.6% for the month of August) as investors became more acclimated to the Fed’s improved outlook. Given that 2Q GDP was revised higher to 4.2% on August 28, the trend of early cyclicals leading the market may continue for a while—especially if the August monthly payroll number (due September 5) comes in north of the 228,000 expected. And while we’re five years into a bull market, we haven’t seen a lasting decelerating trend in GDP or rising inflation—two signs of the late stage of the economic cycle. Until we see that happening, I don’t expect a sustained shift away from early cyclicals and secular growth. Plus, there’s room for these areas to play “catch up,” given that defensives still lead year to date, thanks to their strength in the first half of the year and spikes of geopolitical uncertainty tied to Ukraine and the Middle East.

Figure 1. Defensives Still Lead YTD, Secular Growth and Early Cyclicals Make Back Significant Ground
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.
Sources: Morgan Stanley, Bloomberg LP.

Figure 2. Historical Stock Performance and Economic Sensitivity
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.Sources: Morgan Stanley, Bloomberg LP. Data through 8/31/14.

There’s growing consensus that the Fed may raise rates sooner, but it’ll be because the economy is doing well. Obviously, this is all predicated on the situation in Ukraine not continuing to escalate (which would likely lead to defensives holding up better than the other three areas).

Next up: Payrolls on September 5 and the FOMC announcement on September 17. Stay tuned. Expected GDP growth for 2015 hasn’t moved from 3.0% since mid-June.




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Is the Five-Year Assault on Bank Earnings Power Finally “Tapering”?

By Christopher Mashia, CFA, U.S. Financials Sector Head

August 27, 2014

On August 21, 2014, the Department of Justice and one of the largest banks in the U.S. announced agreement on a record mortgage settlement for nearly $17 billion. This clearly is not the end of the financial services industry’s legal woes, which still include large-scale cases on LIBOR rate setting, foreign exchange manipulation and foreign hiring violations, among others. However, we do believe the agreement represents an inflection in the magnitude of litigation costs incurred by an industry that has faced financial pressures on several fronts since the beginning of the Great Recession and through the recovery.

More specifically, five key pressure points have degraded the earnings power of large cap banks since the financial crisis unfolded:

  1. Record low interest rates squeezing net interest margins (NIMs)
  2. Limitations in capital return to shareholders
  3. Legal and regulatory expenses
  4. Credit deterioration
  5. Weak growth, due to deleveraging in the U.S. economy and regulatory pressures on fee income

Some of these pressure points, such as credit-related losses, have reversed sharply to enhance bank earnings power but most have remained stubbornly elevated. However, we believe that most—if not all—of these headwinds will likely be alleviated materially over the next few years.

Rising Interest Rates Should Benefit Banks

It has been more than five years since the Federal Reserve lowered its target interest rate range to 0-25 basis points. While banks were initially able to absorb the impact of falling rates by lowering the cost of deposits and refinancing into lower-cost borrowings, the low rate environment eventually began to materially degrade margins. Despite reasonable levels of asset growth in recent years, net interest income remained stagnant and, in some cases, growth was negative. Considering the steady improvement in U.S. employment, the normalization of inflation levels, and indications from Chair Yellen and other Fed officials regarding completion of the tapering program and tightening prospects, we believe it is increasingly likely that rates will move higher in 2015.

In our view, large cap banks should all benefit to varying degrees from rising rates (Figure 1), especially from a rise in short-term rates driven in large measure by re-pricing in:

  1. Short-term securities
  2. Commercial prime-based lending
  3. Deposit re-pricing that lags a higher fed funds rate (some from non-interest bearing deposits and some from other transactional and core deposits that tend not to be very rate sensitive)

Even for those who believe rates are unlikely to rise to levels seen in the past (e.g., Bill Gross’ “new normal”), a 100 to 200 basis point increase in short-term rates should be viewed a considerable boon for large cap bank NIMs and earnings-per-share (EPS).

Figure 1: Historically, a Steepening Curve Has Benefited Bank Stocks

Past performance is no guarantee of future results. Source: Bank of America Merrill Lynch, Erika Najarian and Ebrahim H. Poonawala, August 2014, using data from Bloomberg, BAML Global Research Estimates.

Capital Improvements: Far-Reaching but Overlooked

Since the financial crisis, the banking industry has achieved significant capital improvements. Even so, the market remains more focused on the negatives of today’s tough regulatory environment. Overall, bank capital levels have reached levels not seen since the post-Great Depression era, but this appears to be overshadowed by the opacity in which capital return is approved (or not) by the Fed through its annual “stress test,” the Comprehensive Capital Analysis and Review (CCAR). For example, investors were reminded of the CCAR’s unclear criteria when a large bank failed its stress test in 2014 for qualitative reasons, despite soundly passing on quantitative measures.

Nevertheless, we see many reasons for optimism going forward, including the success of several bank holding companies (BHCs) in navigating the CCAR process, capital levels that continue to build well above more stringent Basel 3 requirements, as well as the completion of many high-profile legal settlements. In several instances, the Fed has eventually been willing to unleash capital returns (e.g, share repurchases and dividend increases) for BHCs, having been satisfied by the overall level of capital (quantitative) and strong controls and stress-testing capabilities (qualitative).

Figure 2: Bank Capital Levels Have Reached Multi-Decade Highs

Source: KBW Capital Research, FDIC

Litigation and Settlement Costs Are Likely Abating

Over recent years, the banks have been highly disciplined and quite successful in lowering operating expenses. This success is attributable to several factors, such as a generally low wage inflation environment, as well as management teams’ willingness to restructure, including selling off underperforming units, reducing staffing where possible to protect return on equity, and embracing the secular trend of consumer adoption of technology (mobile/online banking, smart ATMs). Over time, these efforts should continue to reduce the need for some bank branches, while also lowering staffing levels within branches and allowing for smaller (and cheaper) technology-focused branch layouts.

However, litigation and settlement costs have been considerable expense headwinds that have substantially depressed margins and overshadowed operating expense reductions. Additions to litigation reserves have occurred for so many years that they now obscure the true earnings power and operating margins of the business.

As I mentioned earlier, the banking industry will continue to face a steady stream of lawsuits. However, we believe the magnitude of the settlements should be materially reduced going forward as the completion of the largest mortgage settlements mark a meaningful inflection in litigation reserve build.

Banks Benefit from Marked Credit Improvement

Credit quality has massively improved for the industry since the depths of the financial crisis. Commercial losses are near zero and consumer losses are at record lows, with the exception of mortgages. On the whole, losses remain below normalized levels and provisions for loan losses are even lower as reserve releases continue for most banks, albeit at reduced levels.

Mortgage loan loss levels are still pressured by pre-crisis loans with poor underwriting standards and high loan to value levels, but stressed legacy loans are quickly being replaced by portfolios of post-crisis mortgages originated with exceptionally stringent underwriting standards, which we believe should produce losses that are among the lowest we will see over the decades to come.

While we do not foresee credit improvement as an earnings driver, we do anticipate a broadening of strong credit as lifting a major perception issue with some investors who have been hesitant to trust the quality of bank balance sheets. An increasingly pristine credit environment and high bank credit standards should also encourage regulators to lighten their grip on large banks’ share repurchase and dividend decisions.

Figure 3. Mortgage Losses Have Nearly Recovered to Normal Levels

NCO stands for net charge-off, or losses net of recoveries. Shaded areas indicate recessions. Source: Morgan Stanley Research North America, “Large Cap Banks,” August 5, 2014, Betsy L. Graseck, CFA and Manan Gosalia, using data from the Federal Reserve, FDIC and Morgan Stanley Research. FDIC data for 2Q14 not yet available. *Federal Senior Loan Officer Survy on lending standards

Growth Prospects Should Improve

Weak top-line growth has been a key headwind for large cap banks. Investors often cite a hesitancy to pay for EPS improvement driven by expense cuts and share buybacks versus core growth. A variety of factors have had a negative impact on revenue growth at large cap banks since the financial crisis began. Most notably, banks have absorbed substantial deleveraging within consumer lending, while a low rate environment has pressured NIMs, and a number of fee-income streams have been hindered by new regulatory requirements emanating from the Dodd-Frank Act, including the Durbin Amendment, the Volker Rule, and the formation of the Consumer Financial Protection Bureau (CFPB). However, our view is that today’s growth is stronger than a simplistic focus on recent revenue growth trends would imply. Consider the following:

  1. The impact of poorly underwritten legacy loans (pick-a-pay mortgages, for example) is a waning headwind as all of the large banks have been heavily running off pre-crisis loans with poor underwriting.
  2. NIM pressure has offset otherwise fairly strong growth in deposits and earning assets more recently. Banks have been dealing with a low interest rate environment and at the same time have been building liquidity to prepare for a rising rate environment. This headwind will become a meaningful tailwind as soon as short-term rates rise.
  3. Loan growth, M&A, capital market activity, and trading should all benefit from an improving economic environment.

As a result, we expect that the headwind of weak top-line growth should continue to fade over the next few years as the economy continues to recover, non-core loan run-off recedes and NIM pressure abates and ultimately reverses with a rise in short-term rates.

Conclusion

An unprecedented level of new regulation and litigation, as well as a particularly difficult interest rate environment has hampered the recovery in large cap bank earnings following the Great Recession. It is our view that many of the key pressure points plaguing the industry should recede over the next few years, paving the way for improved earnings power and investor sentiment. We believe the extensive due diligence of our sector teams will serve us well as we identify companies that are most likely to benefit from improving trends—before such positive inflections are recognized by the broader market.





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Yellen and Putin: New Odd Couple Driving the Markets

By Gary Black

August 22, 2014

I am surprised the market is not selling off more, given Russia’s latest provocative convoy incursion into Ukraine. But Chair Yellen didn't exactly exude confidence at Jackson Hole and yet wasn't dovish enough to delay expectations of a first rate hike past next summer. In my view, the simple decision matrix for getting stocks right this summer continues to be:

Yellen Putin Market Results
Dove Good Positive
Hawk Bad Negative
Dove Bad Flat
Hawk Good Flat

So, the market looks like it may tread water and digest its recent gains near term before becoming more volatile in September given a rich economic calendar culminating in another Fed meeting on September 16 and 17.

In the meantime, Chair Yellen can't possibly get more dovish as the August employment report nears, and Putin can't be up to any good sending a 280-truck convoy into Ukraine for purely humanitarian reasons.

Longer term, we remain bullish. We believe 3% GDP growth and sub 2% inflation, 6-8% S&P 500 earnings growth, and strong buyback and M&A activity driven by attractive valuations and cheap financing set the market up for further gains.





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The Opportunity in High Yield

By Jeremy Hughes, CFA and Chris Langs, CFA

August 19, 2014

For the first month since August of 2013, the U.S. high yield bond market declined in July, with the BofA Merrill Lynch High Yield Index falling -1.32%. July also marked the worst month of performance for the asset class since June of 2013. However, during the first half of August, the high yield asset class has gained some of the ground lost last month, and we expect further stabilization as yields approach 6%.

In our view, the high yield selloff reflected sentiment and technical factors. Similar to last summer, July’s selloff was tied to investor concerns about when the Fed would begin raising short-term interest rates. While other risk assets experienced pressure later in the month, the high yield selloff began around the same time as Chair Yellen noted that valuations in the asset class “appear[ed] to be stretched.” While the long end of the Treasury curve remained resilient, the curve flattened as the short end continued to price in possible rate hikes in 2015.

In the wake of Fed comments, high yield exchange-traded funds (ETFs) experienced their largest outflows on record, which tested market liquidity. As ETFs sought to meet redemptions, more liquid BB and B rated credits were sold off, despite no deterioration in fundamentals.

As the impact of Fed rhetoric has waned, the asset class has begun to recoup ground. Overall, we believe high yield issuer fundamentals are still strong, with default rates expected to stay well below long-run averages for the next few years. Leverage has slowly crept higher but is still below the peak of the early 2000s, while interest coverage remains near its peak (see charts below). Despite more aggressive new issuance and looser covenants of late, we do not believe we are at an inflection point in the credit cycle. Even so, high yield investors should be prepared for periods of choppiness, with geopolitical risks likely causing market sentiment to swing between risk-on and risk-off.

STRONG FUNDAMENTALS IN THE U.S. HIGH YIELD MARKET
Leverage Ratio: Well Below Peak

Source: BofA Merrill Lynch Global Research

Interest Coverage Ratio: Nearly at Peak

Source: BofA Merrill Lynch Global Research

Our view on interest rates is unchanged: We expect Fed tapering to end this fall and the Treasury market to continue to price in the first rate hike in 2015. Despite anticipated Fed tightening, we expect the long end of the Treasury curve to remain resilient and the yield curve to flatten. Weaker economic conditions in Europe will likely continue to push down interest rates in Europe and lead global investors to chase U.S. yields, as U.S. Treasurys remain more attractive on a relative basis.

Earlier this year, we had been concerned about high yield valuations, given investors’ determined quest for yield in a low interest-rate environment, and we believe these concerns proved valid. However, following the July selloff, valuations are beginning to look more attractive given the spread widening and the historical low correlation of the high yield asset class relative to Treasurys. Institutional investors who are well versed in the asset class are taking advantage of this recent selloff, as discussed in the The Wall Street Journal (“Large Investors Swoop In For Junk,” August 18). Expected low default rates should further support current valuations.

We see the most opportunity in mid quality (BB/B) issuers which have sold off by a similar amount to lower quality (CCC and below) issuers. With the recent back-up in the market, we believe the high yield asset class looks attractive relative to other fixed income alternatives over the next 12 months.

Related resources
High yield scenario analysis and commentary
Calamos High Yield Investment Process





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Putin and the Fed Keep Giving Us Buying Opportunities

By Gary Black

August 15, 2014

In my opinion, there is little Vladimir Putin can do to retaliate against Ukraine for partially destroying the Russian military convoy that crossed into Ukraine last night. However, Ukraine has not blown up Russia’s slow-moving humanitarian convoy—as many had previously feared. So Putin seems to be back in the no-win situation of simultaneously expressing his commitment to finding a diplomatic solution to the Ukraine situation, while being caught sending military equipment into Ukraine, presumably for the separatist rebels. Because Europe still doesn't have the political or economic will to bring additional broad sanctions against Russia, we believe matters are likely to wind up where they have been, with verbal sparring but no real escalation in tensions.

Meanwhile, 10-year Treasury yields continue to fall (to 2.33% as of today). European investors are still chasing U.S. yields downward as European economies, including Germany, contracted in the second quarter and Ukraine sanctions exacerbate business and consumer uncertainty. Given that Japan, South America, and Russia have also recently shown economic contraction and that U.S. housing and retail are still both weak, it's hard to see the Fed raising short-term interest rates any sooner than it has to in 2015. And the debate at next week’s annual Jackson Hole Economic Policy Symposium will likely shift from when the Fed will raise rates to how Europe can get out of its economic malaise.

In sum, we view today's geopolitical volatility as another buying opportunity in what still seems to be the middle innings of a secular bull market.





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EM Growth Provides Tailwind for Automation Companies

By Nick Niziolek and Paul Ryndak

August 15, 2014

Many of our emerging market posts focus on global top-down developments and macroeconomic shifts, as these provide tailwinds or headwinds to companies around the world. Equally important to our research process is our identification of long-term secular themes that may help sustain a company’s prospects, in spite of more challenging economic conditions. One growth theme we have focused on for many years is the growth of automation. Below, our Non-U.S. Industrial Sector Head Paul Ryndak shares his thoughts on future opportunities in automation, drawing on insights from his recent travels to Japan and China.
–Nick Niziolek, SVP and Co-Portfolio Manager


Paul Ryndak, Non-U.S. Industrial Sector Head

One of the investment themes we are most excited about is automation. The days of Henry Ford’s assembly line are long gone, replaced by automated conveyor systems and robots that do much of the heavy lifting, including welding, painting, lifting and gluing windshields onto the car. We believe a number of factors will support the future growth prospects for automation companies, including the rapid expansion of automation within emerging economies, specifically China.

Recently, I met with the management teams of several automation companies in Japan and one consistent theme they discussed was the opportunity for growth in China. Later that week, I visited three automotive production facilities in China with outstanding degrees of automation.

We believe that China will continue to seek out automation solutions as a way to enhance profitability and global competiveness. The tremendous growth of the Chinese auto industry has led many auto manufacturers to build new production facilities with teams of robots and other highly advanced automation features.

There are many other reasons that companies in China are seeking opportunities to automate. Labor costs are rising quickly, providing incentive for manufacturers to be more productive and contain costs. Also, the technical and quality requirements for manufacturing cars, phones and other electronics is increasing, requiring more precision. This precision can be more readily accomplished with automated processes and equipment.

When people think of automation, robotics typically comes to mind. This isn’t surprising, given the increasingly important role that robotics play, not only in auto manufacturing but also in a range of other industries, such as component manufacturers. We believe the expanded use of robots provides significant investment opportunity for automation companies, especially those with business strategies focused on China. At only 213 robots per 10,000 employees, the robot density in China’s automotive manufacturing sector is low, compared to 1091 in the U.S. and 1562 in Japan.


Robotics: China’s Growth Provides Opportunities for Increased Adoption

Source: Barclays Capital, using data from IFR World Robotics 2013.


In both China and the developed markets, we believe the expansion of collaborative robots is one of the most promising areas of growth within robotics. Unlike industrial robots (such as those that are typically used in auto plants) that need to be contained and separated from humans for worker safety, collaborative robots have features such as sensor-based systems that allow them to work safely next to humans. The continued development of collaborative robots provides exciting applications in light manufacturing and assembly processes, and further expands the market opportunity for robot manufacturers.

In addition to robot manufacturers, we have also identified opportunities in automation companies that manufacture sensors and motion controls, automated machine tools and the computer programming that controls the machine tools, and software programs that control the automation workflow. As manufacturing capacity increases in places like China, we expect the trend of automation to accelerate, providing more opportunities for automation companies and investors alike.

Our investment approach marries our identification of secular growth themes with comprehensive fundamental research. In the case of automation companies, the pullback in Japanese equities earlier this year brought the valuations of select companies to attractive levels that do not fully reflect the long-term growth potential we see.





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Why Higher Quality May Mean Higher Risk

By Eli Pars, CFA

August 12, 2014

When I speak with clients about convertibles, one topic that often crops up is how credit quality considerations play into portfolio construction. Some believe that a portfolio built exclusively from investment grade convertibles is inherently safer than a portfolio that also includes below investment grade and non-rated securities. Our view is that in the current environment, the opposite may be true. Here’s why we believe that having the flexibility to invest across credit qualities makes sense:

  • An investment grade portfolio may be subject to a shrinking opportunity set, as investment grade convertibles currently make up a small and decreasing segment of the overall universe. As of July 15, 2014, the 300 securities of the BofA Merrill Lynch Global 300 Index had a total market value of more than $170 billion dollars (USD). However, the index includes just 44 investment grade issues out of the 300, with a total market value of $37.6 billion.

    There’s a similar issue in the U.S. market. The BofA Merrill Lynch All U.S. Convertibles Index included 484 issues as of July 15, with a total market value of $209 billion. The investment grade subset, the BofA Merrill Lynch VXA1 Index, included just 61 names, valued at $47.7 billion.

  • Non-investment grade securities have dominated recent issuance. Recently, global convertible issuance has been very promising, a trend which we expect will continue, supported by global economic recovery. Recent issues have exhibited attractive characteristics and terms, as well as good breadth by sector, geography and market cap. However, this issuance has been largely dominated by non-investment grade issuers, as investment grade issuers have continued to find inexpensive financing in traditional debt.

    Within the global market, 148 issues have been brought to market through the first half of 2014, with a value of $52.3 billion. Only $4.3 billion of this issuance has been rated investment grade, in six issues. Similarly, within the U.S. market, 61 new issues were brought to market during the first half of the year, with a value of $23.5 billion. Just four issues ($3.0 billion) of these were rated investment grade.

  • Investment grade convertibles have typically underperformed the broad convertible universe when interest rates rise. During the past 20 years, there have been nine periods when the 10-year Treasury yield rose more than 100 basis points. During eight of these periods, the BofA Merrill Lynch All Investment Grade U.S. Convertibles Index lagged the BofA Merrill Lynch All U.S. Convertibles Index. While rates are still low, investors should be positioned proactively for an eventual rate increase.

In Rising Rate Environments, Investment Grade Convertibles Typically Lagged the Convertible Universe



Performance data quoted represents past performance, which is no guarantee of future results. Source: Morningstar Direct and Bloomberg. Rising rate environment periods from troughs to peak from October 1993 to December 2013. Data as of 6/30/14.


  • An investment grade portfolio may also be subject to a higher level of equity sensitivity, and therefore, downside equity capture—precisely the risk that most convertible investors seek to avoid. In the current environment, we believe a portfolio composed exclusively of investment grade issues would be subject to a level of equity risk that is higher than most convertible investors would anticipate or intend. While this equity sensitivity may in fact mitigate some of the interest rate risk we discussed above, we believe the profile of much of the investment grade market is not what investors have come to expect

  • Quality restrictions can increase valuation risk at points of the market cycle. Our team continues to identify a range of attractively valued securities in the convertible market. Even so, there are pockets of the market where we believe convertibles are generally fully valued—including a number of investment grade issues. We do expect that equity markets will continue to rise, but believe the global rotation that ran from mid-March to June illustrates that the highest priced securities may be vulnerable to the increased downward pressure when market sentiment wavers. Historically, overpriced bonds often underperform when the market moves in either direction.

  • At Calamos, we believe that the unique advantages of convertibles are best harnessed through actively managed strategies that seek an asymmetrical risk/return profile—that is, one with more equity upside than downside. A flexible approach that can include convertibles across the quality spectrum provides us with the best way to achieve this goal over full and multiple market cycles.




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Distortions in “Value”: Overpaying for Yield

By Jeff Miller

August 8, 2014

In 2014, a global chase for yield is rippling across the U.S. stock market. For example, a strong appetite for anything with a decent yield has driven the performance of the Russell 1000 Value Index (RLV). In the RLV, utilities and REITs account for about 10% of the benchmark. This 10% has accounted for approximately 1.38% of the RLV’s 6.44% year-to-date return through July 31, as REITs have surged and investors have bid up utilities to levels that we believe will prove unsustainable going forward. Put another way, investors may be overpaying for yield in those two sectors at the expense of future total returns. We on the Calamos Value Team are unwilling to sacrifice future returns simply because a segment of the market is desperate for yield today.

As the yield on the 10-year U.S. Treasury bond hovers near 2.5%, and the yield on bank accounts and CDs is near zero, investors desiring current income face a choice: Either they can forgo current income for now, in the hope that rates will rise and they can invest in a year or two at those higher rates, or throw in the towel and buy.

Many have chosen to throw in the towel and buy, which to us seems to be a foolish long-term investment decision. It is our belief that over time, the decision to avoid these two overheated sectors will prove to be prudent. However, this view has created short-term headwinds for our opportunistic approach to value, which focuses on seeking companies that are temporarily out of favor but have strong operating businesses and cash flows, as well as managing risk over a full-market cycle.

What is driving investors to invest so aggressively in utilities and REITs? A lack of alternatives. Yields on government bonds in Europe are as low or lower than those here in the U.S. (For more on this, see the firm’s quarterly commentary “Navigating Complacency in a Growth Regime.” Bank accounts offer little respite. According to a recent article in The Wall Street Journal, the Chinese government has purchased more U.S. government bonds year-to-date in 2014 than in all of 2013, presumably to weaken its currency versus the U.S. dollar and therefore support China’s export-driven economy.*

Since inflation has remained very low here in the U.S. while the economy remains in a slow-growth mode, the Federal Reserve has maintained a very loose monetary policy, keeping its short-term rate at or near 0%. Couple this with a demographic phenomenon in the U.S. and much of the developed world, especially Japan, in which increasingly large amounts of the population are heading for or are already in retirement, and you have the perfect environment for elevating yield alternatives to unsustainable levels.

While we recognize these demographic and central bank forces and appreciate their ability to distort the market for income securities for a significant period, we continue to believe better long-term prospects can be found in other sectors of the market today. In particular, we find value in select financials that will benefit from higher rates, and in energy stocks that are benefiting from the U.S. energy boom and improving economy. Although a rate increase hasn’t yet occurred, investors shouldn’t think that it will be forestalled indefinitely. When rates rise, it could still come as a surprise. We want to invest ahead of the curve, looking for tomorrow’s opportunities among the real values in today’s market.




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Why Buybacks Matter

By Gary Black

August 4, 2014

We believe finding stocks that deliver sustainable growth in their core businesses (via volume growth, pricing, or margin expansion that exceeds investor expectations) is the surest way to deliver outperformance, and it’s where we at Calamos spend the bulk of our research efforts. That said, we believe we also often add value by correctly anticipating change in a company’s cash reinvestment strategy—specifically, by identifying companies that will use their excess cash flow to buy back stock when there is a significant difference between a stock’s earnings yield (E/P) and the company’s after-tax cost of debt or cash. As research by Jefferies shows (Figure 1), this can create substantial value for shareholders as well.

Figure 1. Buybacks Have Given Stocks a Significant Boost

Source: Jefferies, “Global Equity Strategy, US: The Big Squeeze, III,” August 4, 2014, using data from Bloomberg, Jefferies. The S&P 500 Buyback Index measures the performance of the top 100 stocks with the highest buyback ratios in the S&P 500 Index, a measure of the U.S. stock market.

Theory says a company should buy back stock if the internal rate of return on equity free cash flows exceeds the company's marginal cost of capital, assuming no better uses of the cash and no financial duress.

From an accretion standpoint, buybacks are accretive if the forward earnings yield (E/P) exceeds the marginal after-tax cost of debt or cash. If the marginal cost of debt is 3.9%, the P/E on next year's earnings is 15.6x, and the tax rate is 35%, then the return on buybacks is E/P = 1/15.6x = 6.4% versus a 2.5% after tax-cost of debt. This particular buyback would be very accretive to equity holders.

Mathematically, the actual year 1 accretion formula can be spelled out as follows:
% accretion = {$ repurchased/market cap} x {1 – [(cost of debt x (1-tax rate))/(E/P)]}*

If the year 1 buyback is 8% of market capitalization, the 2015 P/E is 15.6x, and the after-tax cost of debt is 2.5%, then accretion would be: 8% x [1 - (2.5%/6.4%)] = 4.8%.

All other things being equal, if the buyback is unanticipated, EPS and the stock price should rise by about 4.8% on such an announcement. However, if the market already expects a year 1 buyback of 5% and the company announced a year 1 buyback of 8%, EPS estimates and the stock price would increase by a still-not-shabby 1.8%, based on: {(8% - 5%) x [1 - (2.5%/6.4%)]} = 1.8%. As the P/E goes up or the cost of debt increases if the firm is perceived as riskier, the efficacy of buybacks obviously diminishes.

In dollars, share buybacks are now at their highest level since 2007 (see Figure 2). As a percentage of market capitalization, buybacks are at their highest level since the third quarter of 2011. We expect the heightened buyback activity to continue in the quarters ahead, given yields of 3.4% for A-rated 10-year corporate paper and 3.9% for BBB-rated 10-year paper (2.5% after-tax with a tax rate of 35%), and a 6.4% S&P 500 earnings yield (based on the S&P 500 Index selling at 1930/$124 EPS for a 15.6x P/E on 2015 estimates).

Figure 2. Share Buybacks in Dollars and as a Percentage of Market Cap

Source: Goldman Sachs Equity Division

In short, we believe that share repurchase activity by CEOs and CFOs, who are closer to the fundamentals of their businesses than anyone, is a good indicator of a stock's future direction.





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Too Much of a Good Thing Is Not Such a Good Thing for Markets

By Gary Black

August 1, 2014

Wednesday’s one-two punch of 4.0% second quarter GDP growth, plus the Fed’s language that inflation had moved closer to its longer-term target, gave the equity markets a severe case of agita. The S&P 500 Index fell -2.7% for the week, its worst percentage decline in the past two years. We expect the recent surge in volatility to continue near-term as the consensus shifts about how quickly the Fed will raise short-term rates in 2015. The worry, of course, is that the Fed will suddenly wake up and realize it has fallen behind the proverbial eight ball in controlling inflation and be forced to ratchet up short-term rates in a messy rather than predictable fashion.

Everyone seems to agree the Fed will be forced to raise rates at some point during the next two years with inflation nearing the Fed’s 2% target. Does it really matter whether these rate increases begin in November 2015 or May 2015? With 209,000 jobs created in July and now six continuous months of 200,000-plus job growth, bond vigilantes have called the Fed’s zero-rate monetary policy “inappropriate” at best and “irresponsible” at worst, with the U.S. economy expected to grow by 2.0% to 2.5% this year. Put differently, the vigilantes say an average growing economy deserves an average monetary policy, not the one adopted in 2008 to get the country out of the worst financial crisis since the 1930s.

Our view is that the market isn’t worried that short-term rates are headed higher. Instead, we believe the market’s concern is that the Fed will be forced to ratchet short-term rates higher—three, four, five times over a short period—to control inflation that may accelerate well beyond the Fed’s 2% target as economic growth shifts into high gear.

Like a stock that misses earnings and falls to a new equilibrium that reflects the lower earnings and then moves higher, once the market discounts the change in consensus thinking about Fed policy and accepts that rates will rise earlier rather than later, stocks can take off again as investors get comfortable with 3% long-term GDP growth, 2% inflation, a 1% fed funds rate, and 3% to 4% 10-year Treasury yields.

We continue to believe we are in the fifth or sixth inning of a secular bull market, with a recovery cycle prolonged by the severity of the 2008-2009 financial crisis, the recession, and 55% market correction, combined with Washington’s impotency in crafting new fiscal policy to stimulate economic growth through tax incentives rather than government spending.

In our view, valuations remain very attractive relative to both inflation and long-term interest rates. Assuming global GDP growth of 3% in 2015 and beyond with little inflationary pressures, we believe corporate profits can continue to grow by 6% - 8% over the next several years. That is good for stocks, and particularly for growth stocks, which remain depressed with forward P/E multiples at just 1.2x the forward P/Es of value stocks but offer twice the forward revenue growth and 50% more earnings growth.

In sum, for now, too much good news is bad news, but once the markets adjust to the emerging consensus that 1% short-term rates and 3% to 4% long-term rates are indeed just fine, we believe equity markets can move to new highs, supported by 3% long-term GDP growth, low inflation, and M&A and buyback activity that remains highly accretive, given compelling valuations and cheap financing.





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The Philippine Growth Story Looks Set to Continue

By Nick Niziolek

July 9, 2014

As the Philippine equity market has appreciated more than 20% in the first half of 2014, our team has continually analyzed valuations and the degree to which we include Philippine equities within our portfolios. While the recent appreciation in equity prices makes valuations less compelling than last year, we are still finding attractive opportunities.

In fact, we are optimistic that the Philippine growth story has several long chapters ahead, a view supported by the country’s progress in infrastructure investments and reform initiatives. While maintaining exposures to the Philippine consumer via opportunities in the retail, banking and gaming industries, we have also identified new opportunities in property development as we believe infrastructure investments are creating significant value for the premium operators in this market.

Within the Philippines, the banking industry is one which we have favored historically, due both to the consolidated nature of competition (three dominant competitors hold 40% market share and lead consolidation within the industry) and positive economic tailwinds. Over the previous 10 years, individual wealth within the Philippines has grown by 12% per annum, but 80% of Filipinos are “unbanked.” Overall credit penetration remains below 40% of GDP, one of the lowest levels in the world, and credit card penetration is still below 10%.

Following a slow recovery from the Asian Financial Crisis, the Philippine financial sector is in a much better economic position for sustainable growth than many other emerging markets. We’re identifying companies with strong capital positions, ample liquidity (loan-to-deposit ratios of less than 70%), and strong asset quality and coverage ratios. Foreign competition has been held in check by regulations that limit foreign ownership of local institutions to 40% and cap foreign banks’ branch networks at 20 banks. As a result, foreign banks are essentially unable to compete with larger local institutions that operate 800+ branches each. In our view, the high growth in branch networks from local players over recent years should provide future margin upside as these locations become more fully utilized and operational efficiencies are realized.

Additionally, the Philippine bank regulator has been proactive, implementing the voluntary global banking standards of Basel III at the beginning of this year, at a far more rapid pace than many other emerging markets. We have been closely monitoring recent developments by the regulator, including recent discussions pointing to a new law being enacted in late July that will likely further liberalize the banking sector and permit additional foreign investment. Although this may create near-term competition for the largest local banks, we believe these developments can have positive longer-term implications for the banking industry and the Philippine economy as a whole, as we expect more foreign capital investment and an acceleration of consolidation within the banking industry.

Finally, the overall economic backdrop in the Philippines remains favorable. As we have discussed in past posts (see "Perspectives on the Philippines"), we believe that as economic freedoms continue to increase so too will the flow of foreign capital, fuelling for the economic investments necessary to further develop this economy.





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The Case For Growth Now

By Gary Black

June 18, 2014

Chair Yellen’s comments in March that short-term rates could move higher early next year, combined with weak economic data, caused a sharp rotation away from growth stocks, especially the longer-duration names we tend to favor (see our post "When Stocks Behave Like Bonds"). There’s been ongoing debate about where we are in the market and economic cycles. Growth has recovered some following stronger economic data, but still trails value year-to-date.

In our view, the economy looks to be positioned for steady growth: not too hot and not too cold. Chair Yellen vowed at her press conference today to keep interest rates low for a “considerable time” after current quantitative easing ended, given continued slack in the economy and inflation that remains below the Fed’s 2% target. Against this economic backdrop, we’ve had a balanced positioning of secular and cyclical growth names. Valuations of growth stocks relative to non-growth stocks remain compelling by historic standards, and we see more room for P/E expansion in growth stocks as the economic recovery strengthens.

The Business Cycle and Equity Market Performance The Business Cycle and Equity Market Performance

Valuations Support the Case For Growth
Large-Cap Growth Stocks Relative to Non-Growth Stocks, Ratio of Forward P/E Ratios
1976 Through Late May 2014 Valuations Support the Case For Growth

Past performance is no guarantee of future results. Source: Corporate Reports, Empirical Research Partners Analysis. Capitalization-weighted data.

This view of growth’s potential is gaining currency: Late yesterday, Empirical Research Partners shifted its forecast from a neutral regime (3 out of 5) to growth-tilt regime (4 out of 5). This is the first time since 2008 Empirical has felt that growth would outperform value. Empirical has long made the case that getting the regime correct (“knowing what game you are playing”) is critical to knowing what quantitative tools will work, and when.

In every business cycle going back to 1970, growth has outperformed value in the last 12 to 36 months of the cycle. This has usually coincided with the following conditions:

  • Flattening yield curve
  • Narrow but widening valuation spreads
  • Breadth of companies showing margin expansion narrows
  • Market rewards high capital spending ratios
  • Market rewards high price volatility (on a risk-adjusted basis)
  • Market rewards earnings and price momentum (also on a risk-adjusted basis)

Growth Stocks Have Typically Outperformed During Late Cycle
Large-Capitalization Growth and Value Stocks
1953 – Mid April 2014; Recessions indicated by shaded areas Large-Capitalization Growth and Value Stocks

Past performance is no guarantee of future results. Source: Empirical Research Partners Analysis. Equally weighted data used for the lowest two quintiles of price-to-book ratios compared to growth stocks.

We expect the merits of growth equities will garner increased recognition as economic growth accelerates in the months ahead. Still, we believe that there will be disparities among companies’ performances. In this environment, we expect our high-conviction, fundamentally driven approach will allow us to pick the winners from the losers within this more attractive growth universe.

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Emerging Markets: PR is on the Upswing

By Nick Niziolek

May 28, 2014

In early March, I wrote a post titled "Emerging Markets Should Fire Their PR Firms," which focused on some of the positive trends that seemed to be getting lost in the emerging market (EM) sell-off. The tide has since turned, and there has been a strong reversal in both news flows from and equity flows into EMs. Headlines have transitioned from "Currency Crisis" to "Modi Wins," and Russian equities have moved above the levels seen since before the Ukraine crisis began.

After falling more than 8% from the beginning of the year through early February, the MSCI Emerging Markets Index has staged a strong comeback. From March 20 through May 23, the index has risen more than 11%, outperforming the S&P 500 Index by nearly 1000 basis points and the MSCI World Index by more than 800 basis points. Year to date, the MSCI Emerging Markets Index has returned nearly 5%, outperforming both indexes by more than 100 basis points.

Moreover, we’ve identified several near-term catalysts that could further support the equity breakout that is underway. Prime Minister Modi’s victory in India has dominated recent headlines, but the Indonesian Presidential election scheduled for early July could serve as a similarly significant positive catalyst for the world’s sixteenth largest economy. Frontrunner Joko Widodo has campaigned on a platform of education, energy, infrastructure, and bureaucratic reforms. His ability to rapidly implement changes as mayor of Surakarta has fueled optimism that he can successfully move forward reforms on a national scale in short order.

Only in EM investing could a military coup be viewed as a potentially beneficial catalyst, but recent developments in Thailand are shining a new light on the risks and opportunities within that country. While Thailand is unlikely to grab favorable headlines in upcoming weeks, the resolution of regional political conflicts could provide a catalyst for Thailand. We have very little exposure to Thailand currently, but there may be an opportunity later this year to increase our exposure, given our view that the new government will look to rapidly roll out stimulus measures to support the political transition.

Although the breakout in EM equities has had good breadth, there have been laggards, including China and Mexico, both of which outperformed during 2013. We have a constructive top-down view of both countries, and are taking advantage of recent weakness by adding to our favorite positions. While the world focuses on reform prospects in India and Indonesia, Mexico is further along, with promising signs of continued momentum. Mexico recently increased its infrastructure spending target to $587 billion by 2018, more than twice the target President Pena Nieto announced in July of 2013 and the equivalent of nearly 50% of Mexico’s annual GDP. This new figure includes $362 billion in public spending and is 71% higher than what the previous administration achieved. Project awards are only now beginning to ramp up, with many construction projects expected to begin later this year, which should provide additional tailwinds for this economy. Meanwhile, we still see significant opportunity within China as it navigates a soft-landing and advances reforms that should further open the economy and encourage private investment.

Despite the good news coming from many countries, investors should remain prepared for pockets of negative news and the volatility inherent in EM investing. For example, we remain cautious on Russia. Even if tensions de-escalate in Ukraine, recent events highlight the ongoing power struggles between Russia and the West that are playing out in many former Soviet states. Our research team was in Moscow several weeks ago and noted that there were no signs of stress within Moscow due to Ukrainian developments, with public approval ratings and nationalism at all-time highs. While we cannot predict Putin’s next move, we must factor in downside risks when evaluating investments in this region relative to the opportunities we are seeing in more stable emerging markets.

While the market has looked past the near-term fiscal and economic challenges within Brazil, due in part to optimism about upcoming elections, we remain cautious as we have not seen a candidate put forth the slate of reforms we believe are needed to foster a stronger recovery. In this environment, we’re continuing to seek out bottom-up growth opportunities that can do well with a less favorable economic backdrop.

We have been pleased to see more positive headlines coming out of the EMs over these past weeks, with equity flows and returns fueling near-term optimism. We expect additional bouts of volatility, but we believe this will create opportunities given the long-term growth potential of emerging markets and several near-term catalysts that can provide additional positive news flows. We have used the market upswing to realize gains in countries and companies that we believe may have risen too far of late, reallocating capital in some of our more favored countries that have lagged during the initial stages of this rally. As always, we are taking advantage of the inefficiencies that we believe are created by passively managed exchange-traded EM funds. We encourage our clients to not try to time these rallies and corrections, but instead remain invested for the long-term potential that EM equities provide.





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Field Notes: India

By Nick Niziolek

May 6, 2014

I recently spent a week in Delhi and Mumbai meeting with corporate management teams and local investors to gain insights into the Indian economy and the outlook for upcoming elections. Meetings like these enhance our team’s understanding of how company management teams are thinking about their businesses and the potential impact they believe future macro events (e.g., elections) may have on how they deploy capital and pursue growth initiatives.

When I meet with company management teams, my primary focus is deepening my knowledge about key business drivers, industry dynamics and near-term growth prospects. However, I always set aside time to discuss the macro environment and what issues are top of mind for management. Often, the conversations take interesting and unexpected turns. During my most recent trip, CEOs shared ranging views, including concerns about the lack of progress on a nearby massive construction project, the perspectives of Japanese investors versus their U.S. counterparts and the policies being implemented under Central Bank Governor Rajan.

In isolation, these exchanges could be viewed as side conversations. However, over the course of a week, my conversations with business leaders in a diverse set of industries helped me gain a fuller picture of what the near-term outlook could be for India and the companies in the region.

One consistent message I heard across industries, regions and political parties was that change was needed and Narendra Modi, the favored candidate for prime minister, was best equipped to bring change to India. Many believe Modi can provide the political and regulatory stability to allow the pent-up demand for infrastructure investments to be unleashed. Many people commented on how the current leadership has rewritten contracts and introduced retroactive policy that makes the business environment difficult to navigate. This approach has hindered economic freedom in the Indian economy, and by extension, the flow of capital into infrastructure projects—hence, cranes that sit dormant for months on end. This concern about the near-term prospects for infrastructure build-out influenced the aforementioned CEO’s admiration for Japanese investors, who are more likely to accept potentially lower returns on invested capital (ROIC) on investments in the region.

Another consistent message of management teams was the concern about the equity valuations of their companies. Specifically, they were worried that investors would become impatient, given that increased economic activity is likely at least several quarters away. This was not just a timing/valuation issue, but they were also concerned that investors’ views have become overly optimistic.

The prevailing view is not that a Modi-Rajan partnership will spark significant economic activity, or that Rajan will have any impact on the economy at all, but instead the view is that a Modi-led government will get out of the way, which will lead to a reacceleration in growth.

In summary, the results of my recent travels were mixed. On the positive side, I had the opportunity to better know several management teams and based on this, I have additional conviction in several of our holdings. Also, we have identified a queue of opportunities that merit additional fundamental research by our investment team. On the negative side, the economic impact of a Modi victory is likely at least 12 to 18 months away and many of the equities we’ve held during this recent rally have appreciated to a degree that we are taking profits in our more cyclically-exposed positions. We have invested these proceeds into information technology and health care exposures that we believe have more reasonable valuations and may benefit, even if there is a lull in economic activity between the elections and enactment of reform initiatives. Longer term, we believe new leadership will be more pro-urbanization than the previous party and we are looking for opportunities that will benefit from this trend.





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The Game is Changing

By John McClenahan

April 1, 2014

I recently wrote a post on monitoring whether we're in a stock picker's market and the importance of volatility and correlation to tracking error. Monitoring the market's economic sensitivity is also important. Generally speaking, the stock market can be broken down into four areas of economic sensitivity:

  1. Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. These tend to be in the consumer staples, health care, telecommunications, and utilities sectors.
  2. Late-stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.
  3. Early-stage cyclical stocks: Stocks that perform well when the economy is starting to accelerate. These tend to be in the consumer discretionary, financials, industrials, and technology sectors.
  4. Secular growth stocks: Stocks that perform the best when the economy is growing at a steady pace but neither accelerating nor decelerating. These tend to be in the consumer discretionary and technology sectors.

With all of the economic data coming into the market every day, it should be easy to identify the winners and losers, right? However, it's actually more complicated than it seems because these groups of stocks tend to react more to investors' perceptions of what the economy will do than they do to the actual statistics that are reported. So day-to-day, investor sentiment can have a significant impact on the relative performance of these groups. And sometimes, one group can dominate or lag for several months or longer.

For example, from 2009 through the first quarter of 2010, early-stage cyclical stocks led the market with secular growth stocks a close second. However, as economic expectations began to decline in mid-2010, secular growth took the lead. This lasted through third quarter of 2012, when economic expectations began to stabilize and early cyclicals started to show renewed vigor. As 2013 unfolded and investors began to realize that expectations had stabilized but weren't rapidly accelerating, defensives led the market with early cyclicals remaining close behind.

This past summer everything changed! The Fed announced the possibility (yes, just a possibility!) of tapering asset purchases in upcoming months. Investors paused because not only did they have to consider the market's economic expectations but also the Fed's reactions to changing economic data. When would tapering start? How much each month? What about the discount rate? Would the Fed change that also? And just how dovish is Janet Yellen? For years, investors didn't need to think about these types of issues as the Fed was on auto-pilot, flooding the market with liquidity.

Secular growth stocks and early cyclicals jumped. But then economic expectations declined and the Fed decided to hold off on tapering … secular growth took the lead. As 2013 closed, economic expectations increased somewhat amid the start of Fed tapering and the beginning of the Yellen era. Secular growth and early cyclicals have been back and forth ever since.

First, growth led and more recently, it was early cyclical—despite no significant change in economic expectations. And while dispersion did recently decline due to the situation in Ukraine, it is still greater than it was for much of 2013. The waters are tough to navigate.

Historical Stock Performance and Economic Sensitivity
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.
Sources: Morgan Stanley, Bloomberg LP

So now what? Well, in her first FOMC meeting as chair, Janet Yellen was as clear as could be. The Fed could start raising rates in as soon as six months. What? Huh? Sometimes someone makes a statement that is literally so clear, but still unexpected, that it is completely unclear. Both growth AND early cyclicals declined as defensives came to the forefront and investors also took shelter in long-maturity U.S. Treasury bonds.

So now investors are confused and Fed officials are trying to backtrack. And as always, we at Calamos are watching economic expectations and listening closely to Fed speak. We're entering a period where bad economic news may be perceived as good since it could mean that the Fed will hold off on raising rates. (For more on this, see Gary Black's recent post.)That's likely to be good for early cyclicals. If economic expectations don't change much and the Fed is successful at calming rate hike fears, it is likely to be good for secular growth.

How do we use this information? Not only do we monitor which of the above types of stocks are performing the best, but we also monitor our exposure to these types. We seek to ensure that the exposures are aligned with our top-down views and the specific mandates of various portfolios. For example, our growth strategies are managed to be more heavily weighted in secular growth and early cyclicals over defensives whereas our value strategies favor early and late cyclicals over growth. Our growth and income and market neutral strategies tend to have exposure to all of these types of stocks.




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If Henry Ford Could See Us Now

By Stephen Roseman

March 27, 2014

A car, SUV, or pickup truck is still, at its core, a method of conveyance. Its utility to a driver hasn't changed since the first of the mass-produced cars rolled off the assembly line in 1908 (the Model T, for you trivia buffs).

What has changed is everything else that vehicles offer drivers today. We have satellite-connected navigational systems, entertainment systems, seat heaters, and anti-lock brakes. Airbag systems are so extensive that a car would resemble a puffer fish were the bags to deploy. The list goes on.

These options and niceties, known as "content" in the auto industry, come at a price to consumers. Who wouldn't pay a little more to keep their loved ones safe and comfortable? However, it becomes a slippery—albeit well-cushioned—slope, as consumers get used to these little extravagances. (Doesn't everyone need seat heaters if there's another Polar Vortex?)

In the ensuing arms race to equip vehicles with features, the average car price has steadily increased, contributing to higher revenues and margins for the auto manufacturers, as well as windfalls for the formerly stodgy but now-not-so-boring parts suppliers.

Companies are benefiting materially from both the recovery in new vehicle sales as well as from an increasing appetite for more content. This opens up new investment opportunities, and the astute investor can profit if they can identify the winners in this comfort-and-convenience race.

Rules of the Road
Because of the highly cyclical nature of the auto industry, it's especially important that investors remain mindful of when the full benefit of the recovery in auto sales is priced into the auto stocks. We remain confident that the recovery in the SAAR (seasonally adjusted annual rate), the measure of total units sold, will continue as the economy recovers.

One way to take advantage of the SAAR recovery would be to invest in the auto industry by buying a basket of stocks—the "rising tides lifts all boats" approach. Instead, we think that the smarter way to invest in the auto industry is to identify companies that aren't just benefiting from SAAR but that have the cycle-insulating benefit of getting more of their content into cars as well. We also like the idea of having exposure to Europe, where recovery has lagged the U.S. so far, but may offer some faster acceleration down the road.

When it comes to understanding the auto industry and the most compelling companies, our fundamental research process includes many of the things you'd likely expect—analyzing balance sheets, dissecting corporate filings and listening to conference calls with management teams. However, our investment theses reflect a much more comprehensive approach, with insights gathered from multiple perspectives—including automakers, parts manufacturers, auto dealers and wholesalers, and lastly, consumer-oriented buying sites. We scour trade magazines, speak to individuals throughout the industry and attend trade shows. These sort of hands-on efforts provide us with valuable information about what consumers want most and which companies are doing the best job meeting those needs.

Drawing on this firsthand research, we've identified a variety of companies that we believe are well positioned to take advantage of consumer trends, such as those related to fuel efficiency. As automakers have to adhere to ever-more-constrictive CAFE standards (read: fuel economy), they recognize the importance of making their cars more fuel efficient (and less polluting). We also see growth opportunities for companies that are at the leading edge of infotainment, safety, and the connected car.

As always, when investing in this sector, a thoughtful and reasoned approach, along with thorough research and due diligence, helps us to find the companies that we believe will be in the winner's circle.

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When Stocks Behave Like Bonds

By Gary Black

March 25, 2014

The market's sell-off in high-momentum stocks—biotechnology, internet, and cloud names, specifically—can be summarized in one word: duration.

As every bond investor knows, when interest rates rise, long-duration bonds get hit the hardest because they are most sensitive to changes in interest rates.

Equities are no different. When Federal Reserve Chair Yellen raised the specter of tighter monetary policy happening earlier than investors expected, the market’s reaction was swift and unambiguous: sell long-duration equities.

Long-duration equities are those where the vast majority of earnings and cash flows are many years out, and current-year earnings and cash flows are non-existent or negative. (Think of a technology company that reinvests all its cash back into its business to fund its rapid growth—where the anticipated payoff could be significant but many years out.) The stocks hit hardest in yesterday’s sell-off were those where substantially all the intrinsic value is in the future "terminal" value (i.e., value based on cash flows that are 10, 15, or 20 years out). The prospect of higher interest rates cuts down the terminal values that drive growth stock valuations in the internet, cloud, and biotech sectors. These sectors were among the hardest hit yesterday and again today.

I believe that as Fed governors speak out over the next few days and try to throw cold water on the market's foregone conclusion that short rates will start rising as early as the spring of 2015—as implied by Yellen’s comments—the shift out of long-duration equities should reverse. We are likely to see a return of "bad news is good news"—that is, weak economic data reduces the odds of tightened monetary policy—which would cause long-duration equities to get bid up again.

Our research shows that over the past 35 years, the combination of negative real but low absolute interest rates at the short end of the yield curve and rising but moderate rates at the long end of the curve indicates an expanding economy without inflation. In such an environment, the technology, consumer discretionary, financials, and industrials sectors have tended to do best. We remain committed to the secular growth names our analysts have identified and believe they can benefit from secular tailwinds such as mobility, 24/7 access to information and entertainment, the emerging middle class, a global marketplace, aging demographics, productivity enhancements, and global infrastructure. At the same time, we remain disciplined about what we pay for companies that can benefit from these secular tailwinds, while being cognizant of the impact of rising rates on these longer-duration equities.

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Convertible Investments for a Cloudy Day

By Steve Klouda

March 12, 2014

Investing inherently includes an element of risk, particularly within industries where disruption is the status quo. Of course, that's typically where the bigger opportunities are, but that doesn't change the fact that the stocks in these industries sometimes produce stomach-churning volatility. Using convertible securities to potentially mitigate the ups and downs of high growth (but highly volatile) stocks may help investors sleep easier at night while still getting exposure to exciting long-term trends.

The cloud computing industry provides a good example of how we can use convertibles in this way. There's no doubt that businesses that focus on the cloud are riding a secular wave of demand. They are at the intersection of multiple demand waves as they benefit from the explosion of social media, faster network speeds, the massive creation of data, the subsequent need for additional storage, and economies of scale. The cloud is changing the way consumers live and how companies conduct business. This is creative destruction at its finest.

However, because of the upward moves in some cloud stocks, a few pundits have drawn parallels to the tech bubble of the late '90s. And yes, cloud companies are experiencing tremendous rates of growth and levels of volatility that we saw with some tech stocks back then. But there are important differences between the two. First, many of the cloud companies (at least the ones we favor) have balance sheets that are in far better shape compared to the dot-com names of the '90s. Most have significant amounts of cash on hand that can provide the necessary capital to grow their businesses and provide for a rainy day. Unlike the debt-laden telecom companies of the late '90s, the convertible bonds issued by today's cloud companies often are the only debt on the balance sheet, which offers the possibility for issuers to improve their capital structure quickly, should the stock rise above the exercise price over the next few years.

The second difference is the structure of the convertible itself. Most of the convertibles issued today by cloud companies have maturities of only five years, attractive conversion premiums of approximately 35%, and even a little income thrown in for good measure. If the long-term theme of cloud computing continues to play out and the stocks do well, the convertibles would be positioned to participate in the large majority of the upside. But if the stocks falter, the convertible holder should be insulated from most of the downside. Additionally, the relatively short five-year maturities of most of these convertibles mean duration risk should be reduced, an increasingly important consideration for fixed-income investors.

We've identified a number of cloud companies with the criteria our investment process favors: a great secular theme, underlying growth prospects, solid balance sheets. By participating via attractive convertibles, we believe we are better positioned to capture an asymmetrical risk profile, with more upside equity participation than downside.

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Emerging Markets Should Fire Their PR Firms

By Nick Niziolek

March 10, 2014

As I scroll through Bloomberg headlines on emerging market (EM) crises and analyze recent events with my colleagues, it has dawned on me that if the EMs had public relations firms, it would be time to fire them. Focusing only on the headlines, you'd believe there is nothing great happening in EMs today, but our team has identified many EM companies with attractive growth theses.

While it may be wishful thinking that articles reporting "Macau gross gaming revenues up 40% year over year" or "leading Chinese mobile platform exceeds 300 million users" would appear ahead of headlines like "Crisis in Ukraine" or "Chinese Trust Default," we are looking through the headline risks to identify the bottom-up growth opportunities that we believe will continue to work in this volatile environment.

Of course, we are concerned about Ukraine. Our team is monitoring developments closely, and we have many discussions about the direct and indirect impacts of events in Eastern Europe. Fortunately for our clients, we have maintained very limited exposure to Russia and no direct exposure to Ukraine. In our investment approach, we favor countries with increasing levels of economic freedom, as economic freedom historically has been correlated with economic prosperity. Although Russia has shown some improvements in economic freedoms, we believe Moscow must do much more. Whereas the 2008 summer Olympics provided a catalyst for increased economic freedoms in China, we have not seen a similar impact from the Sochi Olympics.

Regardless of the outcome in Ukraine, Russia appears to be taking a considerable step back in terms of market sentiment, which we expect to be reflected in higher risk premiums and lower GDP growth forecasts as 2014progresses. While Russian equities continue to look "cheap," and are "cheaper" today than they were last week, we have yet to identify the near-term positive catalyst that will accelerate growth, create a re-rating, or increase market interest in them.

So, what are we positive on within emerging markets? We've previously discussed our optimism about developments in Mexico, the Philippines, China, Taiwan, and South Korea, where we've been focused on consumer and technology sectors. This optimism remains, with many strong growth companies in these countries and sectors adding value for our clients in recent months.

We're also becoming more positive about the potential for India and Indonesia. I have a trip scheduled to India later this month, which is excellent timing as elections begin on April 7. Optimism among market watchers is building about a potential partnership between Narendra Modi, a frontrunner for prime minister and Reserve Bank of India Governor Raghuram Rajan. The hope is that Modi and Rajan can push forward the reforms necessary to fuel the next leg of the Indian growth story. Already we've seen comparisons to the 1980s' Reagan–Volker partnership. Following the taper fears of last May, Rajan's aggressive rate hikes have been credited with recent declines in inflation and current account deficits. I'm looking forward to meeting business leaders in various industries as well as economic officials to get better sense of their view of the country's prospects.

In practical terms, the media is the PR firm of the EMs and firing the media is out of the question. We fully expect Chinese trust defaults and concerns about weaker EM economies to remain headline fodder. Still, we are optimistic that the news flow may transition to more positive developments (elections in India and Indonesia, for example) as we move through the year. In the meantime, we continue to identify strong growth opportunities within the EMs and believe our longer-term focus will serve our clients well.

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How Do You Know It’s a Stock Picker’s Market?

By John McClenahan

March 6, 2014

In our most recent Global Economic Review and Outlook, we described 2014 as the year of the fundamental investor with macro factors becoming a less significant driver of investment performance. But how do we monitor this? And what does this mean for portfolio risks and returns?

Generally, when macroeconomic or sociopolitical factors are driving the market, stocks will tend to move together either increasing or decreasing in value. Traders and market pundits will say breadth is strong. If this continues, the average correlation between stocks will increase. When there are fewer significant macro topics driving the markets, stocks will tend to move independently based on company- and industry-specific fundamental factors, such as revenue and earnings growth, return-on-invested capital, valuation, and innovation, among others. When this occurs to a great extent, dispersion—the opposite of correlation—is said to be high. If this lasts over several months or years, it is described as a “stock picker’s market” because gains are to be had by selecting individual stocks as opposed to just buying the overall market.

For example, as we emerged from the 2008 financial crisis and investors regained confidence in the markets, breadth was strong and the average correlation among stocks was high, just as it was when stocks were tumbling the year before. Correlations continued to increase through the third quarter of 2010. But, with the notable exception of the sovereign debt panic of late 2011, average correlation has been declining ever since. In other words, as markets have rallied in the years since the crisis, investors have become more selective in purchasing stocks. Despite the increase in dispersion, I wouldn’t have called this a “stock-picker’s market” until recently, as correlations were still above their long-term averages.

However, the average correlation among stocks is back to its long-term average (as the chart below from our most recent outlook shows) after the best year for stocks in over 16 years. And as many investors believe stocks will post more modest returns than in 2013, stock selection is again front and center.

U.S. Equity Correlations Have Fallen

S&P 500 INDEX, AVERAGE PAIR CORRELATION CALCULATED USING 100 DAILY RATE OF CHANGE DATA, SMOOTHED OVER 20 DAYS

Past performance is no guarantee of future results. Source: GaveKal Research, January 7, 2014

Why does this matter? If dispersion is high, managers who exhibit a high degree of difference from their benchmarks (“active share”) may be more likely to outperform. Since all securities won’t be moving in tandem, fundamental research should be rewarded. Moreover, alternative strategies such as market neutral and long/short equity (which can extract alpha from both rising and falling stocks) may be better positioned to post strong returns.

But what about risk? Decreased correlations typically lead to lower market and portfolio volatilities as diversification increases. But tracking error (the volatility of portfolio returns relative to a benchmark) can increase. However, lower overall market volatility works to counter the adverse effect of decreased correlations on tracking error.

Hypothetical Effect on Tracking Error

 DecreasedIncreased
VolatilityFavorableAdverse
CorrelationAdverseFavorable

While not overly complicated in theory, knowing where a portfolio stands in terms of expected volatility and tracking error isn’t something that can be easily done via intuition. Even if you believe high active share is vital to investment success (as we do at Calamos), it is important to monitor these risk levels. That’s why we track these risks over time using a variety of measures, which allows us to select stocks and industries we believe will differ significantly from a portfolio’s benchmark.

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When Volatility is Your Friend

By Jeff Miller

March 3, 2014

Academics will tell you that volatility is bad in and of itself. It’s like an original sin. They think something that moves a lot is risky. Something that has gone up and down is hard to incorporate into a mathematical model, and academics don’t like things that mess up their models. Hence all the footnoted assumptions in academic papers describing why (if you know what you are reading) the models won’t actually work in the real world. When asked, academics are likely to say that things like skewness, risk aversion, valuation aren’t elegant to model, so they fix all those variables to calculate a security price at a given point in time.

Option pricing models like Black Scholes (the most commonly used model) have to make future assumptions to price a security today. Many people who have studied these models know they work pretty well for valuing embedded options in long-dated securities like convertible bonds, but have more limited applications when it comes to near-term pricing in volatile markets. People use the models anyway because everyone else does and because the models often work well. You can trade derivatives on the various pieces of a model’s outputs, such as implied volatility, gamma, delta, etc. So long as everyone is using the same model and you get the direction of the trade right, it works out fine most of the time.

But there is a cost to the simplification and assumptions. A key portion of the Black Scholes model is an estimate of the future volatility between now and the expiration date of the option. And given that there aren’t a lot of good ways to do that, most market participants use past volatility to estimate future volatility. And therein lies our opportunity …

A Crazy Little Thing Called Beta
What if a stock’s volatility is in the recent past, like yesterday? And what if the volatility was to the downside, meaning that the stock price went down. What then? Again, your business school professor will tell you that this is now a riskier stock. Historical volatility is up. Yet as an investor, the price of a company just got cut significantly. How is it more risky NOW than it was last week? Because beta has increased—and academics don’t like that. Less is more to them.

But as value investors, we like high beta, so long as it is downside beta (that is, a stock dropped), the drop just happened, and we didn’t own the stock yet. This gives us a chance to buy a stock cheaper. (Conversely, we love high beta if it is upside beta on a stock we own.)

A Hypothetical Illustration of How it Can Work
Here’s a hypothetical trading example that illustrates how we could utilize options strategies within our opportunistic value approach. A company we follow closely but don’t own runs into a regulatory issue in a country from which it derives about one-third of its revenues. The day before the news comes out in a state-run newspaper, the stock closes at $136 per share.

Day 1: A newspaper article questions the company’s sales practices (allegations the company denies). The stock trades as low as $108 before closing at $115. The move gets our attention, but we don’t do anything. We have a three-day rule when a company has a big selloff—wait three days for the selling to run its course, then buy. (This works more often than you might think it should, but it’s actually based on the mechanics of the way market participants get into and out of positions.)

Day 2: The company’s main regulator in the country in question announces it is opening an investigation into the company’s sales practices. The stock trades as low as $68 before closing at $85. Now things are interesting. We do some work and estimate that if this government completely banned the company from ever doing business in its country again, the stock would be worth about $70 a share. Put another way, if we took all the company’s revenues from this market (again, about one-third of its total revenues), the rest of the company would be worth about where the stock was trading. But we believe a ban on the company was unlikely, since the government has recently given it more operating licenses. We believe it is much more likely that the government would require the company to pay some big fines, make a statement of regret for its actions, and charge a bit more for its products to give the local competition a leg up.

Day 3: The stock starts to sell off again, trading down in a fairly orderly manner throughout the morning. Now, it needs to be noted that options are priced using a normal distribution curve. This basically means that the main academic model, Black Scholes, assumes that a stock is equally likely to move up or down and that the probability distributions are equal as well (think of a nice bell curve). However, this stock just went from $140 to $85, and we could wipe out a third of its business and not have much downside. Our view of the probabilities is very different than the market’s, and the recent volatility enables us to extract some value from the situation.

So, we buy a 2% position at $77, near the day’s lows. We simultaneously sell a roughly equivalent amount of February 90 calls for $4 and February 65 puts for $4. This means we are obligated to add to our position at an effective cost of $61 ($65 strike minus $4 premium we collected) or sell our position at $94 ($90 strike plus the $4 premium we collect). If the stock stays above $69 (our purchase price of $77 minus the $8 in total premium we collected), we’d make some money. Again, we think $70 is the burndown value of the company, so we are okay with this. If the stock goes below $65, we’d be adding to our position at a low price. If the stock rises to $90, we’d make $21 per share: $8 from selling the puts and calls, and $13 from the stock price appreciation, or nearly 27% in about a month if we hold them to expiration. Not bad. But there is a different reason we like the trade: We’d make about 11% if the stock didn’t move. The market is pricing future volatility so high, even though the stock has already fallen from $140 to our price of $77, that if the stock price did NOTHING but stay right where it is, we’d make more than 10% in about five weeks. You have to love those odds. We’ve always believed when you get a good hand, you play it. Over time, the odds will be in your favor.

By taking advantage of flaws in the way the options market estimates volatility, we have opportunities to establish positions in companies we like at much lower prices than if we simply bought them outright. This is why we believe volatility is not a sin; often, it can be a friend.

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Cocos: An Overview of the Anti-Convertible Bond

By Eli Pars

February 27, 2014

Contingent convertible bonds, or cocos, have been getting more global press recently, including in this past Friday's Financial Times. As one of the world's oldest and largest managers of convertible strategies, we are asked about cocos frequently. In many ways, a coco is the mirror image of a convertible bond. Instead of the equity upside participation and potential downside protection that can make a convertible bond so attractive, cocos may have much higher potential downside.

A convertible bond is a corporate bond that allows the holder to convert into a fixed quantity of shares in that company's common stock. If things go well and the stock rises, the convertible bond holder participates in the rising stock price, capturing equity upside. If the stock falls, the convertible is still a bond and the holder receives a fixed coupon and par at maturity. Think of a convertible bond as a security that looks like a stock if things go well and like a bond if things go poorly.

Cocos are also hybrid securities, but the similarities to traditional convertibles pretty much end there. Banks issue cocos to meet regulators' requirements for capital reserves, and to provide a cushion should they find themselves in a serious predicament. Cocos typically pay higher coupons than a bank's straight bonds. However, if the bank gets in trouble (think 2008), these bonds turn into equities. Think of them as anti-convertibles. I also like the term "Bizarro" convertibles, to borrow from Superman comics and a Seinfeld episode. If things go well, you just get your fixed coupon and par back at maturity. But if things go poorly, you quite likely will get little to nothing in return. After all, if a bank is in bad enough shape that its cocos convert into equities, that bank stock you are getting may not be worth much. In many cases, it won't be worth anything at all. Cocos have become quite popular with banks in Europe; we believe they will probably end up being used in other markets as well.

These securities are not your father's (okay, older brother's) cocos. Originally, "contingent convertible" described convertible bonds that were convertible into the equity only after the stock had risen to where the bond was well into the money. These contingent convertibles became popular in the U.S. around 2001 and had some accounting benefits for the bond issuers. The term wasn't applied to bank hybrids until several years later.

In our convertible portfolios, we're focused on upside equity participation with potential downside protection over full market cycles. Because the risk/reward profile of these bank cocos is the opposite of the risk/reward profile we look for in convertible bonds, we are quite willing to pass them by.

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Indonesia: First In Line to Break Away from the Fragile Five?

By Nick Niziolek

February 13, 2014

As one of the emerging markets' Fragile Five, Indonesia finds itself saddled with a current account deficit, a fiscal deficit, and negative market sentiment. While it's far too early to sound the "all-clear," we're seeing indications that Indonesia is making progress toward graduating from the Fragile Five.

Year-to-date, the market has been positively surprised by economic data that Indonesia has reported. Real GDP growth for the fourth quarter came in at 5.7%, with full-year GDP reported at 5.8%. While year-over-year investment growth declined from nearly 10% in 2012 to 4.2% in 2013, consumption was more resilient than expected at 5.3% and exports grew at 7.4% year over year. Indonesia also moved from a trade deficit in the third quarter of 2013 to a surplus in the fourth quarter. Today, we saw additional data pointing to stabilization, with the current account deficit now below 2%.

IHS forecasts a slight decline of GDP growth to 5.0% in 2014, but against the backdrop of an improving current account deficit, flattish inflation, abating currency depreciation, and increasing foreign reserves, discussions about interest rate cuts have begun, albeit still not likely until the second half of 2014. Consensus expectations are that GDP growth bottoms out in 2014 before returning to more normalized 6% year-over-year levels, which would be a positive backdrop for Indonesian rupiah appreciation. Year-to-date, the rupiah is one of a select few EM currencies that have appreciated.

While the other Fragile Five countries continued to tighten in January, Indonesia has been on pause since November. Currency depreciation helped achieve a trade surplus, and the government has used other measures to support the rupiah, such as lower loan-to-deposit ratios, higher reserves, and swaps. A transition from tightening to easing without significant adverse impacts on growth and inflation would certainly be a positive for the Indonesia economy. More broadly, it could boost EM sentiment.

Indonesia holds legislative elections in April and presidential ones in July, with the presidential installation in October. Stalled reform initiatives probably won't pick up prior to October, although we believe increased discussion and optimism around these topics are likely. Indonesia recently announced a delay in its raw mineral export ban and an increase in allowed foreign direct investment in ports and airports. Both are positive steps toward much-needed larger reforms.

Indonesia is not out of the woods yet, but we are encouraged by its recent progress. Upcoming elections and potential monetary easing could provide key near-term catalysts. Indonesia represents 2.4% of the MSCI Emerging Markets Index, and we have been underweight in our portfolios. However, if we identify bottom-up opportunities, we are increasingly comfortable about moving closer to an equal weight in Indonesia.

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U.S. Equities: Cheap Relative to Bonds and Inflation

By Gary Black

February 12, 2014

Our regular followers are likely familiar with some of our favored equity valuation measures. Below, we show updated valuation charts comparing S&P 500 Index trailing earnings yields versus 10-year Treasurys and versus inflation. This analysis, which spans 60 years, offers a measure of the current "cheapness" of U.S. equities versus both bonds and inflation relative to the past.

Based on trailing earnings, the return advantage offered by equities versus 10-year Treasurys was about 300 basis points at the end of January; the equity advantage versus inflation was about 400 basis points. Looking back over the past 60 years, the current return advantage offered by equities over bonds would rank at the 24th percentile of cheapness (1st = least expensive, 100th = most expensive) of all observations. Versus inflation (which some investors prefer given their views that the long bond has been engineered lower by rounds of QE) equities today would rank among the cheapest 29th percentile of all observations over the past 60 years.

At yesterday's S&P 500 Index close of 1820, the current S&P earnings yield on 2014 earnings was 6.3% (2014 EPS = $115, P/E = 15.8x). Roughly, that gives equities a 330 basis point advantage versus an expected 10-year Treasury yield of 3.0% at year-end 2014, and a 460 basis point advantage versus expected 2014 inflation of 1.7%. So, equity valuations on 2014 earnings and rates look even cheaper.

U.S. Equities: Attractive Versus Bonds
Differential of S&P 500 Trailing Earnings Yields and 10-Year Treasury Bond Yields
1950 Through Late January 2014

U.S. Equities: Attractive Versus Bonds

Past performance is no guarantee of future results
Source: Standard & Poor's, Corporate Reports, Empirical Research Partners Analysis.

U.S. Equity Advantage Over Inflation
Differential of Trailing S&P 500 Earnings Yields and Inflation
1950 Through Late January 2014

U.S. Equity Advantage Over Inflation

Past performance is no guarantee of future results
Source: Standard & Poor's, Corporate Reports, Empirical Research Partners Analysis.
Trailing earnings yields less the core CPI. Prior to 1958 the overall CPI is used.

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Are We There Yet?

By Jeff Miller

February 4, 2014

Are we there yet? That's the question many investors are asking themselves after the recent declines in global stock markets. Year to date through February 3, 2014, the Dow is off 7.3%, the S&P 500 Index is down 5.8%, and the Nasdaq Index has declined 4.3%. And that is the good news. Overseas markets have been even worse, particularly in Asia. The Japanese Nikkei Index is down 9.5%, and many other markets in Asia have fallen more than 6%.

There are a few factors at work, but most of them share a common theme—emerging markets overall, especially China. On a stock-by-stock basis, U.S. companies got hammered if they reported strong earnings but weak sales in China, no matter how small or insignificant revenues or earnings from China were. On the other hand, companies that reported okay sales in China did well.

Why is China so important? Part of the reason for this pattern is China's purchasing power. The market's fear is that if China slows, Chinese demand for our higher-margin consumer and industrial goods will decline at the same time U.S. consumer spending growth is also slowing. In addition, a slowing China means lower demand for commodities and raw materials—the sales of which provide much of the hard currency for governments in many emerging markets.

To make matters worse for those emerging markets, the beginning of the end of quantitative easing in the U.S. makes U.S. assets relatively more attractive than the alternatives in many emerging markets. Ultra-low interest rates in the U.S. were intended to stimulate investment in manufacturing and jobs—and it worked, just not in the United States. That cheap money was invested in emerging markets. Now, the prospect of higher U.S. interest rates has made U.S. investments more attractive at the same time emerging markets have become oversaturated in investment dollars from abroad. As cheap liquidity returns home to the U.S., the traditional cycle of boom and bust is shifting once again to bust in emerging markets.

It's not just a slowing China that's causing the selloff. To some extent, China is just throwing gas on the fire. A confluence of events are hitting the markets all at once. Emerging markets such as Turkey, Indonesia, Argentina, Brazil and South Africa are all contributing to market anxiety through political unrest or anti-capitalist government policies. Investors tend to avoid political situations as "uninvestable" (read: we don't know what is going on, so we're out of here).

Friday's U.S. non-farm payroll number was much weaker than expected, while yesterday's ISM Manufacturing Index came in at a very weak 51.3 versus a prior 57 and expectations of 56. (Levels below 50 indicate contraction.) New orders also declined significantly from 64.4 to 51.1, while inventories fell 3 percentage points. Overall, this was an ugly release. Moreover, a number of high-profile U.S. consumer companies reported weaker-than-expected sales last week. This disappointing news, combined with generally weak retail sales overall, led to fears of a retreating consumer. And so the market continues to sell off.

Markets go up and markets go down—the cycles haven't changed much in 400 years. But the key to successfully navigating the markets is to know what game you are playing. "Play the game in front of you" is one of the Calamos Value Team's trading rules. So, it helps to know what kind of selloff the markets are in. Normally, the market's ebbs and flows are driven by buyers and sellers reacting to news on companies, changing industry prospects, or prospective interest rate changes. Usually, if the S&P 500 Index breaks meaningfully below its lower Bollinger Band on a daily chart, the market bounces in a day or so. (The Bollinger Bands measure recent market movements and generate two standard deviation bands above and below the recent price range.) The reason is simple: It's unusual for a whole market to stay two standard deviations below its recent range without dip buyers and bargain hunters showing up. We do it, and so do lots of other value buyers and traders.

Since this current decline isn't a "normal" selloff, I decided to look into the macro-driven selloffs in the recent past (1997, 1998, 2008, and 2011) to see if our team's sentiment and oversold indicators (i.e., the things that work in a regular day in and day out market) work in a macro semi-panic. They don't. The U.S. stock market has been oversold on a short-term basis since January 24, 2014, when the S&P 500 Index closed at 1790. Yesterday, it closed at 1742, or nearly 3% lower.

However, my work shows that in the U.S., the initial phase of these types of selloffs lasts for seven to 10 days before stabilizing (another leg lower is possible, but usually the market bounces first), and yesterday was day seven. Volume hasn't spiked to the levels that normally indicate a capitulation, so we could see some more selling in the next few days. Dip buyers will wait for "clarity" (meaning they don't want to lose their fingers trying to catch a falling knife). When you get into a macro driven selloff like this, there are factors at work beyond "this stock is cheap or expensive." You get forced sellers, people that are levered and wrong and hitting stop losses or margin calls, or those that have to sell because of redemptions. It's these forced sellers, those that have no choice but to sell, that are in charge at this stage of a selloff.

Raghuram Rajan, the head of the Reserve Bank of India, summed up what is going on in the markets particularly well. (He spotted the 2008 financial crisis early, in 2005.) This weekend, John Mauldin's Thoughts From the Frontline quoted him in "Central Banker Throwdown." Speaking about the last week's currency market turmoil, Rajan said,

"Fortunately, I think we've had a few months in India to prepare, given that first inkling that there would be this withdrawal of the money, given the wave of attack we saw in terms of money flowing out. I think we are much better prepared now, but I would still say international monetary cooperation has broken down. ...

"You see, the nostrum amongst economists here is 'Let the prices adjust and things will be fine. Let the exchange rate move; let the money flow out; and you will figure it out.' That is often a reasonable prescription for an economy that has its fundamentals, as well as its institutions, well-anchored. But when that's not the case, volatility feeds on itself. Exchange rates fall. Stop loss limits are hit. More selling takes place. Then some firms get into difficulty because they have unhedged exposures. Government budgets get hit because they're not hedged against currency fluctuations. There are also second- and third-round effects which happen in a country which is not as advanced or industrialized."

U.S. investors aren't driving the bus. Currency traders are, and that is a huge market. We'll have to buckle our seat belts and ride this one out, while using this weakness to buy stocks of companies we like. Again.

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Field Notes: Latin America

By Nick Niziolek

February 3, 2014

Members of the Calamos Research Team recently traveled to Latin America to meet with company management teams from Brazil, Mexico, Chile, Colombia, and Peru. We came away with valuable first-hand insights about the regional macro environment and how companies are capitalizing on this landscape.

The feedback was fairly uniform, with most company management teams expecting a challenged consumer in 2014. The optimists expect a pick-up in consumer activity during the second half of 2014, and most are more positive on 2015. Despite this headwind, there are other regional secular trends and company-specific catalysts that may result in growth opportunities for select companies, and the Calamos portfolios.

Mexico. Uncertainty around the recent "sugar tax"* and the increase in the maximum tax rate to 35% make it more difficult to forecast consumer activity, but most management teams expect weakness at least through 2014. The tone is more optimistic about recent reforms, but managements are realistic that these policies will take time to implement and their benefits will likely be a 2H2014 or 2015 story. Read my earlier post on Mexico.

Our consumer exposure within Mexico continues to be around bottom-up growth opportunities with company-specific near-term catalysts. As Mexico has become a consensus overweight among global investment managers, attractive valuations have become more scarce. We are taking an opportunistic approach, and when Mexico has sold off alongside the broader emerging markets region, we have bought selectively.

We have exposure to Mexican financials, which we believe will realize more near-term benefits from reform initiatives. Select companies offer attractive bottom-up growth potential, as credit penetration increases in this country. We have also identified industrial and materials companies that feed into the energy supply chain, while further benefiting from Mexico's close ties to the improving U.S. economy.

Brazil. The consumer remains highly levered. Actual debt-service costs are likely 1000 basis points higher than what the central bank reports because popular installment loans are excluded from its calculation. While debt-service costs began to fall in the second half of 2013, the central bank has been forced to increase interest rates as inflation remains above target levels. This in turn should negatively impact debt-service costs. Economic growth has now become the Brazilian government's third most important policy outcome, behind inflation targeting and maintenance of the country's credit rating, although the government understands the need to keep growth a very close third.

Despite this dreary economic outlook, there are still opportunities. Most of the macro concerns are already priced into valuations. The Brazilian index is off nearly 50% from its 2011 peak, with currency depreciation playing a significant role.

Within the Brazilian financial sector, we believe there are many underappreciated growth companies that can benefit both from recent changes in government policies and from incremental economic improvements. Where else can you invest in emerging market banks that consistently return more than 20% on equity with loan-book growth in the low-double digits—for less than two times book value?

In recent years, private banks have faced challenges, including a crowding out by public banks that were providing credit more indiscriminately in an attempt to spur economic growth. This resulted in lost market share and slower growth for the private banks. As government has adjusted its policies in 2014 to focus more on inflation and the country's credit rating, private banks can remain selective in their underwriting policies and potentially see an improvement in growth as the lending environment becomes more rational. Despite these positive developments, valuations for the private banks remain attractive. Many global portfolio managers utilize these liquid institutions as proxies for country exposure and are significantly underweight Brazil, given its negative near-term economic outlook. We are also underweight, and while we are monitoring macro developments for a potential inflection point, we maintain some exposure through companies that also have significant near-term bottom-up catalysts that we believe could result in outperformance regardless of exactly when the economic backdrop improves.

We continue to see a strong secular growth opportunity within the Brazilian education industry. With college graduation rates nearing 20%, Brazil remains far behind other Latin American countries, such as Mexico (about 40%) and Chile (about 60%). This is due in part to Brazil's less-developed education system, with some state-run universities reporting lower acceptance rates than Ivy League institutions. Given the limited supply of college-educated workers, the unemployment rate for these grads is effectively 0%, and wage inflation is above average. This has provided a powerful tailwind for private education companies, a tailwind that strengthened when the government began providing subsidized student loans at negative real rates two years ago. Although enrollment has increased, many students are not yet aware of the program's benefits. We expect the program to provide a longer-term catalyst for companies in the education industry, with improving utilization rates in the next two years as initial classes work through their four-year degrees, as well as longer term as a higher graduation rate brings Brazil more in-line with many Latin American peers.

Colombia. We heard universal optimism about Colombia's economic potential, including predictions that Colombia will become the second "rich" Latin American country, joining Chile. Colombia continues to move up in the Heritage Foundation's Economic Freedom Index—the result of recent improvements in trade, business, and fiscal policies. Colombia has moved into the "mostly free" category, ranking behind only Chile within the region.

The opening of peace negotiations with the FARC insurgency has contributed to optimism about further improvements in national security, although only two of five agenda points have been agreed to thus far. Colombia also has strong ties to the U.S., the destination for nearly 35% of its total exports. Better U.S. economic growth prospects could have a positive knock-on effect for Colombia.

To date, our exposure to Colombia has been primarily indirect, as many of our Brazilian, Mexican, and Peruvian holdings generate revenues from this country. However, we are researching several new growth opportunities that may warrant an allocation of capital later this year.

Conclusion
While economic policies and inflationary headwinds create near-term headwinds for Latin American companies, we believe we are getting closer to an inflection point for the region. Meanwhile, our team has identified growth companies we believe can outperform regardless of the economic environment. Drawing upon the insights we've taken from our recent meetings with strong Latin American corporate management teams, we are comfortable allocating capital to select bottom-up growth opportunities. As the economic situation improves, we believe these companies are positioned to benefit from those tailwinds as well.

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Casting Light on China's Shadow Banking System

By Nick Niziolek

January 29, 2014

"China's shadow banking system," the name alone sounds mysterious and uncertain. In recent weeks, this complex system of wealth management and trust products has struck fear into investors, due to apprehension about a potential default. As we follow the ongoing developments in shadow banking, we ourselves are concerned. However, over the long-term we are optimistic for China's plans to further liberalize interest rates and promote financial disintermediation.

During our trip to Asia last fall, we met with the major players within the Chinese banking system, including those with expert understanding of how the banks' off-balance-sheet products work, the magnitude of the market, and the fallout that changes to industry dynamics could have on the larger financial system. Our discussions confirmed the complexity of this financial system. There are varied estimates on size and potential impact, but there’s general agreement that the system has grown rapidly. J.P. Morgan estimates that the shadow banking system doubled in size between 2010 and 2012, equivalent to nearly 70% of GDP, and that it may have grown an additional 30% in 2013.

The shadow banking system broadly refers to an estimated $7.5T* in credit intermediation outside the regular banking system. This Chinese shadow banking system's products differ from those offered by banks in the United States and United Kingdom in that many of the products are directly controlled by the banks and are merely an alternative means to extend credit to their other customers. Few are market traded and the counterparties are non-financial corporate borrowers and investors, as well as retail investors. Trust loans at an estimated $1.5T* represents a non-bank extension of credit (that is, off the banks' balance sheets) in the Chinese shadow banking system and have received increased attention over the past couple years given their outsized growth and increased reports of defaults.

In response to customer demands for higher yields, $1.5T of trust products have been created. The banks have benefited significantly as these products allow them to extend credit outside of the banking system, and thus above the government's stated targets for credit growth. The largest borrowers of the loans underpinning the trusts are local governments, property developers, and corporations looking to fund long-term investments.

The loans in the trusts typically have terms from 18 to 36 months and yields in the 9% to 13% range. Despite these high yields, Chinese investors largely perceive these trusts to be "risk-free" given their implied backing from the banks and government. This system works as long as investors are willing to reinvest every 18 to 36 months or new investors come into the market.

China's government is committed to slowing credit growth and allowing markets to price credit risk through the removal of implied bank and government guarantees. However, the government also clearly recognizes that these longer-term objectives must be balanced with more immediate concerns—including the potential that defaults could spiral out of control and lead to a liquidity crisis and a seizing up of the financial system. This would not be unlike what happened when U.S. banks stepped away from the auction-rate preferred market, leaving investors with illiquid securities. This was the first indication that the financial system was starting to seize up.

Shadow banking is a by-product of innovation within a heavily regulated, traditional banking system that is struggling to satisfy the country's credit and liquidity demands, while providing attractive real interest rates to households and business depositors. The healthy direction for the shadow-banking system would be to improve transparency, appropriately price risks and increase monitoring and control of the market, in parallel to the interest-rate liberalization of the banking system. Unwinding this without fueling systemic risk will be complex because credit is not being priced accurately and nonperforming loans are shuffled around the financial system.

While we have seen more than 50 trust defaults over the past few years, they have been relatively small and easily contained. However, the most recent threat of default was a different matter, given its size ($500M) and initial indications from the Chinese Central Bank that it would not support this product in default. Global markets participants feared that if Chinese investors began to view these trust products as entailed high risk, this changed perception could spiral quickly, causing China's trust and wealth management industries to seize up, with ensuing fallout that could roil the global financial system to the extreme. However, after Asian markets closed on Monday, an unknown "investor" stepped in to purchase the defaulted trust from its current holders. It is widely hypothesized that the unnamed investor is connected in some way to the central bank.

Emerging markets have received a reprieve and a systemic risk has been temporarily taken off the table. Still, this should serve as a wake-up call for those investors who are focusing on the returns in emerging markets without giving equal—or greater—consideration to the risks. We have always been diligent in our monitoring of events and potential consequences within the Chinese banking system, and this certainly won't change.

China is clearly in a period of transition. The government wants the market to set prices and allocate capital, which would help prevent excess leverage in unproductive products. What is important to us as investors is how China navigates this transition. It is our hope that the government sends the right signals, while not disrupting the flow of liquidity within its financial system. The unknown investor that came to the rescue illustrates how the government is trying to balance their nearer-term and longer-term priorities, in this case—communicating the risks of these products without allowing a default to happen.

We expect we will discuss Chinese trusts again this year, as other high-profile trust products will likely default. But, we also expect that our team will be identifying companies positioned to benefit from the longer-term financial disintermediation trends. While we remain underweight to Chinese banks, we are finding new opportunities within the private banking system as e-commerce companies begin offering online banking services and the brokerage and insurance industries benefit from the opening of the world's second largest economy.

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The EM Sell-Off Creates Opportunities for the Active Manager

By John P. Calamos Sr.

January 28, 2014

Currency fears in Turkey, India, South Africa and Argentina, and escalating political uncertainty in the Ukraine are roiling the emerging markets. Investors are responding fearfully, and that fear is causing volatility, leading to more fear, and so on. This downturn may still have some distance to go.

Fear is an increase in systemic risk. It is something that needs to be monitored. At this point, we are of course concerned about the EMs' slide, but we still believe there are many reasons to invest in EMs. It's about being selective.

Although the real problems are confined to just a few countries, the sell-off has cascaded across the EMs. This isn't surprising: market participants often (over)react broadly and emotionally in response to bad news.

As we stated in our most recent economic outlook, "2014: Year of the Fundamental Investor," we expect the nearer-term prospects of emerging markets to be uneven. This creates opportunities for longer-term investors. As the dust settles (which might take a while yet), we expect investors to be more discriminating. This calmer mindset will likely rekindle interest in countries with stronger fundamentals—that is, those that aren't struggling with weak currencies, high current account deficits and fiscal deficits, or elevated levels of political uncertainty.

In fact, in the midst of this acute volatility, we continue to be select buyers of fundamentally strong companies in countries that are currently in a better position for growth. Investors who lump countries like Mexico and the Philippines in with the more troubled ones (India, Brazil) could very well be missing out. As our co-PM Nick Niziolek wrote in his recent posts , these are both countries where positive government reforms are providing an improving backdrop for private sector growth, foreign direct investment and continued economic growth. We also continue to like opportunities in more-export driven economies like Taiwan, which we believe can benefit from the developed markets' recovery.

And what about China? Overall, we're still constructive. The country is in the midst of a far-reaching shift from a manufacturing-based economy dominated by state-owned enterprises to a consumption-driven economy with greater private sector participation. This is a transition that will take time and there will be volatility (inherent in emerging markets), but the Chinese government has many resources at its disposal. The expansion of free markets in China could provide a monumental tailwind to global growth.

Finally, the secular growth themes in the emerging markets are as powerful today as they were before the sell-off. The rise of the global middle class consumer is a mega trend, and for investors who are wary of increasing direct emerging market exposure, developed market companies that provide goods and services to the emerging market consumer continue to be a compelling alternative, in my view.

As always, it pays to be selective. Emerging markets will continue to be volatile, but therein lies the opportunity for the long-term active investor.

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Sherman’s Rant: Passion and The Quest for Investment Excellence

By Gary Black

January 21, 2014

By now, probably everyone has heard about Seattle Seahawks’ cornerback Richard Sherman’s explosive, adrenaline-induced rant following the Seahawks’ victory over the San Francisco 49ers on Sunday. While many viewed Sherman’s rant as rude, disrespectful, and offensive, you have to give him credit for his intense passion, focus, and obsession with being the best cornerback in the National Football League.

I certainly don't condone Sherman's behavior, which inspired hours of social media tweets, criticism, and hate mail. But like him or not, his teammates love him, the NFL brass loves him, and most importantly, the fans who buy Super Bowl tickets love him because of his determination to do whatever it takes to win football games. After being drafted in the fifth round by the Seahawks in 2010—behind many players that in his opinion weren’t in the same league as him—Sherman famously recounted what was going through his mind to a reporter, "When I get to the NFL, I am gonna destroy the league, as soon as they give me a chance." And destroy it he has.

Great investors, like great football players, are also obsessed with winning. While nerdy by comparison, winning in investing is also characterized by intense passion, focus and sheer determination to beat the competition. With about 10,000 hedge funds and 7,400 long-only funds all trying to outperform each other in an environment where everyone is smart and correlations have risen, the investment game has clearly changed in the past 10 years, with Reg FD, company guidance, and the internet leveling the playing field. Being close to the company is now a necessary but insufficient condition to generating strong performance. So is being able to build a 10-year discounted cash flow model with every assumption under the sun about total addressable market, market share, pricing, and margins built in as sensitivities.

In my 25 years in the business, the men and women who get it right most are those obsessed with figuring out the one or two most important drivers of a business, and then researching those factors relentlessly until they are totally sure they have figured it out. Those most obsessed about winning, and most relentless in their research efforts, tend to be the most confident in their conclusions, and thus tend to make the most money for their investors.

At Calamos, we hire passionate, driven analysts who pride themselves on knowing their sectors better than anyone else. They don’t depend on company managements to tell them the answers; they do their own research, and speak with the companies, competitors, suppliers, and customers to find out what is actually happening. Our analysts don’t blindly depend on reversion to the mean when looking at market share, margins or returns. They think about how the company’s investments, positioning versus peers and execution will play out over time in generating cash flows that beat consensus expectations. Our analysts think like owners, and do whatever it takes to understand the company’s strategy, brand positioning, and distinctive competencies.

When looking at potential investments, our analysts identify the one or two most important drivers of the business, do exhaustive research to forecast those drivers, and come up with valuations using different approaches to determine a security’s risk/reward. Finally, they think about timing: A company may have a great business and be attractively priced, but it may not be a good time to invest, or there may allow for a cheaper entry point down the road.

Like great athletes, great analysts and portfolio managers are obsessed with winning—that is, generating higher investment returns than their competitors. It’s what drives the truly great investment athletes in our business. And when we get it right, the adrenaline rush can be exhilarating.

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Perspectives on the Philippines

By Nick Niziolek

January 14, 2014

Those familiar with Calamos know that our approach to emerging markets (EM)is active and focused on countries that are moving in a favorable direction in regard to economic freedoms. In my last post, I wrote about our team's constructive outlook on Mexico, where investor optimism about a broad package of reforms has helped drive an equity rally. Our longer-term outlook on the Philippines is also positive. Among the favorable trends, President Aquino has reduced corruption during the first four years of his term, which has benefited infrastructure improvement efforts by reducing funding leakage and fostering a more attractive investment environment. This is especially important for the Philippines as foreign direct investment is presently the lowest in the region.

The Philippines market finished 2013 with a positive return, but it was a volatile year as the index traded off nearly 20% as EMs sold off in May and June on taper concerns. After recovering more than half of these losses during the outset of the second half of 2013, the market experienced another downward leg following Typhoon Haiyan in early November. The humanitarian impact has been severe, and we expect food inflation likely to remain elevated for several quarters and GDP growth to be temporarily impaired.

However, we expect the economic impact to be short-lived. Also, many Philippine-listed equities tied more closely to Manila and Cebu, which escaped the brunt of the typhoon's impact. October remittances were reported at a record $2.06 billion, with the Central Bank expecting surging November and December remittances as friends and family providing support following the typhoon. This is positive for both consumption and recovery following this disaster. Moreover, demographics provide a tailwind to the country's economic growth prospects. With a well-educated population that includes many English speakers, the business process outsourcing industry in the Philippines has grown rapidly, and is now larger than that of India's.

Overseas Filipino Workers Send Record Amounts Home

Overseas Filipino Workers Send Record Amounts Home

Source: CLSA, Philippine Market, December 30, 2013, Alfred Dy.

When we visited Manila in the third quarter of 2013, business leaders voiced consistent concerns about the need for infrastructure improvements to sustain the country's economic growth; among them, they felt that the momentum that President Aquino had realized early in his six-year term was waning. In recent weeks, we've seen developments that point to an increased commitment to infrastructure spending. In particular, there's been a ramp-up in public-private partnership (PPP) grant award activity. PPPs are business ventures between a public sector and private sector entity. PPPs represent one of the ways that a government can give a larger role to private businesses, to mutual benefit. In the case of the Philippines, the PPP projects in the pipeline run the gamut from building better roads and schools, modernizing of health care facilities and improving airports and power supply. These projects bring both short-term benefits (jobs) as well as longer-term ones (promoting education, commerce and longevity).

The Philippines government has set its sights on awarding 15 PPP projects before President Aquino's term ends in 2016, versus five awarded through 2013. From a dollar-perspective, these projects could amount to more than $4B in infrastructure investments, or four times the $1B already awarded. All these shovels in the ground could provide significant stimulus for the economy as well as provide the infrastructure necessary for sustainable growth.

Significant Ramp-up: Infrastructure as a % of GDP

Significant Ramp-up:  Infrastructure as a % of GDP

Source: CLSA, Philippine Market, December 30, 2013, Alfred Dy.

We maintain our positive view on the Philippines relative to other EM opportunities, but acknowledge it is not without risks. While we are optimistic that we will see progress from PPP infrastructure projects in 2014, we will continue to closely monitor these developments as execution is critical. In particular, we are watching developments related to a water tariff issue, where the government has sought to change terms mid-stream. The positive news is that similar cases have held up in third-party arbitration.

We have used the market pullback to add to consumer opportunities that may benefit from a short-term increase in inflation as well as financials that may benefit from increased investment related to PPP projects and recovery efforts. We're also following opportunities where valuations are becoming more reasonable, both in companies that we believe can directly benefit from increased infrastructure investments as well as those that are positioned to receive ancillary benefits.

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Markets Will Likely Weather Jobs Report

By Gary Black

January 10, 2014

Today's job growth report fell short of economists' expectations, with the Labor Department reporting a gain of 74,000 jobs in December. We believe the market will overlook the weak December employment numbers. The calendar was compressed with Thanksgiving coming late; the weather was bad; and if one considers both November (which was revised up) and December data, the average monthly job growth has been a respectable 160,000.

At the margin, the employment numbers could allow the Fed to take a more gradual approach to tapering or adopt a "wait and see" approach. The December numbers are also inconsistent with the other stronger economic data we’ve seen over the past few weeks (such as ISM manufacturing data, new unemployment claims, ADP’s private sector job growth report, and the trade balance), which has caused consensus estimates for fourth quarter GDP growth to double to around 2.5%.

In our view, stocks remain cheap by many measures. Equity earnings yields of 6.3% (inverse of a forward P/E estimate of 16x for the S&P 500 for 2014 and earnings per share of $115) provide a 340-basis points advantage relative to 10-year Treasury yields at about 2.9%. At this level, the equity return premium still ranks among the most attractive over the past 60 years, and inflation pressures remain subdued.

Globally, Europe and Japan continue to rebound economically, and emerging markets remain stable. Quarterly earnings will move to center stage starting next week. Other than retail and restaurants—which like the employment numbers were similarly affected by the compressed calendar and weather—we believe most sectors are likely to do better versus reduced expectations.

We continue to like equities, and growth equities remain cheap relative to value equities, in our view. We would use the recent market pullback to add to higher growth names with strong franchises in sectors that benefit from secular shifts to mobile, the cloud, and internet/social media; consumer discretionary names tied to housing and autos; and financials that may benefit from the upward slope in the yield curve, increased lending, and stronger equity markets.

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Let the Taper Begin

By John P. Calamos Sr.

December 18, 2013

The Fed's announcement today that it would begin to slow its quantitative easing was met with a roar of approval from the stock markets. While there's no reason to anticipate a string of daily 250-point rises in the Dow, I'm optimistic about the longer-term benefits of the taper for the markets and economy.

We can be confident that the Fed is undertaking a deliberate and well-thought out plan. There's nothing reactionary about what's happening. Chairman Bernanke and his colleagues have latitude to work with, and they've stated their intention to keep the spigot on, maintaining a level of stimulus until a healthy degree of inflation kicks in.

In my view, there can be no doubt that the Fed's unprecedented easing did help move the U.S. economy through an extremely challenging time, but it also caused dislocations in asset valuations and discouraged banks from lending to small businesses and individuals. And even Chairman Bernanke noted that the taper has fallen short of what it set out to do. Inflation has been nearly flat, the velocity of money hasn’t picked up commensurately, and job growth has been measured.

Ultimately, the best fix for the problems that remain are pro-growth policies. A more normal interest rate environment should serve as a catalyst for increased credit access for small businesses, the engine of job growth. Over the past few years, people have increasingly thought of the Fed as the guiding hand of the markets and the economy, but this isn’t really the case. Of course, monetary policy has an impact, but it's only one piece in the puzzle; we also need sound fiscal policy. We can’t tax our way to economic growth.

The Fed's decision from taper talk to taper action affirms the slow—but more importantly, steady—economic recovery in the U.S. The good news seems to be getting better. The U.S. has been driving the global recovery, but we're starting to see a positive global synchronization among major economies. The emerging markets are regaining their traction. China does not look to be in a bubble; and the Chinese government is taking steps that support the economic freedoms that both support growth as well as investment opportunities. Europe is coming back, especially the northern economies. Economic conditions in Greece are also improving, with growth forecasted in 2014. This global synchronization is a positive for U.S. investors and markets, because the strengthening in international markets is not coming at the expense of a U.S. recovery. Instead, it can support it.

While my expectation is that U.S. and global equities will continue to move higher in this environment, I don’t believe that a rising tide will lift all boats. Successful investors have to do more than look at the market, you also have to look in the market. As tapering eases, I believe company fundamentals will play a greater role in stock prices. We're positioned (and have been) for this shift from yield to growth and growth cyclicals. This is an environment where we see considerable opportunities for long-term investors.

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¡Viva La Reforma!

By Nick Niziolek

December 17, 2013

2013 may go down as a monumental year in Mexico's history. Soon after taking office, President Enrique Peña Nieto announced the "Pact for Mexico," bringing opposition parties together with his Institutional Revolutionary Party (PRI) to move forward with far-reaching structural reforms. This was a significant positive development for a country whose political system had been deadlocked for more than a decade. More importantly, President Nieto focused on reforms in education, labor, the financial system and the energy sector—all critical areas for businesses deciding where to allocate capital. The pact's broad scope includes privatization of the energy sector and improvements to lending rights and labor relations.

Also, President Nieto has taken a different approach to domestic security issues, with local headlines increasingly dominated by economic optimism, as opposed to ongoing updates on the drug war. While more progress needs to be made on security issues, an improving economy could ultimately provide a headwind to organized crime in the region.

Given our positive view on Mexico and the impact reforms will likely have on multiple industries within its economy, one might infer a case for broad-based exposure to the Mexican equity market via a passive strategy or ETF. However, we believe that active management remains crucial for capitalizing on Mexico's investment opportunities; bottom-up selection provides us with an important advantage in adding value.

Often, the emerging market investment story focuses on the consumer, but many of the larger consumer companies in the Bolsa (the Mexican Stock Exchange) trade at rich valuations. So, although our bottom-up research has uncovered opportunities tied to the consumer, it's not our greatest area of emphasis in Mexico. Instead, our bottom-up work in Mexico is focused primarily on industries and companies we believe are most likely to benefit from pending reforms and the re-acceleration of the Mexican economy. We've found opportunities within the Mexican banking sector, where companies are positioned to benefit from strong loan demand and improving credit and asset quality. Through select materials positions, we've sought to benefit from increased demand from the energy sector for a range of infrastructure needs, such as new plants.

Mexico's reforms and economic progress provide opportunities for companies outside of Mexico as well. Our team's bottom-up process focuses on where a company's assets are domiciled and where its revenues are generated. These are important drivers in understanding a company's growth potential and broadens our ability to access the growth story we see unfolding in Mexico.

For example, we believe the railroad industry will be critical to Mexico over the medium-term, with energy reforms and a North American manufacturing resurgence supporting significant growth potential. Yet there are limited Mexico-domiciled companies from which to choose, leading us to also seek out developed market opportunities with significant links—such as revenues and assets—to the Mexican rail industry.

We believe our revenue-based approach also has been advantageous in the energy equipment and services industry. We expect significant growth within the Mexican oil industry on the back of reforms, but there are limited choices for investing in local companies positioned to benefit from these improvements. To address this, we have also identified several global energy and equipment companies that we believe can capitalize on the increased demand we expect over the next few years.

Moreover, while the tapering of quantitative easing in the U.S. and a stronger dollar may create headwinds for many emerging markets and emerging market currencies, we believe Mexico is not as vulnerable as countries struggling with weakening currencies and current account deficits, such as India and Brazil. Given its close ties to the U.S., the Mexican economy could benefit notably from U.S. economic recovery. Reflecting this view, as U.S. taper talk unsettled the global market in May and June, we used the sell-off to opportunistically buy Mexican equities.

We believe the growth story in Mexico underscores the benefits of an investment process that is both top-down and bottom-up. One might argue that a top-down view is the most critical element in emerging market investing; incremental improvements in economic freedoms may have significant long-term impacts on capital flows into these countries and the growth potential of the companies competing in these markets. Yet, in our opinion, a correct top-down view is only half of the solution. Strong fundamental research remains essential, as not all companies will benefit in equal measure from our top-down outlook. Moreover, many beneficiaries may be located outside of a particular emerging market.

Heading into 2014, we remain optimistic about the Mexican economy and believe we have identified a number of strong bottom-up opportunities that will continue to benefit from these positive developments. ¡Viva La Reforma!

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Take the Data, Leave the Cannoli

By Stephen Roseman

November 5, 2013

Technology has transformed consumers' lives—smartphones, tablets, streaming video, social media, near-ubiquitous wireless connectivity, MMOGs (massively multi-player online games), to name a few. Even on an airplane flying at 35,000 feet, we can shop online, post news of our purchase to our social media accounts, enjoy the support and approval of our friends regarding said erstwhile purchase, and then return to Words with Friends. Many of these online experiences, or even the words to describe them, didn’t exist 10 years ago.

For all of technology’s influence on our lives as consumers of "stuff" (both material goods and media—music, movies, etc.), the impact of technology on the companies selling us the stuff is as great, if not greater. The use of mobile devices for shopping and buying is one example. According to one study, 31% of web traffic today originates from a mobile device. If you’re a retailer, you have a lot less screen real estate to convert your traffic into a sale, compared with a laptop or desktop. Traffic is good, but retailers only get "paid" on the conversion when they ring the (sometimes virtual) register.

And that traffic can also be heavily influenced by the lightning speed of technological change. Recently, a major email service provider changed how solicitous emails were handled. Messages from retailers started being automatically delivered to a previously non-existent inbox—an inbox most people weren’t aware of. More than a few retailers mentioned a drop-off in their web traffic and possibly even their store traffic. After all, if you don’t get the message about a big sale from your favorite retailer, you’re not going to make a special trip to the store or visit the website.

The impact of technology on retailers extends beyond the customer-facing side of things. There are seismic shifts occurring throughout the retail business that customers don’t see or feel. Of course, many readers are aware of the increasing automation in the distribution centers that fulfill online orders, but it doesn’t end there. Retailers are able to optimize their offerings, prices, and availability of products and services to consumers by the time of day, customer browser type, or zip code. While largely invisible to us, it’s game changing for companies. Companies are able to use radio-frequency identification (those stiff little tags you cut out when you take your products home) to better manage and move inventory and control “shrink” (that’s theft, to you and me). Companies can also “geo-fence” at a more granular level (for example, to track when a mobile device—and its attached consumer—enters a mall).

We’ve come a long way since the days of the five-and-dime store, and it’s impossible to know what technologies we’ll be writing about in 2023 or even what words will have entered the consumer’s lexicon by then (omni-channel, anyone?). What I am sure of is that technology will continue to change consumer industries and consumer behavior. Mostly for the best, I believe.

So, what are the implications for finding investment opportunities in the consumer sector? It’s our job as investors to stay on top of changes and understand which companies are likely to win and which are likely lose. There are many well-known winners in the retail technology arms race, but what’s really exciting for us as investors is finding the less obvious companies with businesses that are ready to inflect because of the way they are using technology to enhance the consumer experience. Here are some things we look for:

Companies that go fast … but not too fast
We want companies that are proactively adapting to change. In the early days of the internet, many companies thought of their websites as virtual billboards. Those that went a step further and were earlier adopters of transactional websites gained a leg up on those that didn’t.

While we like early adopters, we don’t want companies that move so fast that they upset the apple cart with a single-step shift in their business models. Successful companies don’t lose sight of risks when they implement new technologies. For example, one early adopter recognized the potential of radio frequency (RF) inventory systems, and began by running RF systems alongside human inventory management. This allowed time to iron out the kinks before making a larger shift.

It’s shopping, not buying
Staying at the cutting-edge of technology innovation is important, but it’s not the only determinant of success. We also want companies that are staying close to consumers. Consumer activity isn’t all about convenience—a fact that’s often missed by investors. There’s a ritualistic activity in shopping, otherwise it would just be buying. This is why the Internet didn't put malls and lifestyle centers out of business—they're bigger than ever—even though all of the internet bulls were calling for their demise 13 years ago. It's also the reason that streaming didn't put the exhibition movie business out of business (also bigger than any time in history). People want the experience of going to a theater. In other words, it's not just about the consumption of a product, it’s about how the product is consumed. If it were just about the content, we could “eat” intravenously but we don't; sometimes we want a trip to a steak house, sometimes we want to zip through a fast-food drivethrough.

Investing successfully is about bringing together different skillsets, and they’re not all financial. To find the future winners and avoid the losers before it’s obvious to everyone else, you need to be a student of industries, companies and history—and of what consumers want.

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Washington: Light At the End of the Tunnel?

By Gary Black

October 3, 2013

The Republicans continue to lose ground in the public opinion polls as the federal government shutdown drags on. As the President scores almost daily body blows against the GOP (laying the foundation for blame in next year’s mid-term elections if the economy slows with tapering), Republicans surely are trying to extricate themselves from what looks increasingly like a losing fight. In the latest CBS news poll released this morning, Americans overwhelmingly disapprove (72% to 25%) of shutting down the government. Even among those who disapprove of Obamacare, 59% disapprove of shutting down the government over the issue, versus 38% who don’t. Additionally, 44% of Americans blame Republicans for the shutdown, versus 35% who blame the President and Congressional Democrats. In the latest Quinnipiac poll released on October 1, 17% of voters approve of the job Republicans are doing versus 74% who disapprove—a record-low favorability rating.

The President offered a clear opening for the Republicans in his speech yesterday afternoon. According to Obama, the way out for Republicans is to give up fighting the Affordable Care Act, which already has been passed by both chambers and upheld by the U.S. Supreme Court (not to mention, the Affordable Care Act was a key issue in the Presidential re-election last year, which Republicans lost).

Instead, Obama said he is open to a good budget deal without tax increases, and what is being referred to as a “grand bargain” by legislators. This would include entitlement reform, corporate tax reform, chained CPI (that is, cost of living adjustments for Social Security and veteran’s payments tied to CPI), and most importantly, reduced defense spending cuts as phase II of the sequester kicks in on January 1, 2014. In return, Republicans would have to pass a clean continuing resolution and increase the debt ceiling before the October 17 deadline.

How likely is such a deal over the next two weeks? Representative Paul Ryan is leading this charge with the blessings of Senate Minority Leader Mitch McConnell and House Majority Leader John Boehner. It would allow tea party Republicans to tell their constituents they got something from the President, not a repeal of Obamacare but something potentially much bigger.

Many of the legislative elements of the grand bargain have long been discussed in Washington, and the structural elements could be attached to legislation that contains a clean continuing resolution and an increase in the debt ceiling. Given the Republican’s weakened position after three days of shutdown, and Boehner’s comments this morning that he would suspend the Hastert Rule (the practice of passing legislation with majority of the majority party), he clearly is sending a message that if push comes to shove, he would cobble together enough moderate Republican votes with the vast majority of House Democrats to avoid a debt-ceiling debacle. That increases the odds of a grand bargain, which would be very good for equities.

We remain bullish and view the recent market weakness as an opportunity to buy equities.

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Don't "Tin Cup" It

By Jeff Miller

September 19, 2013

Roy (“Tin Cup”) McAvoy: “If I had it to do all over again, I'd still hit that shot.” Romeo: “Man, you'd bury yourself alive just to prove you could handle the shovel.”

Tin Cup, 1996

Eventually, many investors face their own “Tin Cup” moments, when they think they are smarter than the market or the management team running a business. Some—the activist investors that make the news—may be so blinded by their egos that they believe they can turn around a poor-performing business, if only they owned a large stake, threw out the current management and ran it themselves. With few exceptions, we think scenarios like this are recipes for disasters. In Tin Cup moments, investors ignore what made them good in the first place, which was hitting the ball down the middle of the fairway and then chipping onto the green for a par. Boring? Maybe. Effective? Absolutely.

As value investors, one of our trading rules is “don’t Tin Cup it”—that is, don’t try to reach the green with a subpar company. Most companies that are bad are bad for a reason: they have toxic cultures, bad management, second-tier products, etc. Turnarounds and comebacks make for great storylines in the movies, but in the real world, these stories usually are just that—stories. Weak companies tend to stay weak, and strong companies tend to stay strong. For years, this truth has been the basis of our team’s value investment process: find strong companies first, then buy them when they are cheap.

So how do we do this? “Cheap” is straightforward. “Strong” is where the work comes in. For us, a strong company is one that earns a high return on invested capital and can sustain that high return over time. The trick is finding the companies that “can sustain that high return over time,” which is why we spend a lot of time researching companies and visiting with management teams.

While most people can tell you what makes a strong company, far fewer can identify them. Think about companies like people: All of us know how to look as fit as Brad Pitt; it’s actually quite simple so long as your genetics aren’t totally against you. Workout hard and regularly while eating a high-protein, low-carb diet. Do this religiously for three to six months and voilà—Brad Pitt in chinos. But then why don’t more people look like Brad Pitt? Lack of discipline, time, energy, desire.

It is no different in Corporate America. Many times we hear investors say, “If XYZ company just acts more like ZYX company, it can earn a 15% return on equity and trade at 15x earnings.” Well, yeah. But the fact is that XYZ company is unlikely to act like ZYX, absent a serious cultural and management change.

Some companies are just miserable places to work, which drives away their human talent. Some lack leadership, so management drifts from strategy to strategy, always with a new story to tell but never really making any money. Others are stuck making a second-rate product that is in decline. Without a major business shift, these businesses are destined to earn mediocre returns and trade at commensurately mediocre multiples. There’s not a lot of money to be made in these types of companies.

Tin Cup McAvoy: Suppose there's this guy, and he's standing on the shore of a big wide river, and the river's full of all manner of disaster, you know, piranhas, alligators, eddies, currents, stuff like that. Nobody'll even go down there to dip a toe. And on the other side of the river's a million bucks, and on this side of the river is a rowboat … I guess my question’s this: What would possess the guy standing on the shore to swim for it?

Dr. Molly Griswold: He is an idiot.

Ah, that brings us back to those activist investors who are in the news all the time, taking on poor management teams and restructuring businesses. To paraphrase Warren Buffett, when a good manager meets a bad business, usually the business wins. We’ll stick with the strong businesses, thanks.

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Markets Climb the Wall of Worry

By Gary Black

September 10, 2013

The short-term worries that troubled U.S. equity investors in August have continued to melt away—that is, they seem to have been resolved or discounted by market participants in September. Here’s what we’re seeing:

Syria: A military conflict between the U.S. and Syria is likely to be avoided. The White House has seized upon the Putin-led proposal to allow Syria to surrender its chemical weapons, although the details are still undetermined. President Obama has a fraction of the votes needed in the Republican-led House to launch even a limited attack on Syria, echoing the sentiment of 60% of the American public who opposing a military strike. I expect Obama’s televised speech tonight will likely open the diplomacy door wider.

Tapering: The market appears to have baked in the expectation of an announcement next week that the Fed will gradually reduce its bond buying from $85 billion per month to $75 billion per month, accompanied by language that gives the Fed lots of room to reverse course if economic conditions worsen.

Fed chair: The market also looks to have discounted that Larry Summers will become the next Fed chair, rather than Janet Yellen. The announcement is likely two to six weeks out, depending on the outcome of near-term events in Syria. Former Treasury Secretary Tim Geithner has apparently thrown his support behind Summers, which has led to speculation that Yellen will withdraw her candidacy quietly.

Debt ceiling and continuing resolution: We expect Congress to pass a continuing resolution this week, kicking the can to December 13 (one week before Congress’ winter recess) and avoiding the spectacle of a Republican-led government shutdown set to go into effect on September 30. This could be accompanied by language raising the debt ceiling.

German elections: Polls indicate that Angela Merkel’s Christian Democratic party will handily win the September 22 election over Peer Steinbruck’s Social Democratic party, paving the way for Merkel to remain Chancellor for a third term. Once her party wins, we expect further softening in her European austerity language.

Other positives: Global automotive sales continue to soar; China’s industrial production, exports and retail sales are all stronger than expected; Japan’s GDP growth was even stronger than expected in the second quarter (3.8% versus an estimate of 2.6%), and a new government stimulus package to counter a doubling of sales tax is likely this month.

Conclusion
The S&P 500 Index is already up 3.0% this month, having retraced almost all of August’s 3.1% decline. We believe we are in the mid-cycle of a secular bull market, with equity earnings yields of 6.8% (1/2014 forward P/E estimate of 14.6x), providing a 380 basis point advantage relative to 10-Year Treasurys now pushing 3.0%. This 380 basis point equity premium would still rank among the cheapest 20% equity yields (relative to bonds) over the past 60 years. Putting this differently, if S&P 500 earnings grow from $110 in 2013 by 5% per year (equal to estimated nominal U.S. GDP growth over the next few years) to $125 in 2016, and long-term interest rates move up to 4%, we would expect a normal P/E multiple of 18x to 20x, based on what multiples have been over the past 50 years when long-term interest rates were in the 4% to 6% range. This would equate to an S&P level of 2250 to 2500 by 2016, and a compound growth rate of 12%, plus a current dividend yield of 2.1%, for an annualized total return on equities of 14% to 15%.

U.S. Equities: Attractive vs. Bonds

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Perspectives on India

By Nick Niziolek

August 12, 2013

Financial headlines are focusing on deceleration in emerging markets and near-term revenue and earnings pressures for companies that derive revenues from EMs. There’s been considerable press attention given to India, as structural issues are being complicated by pending elections, investment-led slowdown, and sputtering foreign direct investment policies. These in turn are contributing to a weaker rupee, which is especially unwelcomed in  a consumption-driven economy.

In our emerging market portfolios, we have been reducing exposure to India throughout the year as inflation continues to tick higher, growth remains subdued, and current account deficits remain high.  However, it doesn’t mean there aren’t still reasons for investors to have exposure to Indian companies.

The EM story isn’t one dimensional . The growth is about more than big U.S. and European companies selling soda and chocolate to EMs, or even providing luxury goods to a new crop of  billionaires.  EMs are suppliers to worldwide markets, in ways that extend beyond commodities.

We have pared exposure to India but are not jettisoning Indian companies wholesale. We are positioning portfolios to capitalize on companies that are tied to developed markets and which are less vulnerable to a weakening rupee. India is home to global outsourcing companies, staffed by highly educated professionals, as well as companies which are supporting the worldwide demand for health care by producing affordable generics.  These are the areas that we are presently most interested in, along with some defensive staples, like tobacco companies, which tend to hold up well even when other domestic-demand-driven companies slow.

Our research efforts are focused on identifying these bottom-up growth stories, within our top-down framework.  Simply put, if the developed markets get stronger relative to EMs, it doesn’t mean that EM growth opportunities aren’t still out there.

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EMs: Still More Good News than Bad

By John P. Calamos, Sr.

August 12, 2013

The good news is that we are in a global market that provides opportunities around the world. The bad news is that we are in a global market, so whatever happens anywhere affects us all.

Today, the Wall Street Journal pronounced on the front page, “Emerging World Loses Growth Lead,” citing declines in global trade and improved conditions in the developed economies.  The WSJ cited data from Bridgewater Associates L.P. that “for the first time since mid-2007, the advanced economies, including Japan, the U.S. and Europe, together are contributing more to growth than the emerging nations.” And in July, the IMF announced revisions to its growth estimate for emerging and developing economies to a “more moderate pace” of 5% in 2013 and 5.4% in 2014, with China’s GDP growth estimated downward to 7.8% for 2013-2014.

Less robust growth in the emerging markets (EMs) isn’t welcomed, especially when we don’t know where the bottom will be, but investors shouldn’t get ahead of themselves. Expansion levels remain entirely respectable, both in absolute and relative terms.  After all, the U.S. is staging a recovery with a growth level well under half of that of the IMF’s estimates for the EMs.  Most of us are quite happy about it.  Even the WSJ notes, far further down in its article, “The latest rebalancing of global growth is nascent and could reverse, should emerging economies bounce back even a little.”

As EMs mature and expand, it’s to be expected that growth rates would decelerate from torrid levels. It should also come as no surprise that their economic expansion is not proceeding along a straight-line upward trajectory.  That’s not how economies work. And we should be happy that the developed markets are regaining their footing—to my way of thinking, that’s good for the global economy as a whole.

EMs: Still Doing Their Fair Share for Global Growth

If 5% growth in the EMs cause for extreme consternation, that points to a bigger problem. When global economy needs the EMs to deliver rapid growth, year over year to stay afloat, that’s bad news for the global economy.  EMs can’t be expected to go it alone, dragging the developed markets forward indefinitely. Developed markets must do their share, striking the right balance between capitalizing on EM opportunities without becoming overly dependent on them, whether that’s for loans or export markets.  

Although GDP is decelerating, EMs still look well positioned to be an important driver of economic growth, thanks in large measure to the rise of a middle class. Of course, consumers do adjust their spending habits in tougher economic times, but the exponential prosperity of the EM consumer class provides sustainable opportunities for companies worldwide, even if GDP growth dips to more modest levels—assuming that growth is sustainable.

Moreover, many of the EMs have healthy debt-to-GDP levels and as the EM consumer class grows, we would expect to see an increasing focus on services within EM economies. Over time, this diversification should help smooth some of the bumps in the road that have resulted from having economies dominated by manufacturing and commodities.  And although conditions are different in every country, there have been some noteworthy bright spots, such as China’s recent decision to allow banks greater flexibility in setting interest rates for borrowers.

While economic conditions matter, ultimately it is secular growth themes, not short-term GDP data, that underpin the EM investment story.  So, the deceleration we have seen thus far shouldn’t fundamentally negate our view of the opportunities. The recent volatility does however remind investors to do their homework.  This choppiness will continue as EMs seek to manage their own growth against the backdrop of expanding importance in the global economy. The potential end of QE in the U.S. won’t make things any easier, either. As investors, the key is to be aware of the risks of each country and company. We are continuing to find many exciting companies in EMs that are doing the things that we believe can lead to sustainable growth potential for investments. Alternatively, we are accessing the secular opportunities through developed market companies. By doing both, we believe we’re especially well positioned.

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Welcome to Wonderland

By Jeff Miller

August 9, 2013

“If I had a world of my own, everything would be nonsense. Nothing would be what it is because everything would be what it isn't. And contrary-wise; what it is it wouldn't be, and what it wouldn't be, it would. You see?”

—Alice, in Lewis Carroll’s Alice in Wonderland

What’s good is bad and what’s good is good, depending on where you are, you see?  When Ben Bernanke answered questions on June 19, he caused consternation in the markets by stating that the Fed would, sometime in the near future, start to “taper” its bond purchases. Not stop buying bonds and definitely not start selling them—just “tapering.” In the next four trading days, the 10-year Treasury yield moved from about 2.17% to 2.65%, faster than you could say “leveraged carry trade.” Since then, it has basically gone sideways.


The stock market initially sold off dramatically, with the S&P 500 Index declining about 5.6% in the four days from June 19 to June 24. Then, unlike the bond market, U.S. stocks changed course and started to go up again. Why? Because what is good is good for stocks. Rates are so low that an increase in borrowing costs for a strong operating business is immaterial. But a stronger economy?  That is material.  A stronger economy, where more people are employed and buying goods and services, can help drive earnings higher for most large U.S. companies because they are operating very efficiently.  Hence, an X% pickup in revenue could easily lead to a 1.5 or 2 times X% pickup in earnings. That’s powerful.  And it took the stock market a few days to remember that what is good for the economy is good for stocks, taper or no taper.


Even in Wonderland, endings are inevitable, as its king stated:  “Begin at the beginning … and go on till you come to the end: then stop.” This is proving a harder truth for bond investors to accept. The bond market, unlike the stock market, clearly is afraid of the end of quantitative easing (QE). Rates are extremely low by historical standards. The last time they were this low for this long was in the early 1950s. If you are long a lot of plain vanilla bonds, higher rates mean lower prices for your holdings—the math is brutally simple.  Sure, you can hold them to maturity, but do most investors really want the current paltry yield of the 10-year Treasury for the next 10 years?


Since 2008, many investors simply may have been trying to avoid losing their proverbial heads. It brings to mind a conversation between Alice and the Cheshire Cat.  Alice asks which way to go from here, but admits she doesn’t much care where she goes. I think a lot of investors have not much cared which way they went during the past five years, so long as their investments didn’t go down. Investors are now learning that not caring which way they go from here can lead to losses in bonds as well.


Bond investors are justifiably skittish. I think that many have quite a bit of cognitive dissonance going on right now,  not unlike the White Queen, who sometimes “believed as many as six impossible things before breakfast.”  Bond investors have seen some losses, but now those losses have  stopped (for the time being).  For about month, stocks have been trading in a narrow range, but intraday, there have been mini-rallies and sell-offs based on the bond market, which has been moving based on rumors of a taper starting in September versus December.


Really? The markets care that much about whether the Fed tapers in one month or in four? Apparently, yes, it does. The bond markets are in such a state that a three-month difference can send yields higher (or lower) and send stocks in the opposite direction, at least in the very short run. These bond market moves are usually based on a parsing of the speeches or testimony of various Federal Reserve governors, leading bond “investors” to pay more attention to rumors than to fundamentals. This is certainly one way down the rabbit hole, as the Fed has warned about for years, including  in 2002, when then-Governor Bernanke’s commented on the “unhealthy tendency of investors to pay more attention to rumors about policymakers’ attitudes than to the economic fundamentals that by rights should determine the allocation of capital.”


Right now, Ben Bernanke and the Fed are trying to wean markets off of QE and get them focused on the idea that a taper will begin if—and only if—the U.S. economy is getting stronger and notably better than it is today. A stronger economy will be good for earnings and, presumably, good for stocks and the stock market, which should ignore the bond market noise and focus on fundamentals. What’s good is good again.

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The Times They Are A-Changin’

By Stephen Roseman

August 6, 2013

Since the U.S. credit crisis began, economists and investors alike were taken aback by how well consumer spending held up, especially for relatively “small ticket” consumer discretionary items—iPads, shoes, handbags, dining out, et cetera.  In a nutshell, people were spending on small-ticket  “feel-good items” while relatively big-ticket durables (appliances, cars, houses) bore the brunt of the consumer slowdown.

Well, to quote a young Bob Dylan in 1964, “the times they are a-changin’.”  Fast forward to 2013, and many auto- and home-related businesses are going gangbusters.  We’re now seeing the inverse of what we saw over the past five years.  Now companies from restaurants to apparel and cosmetics retailers can’t explain their sudden, relative slowdown.  In the meantime, auto dealers are putting up year-over-year positive growth numbers that in some cases, they have never seen before.  Purveyors of pricey home décor, appliances and furniture are continuing to surprise to the upside, driven by seemingly insatiable consumer appetite.

So, what happened?  It’s likely the rebounding “wealth effect.”  As was well-documented in the recessionary period after the credit crisis, as well as the dot-com bust, as people lost wealth in their homes and/or retirement savings, whether on paper or realized, they reined in spending dramatically.  The inverse of that dynamic has taken hold again, as it did after the dot-bust.  In brief, from where I sit, consumers’ shopping habits have shifted from “income statement” related small purchases to “balance sheet” related large purchases.  Said differently, the items that require good credit, and potentially financing—houses, cars, RVs, boats, et cetera—are enjoying a massive resurgence from the (deep) cyclical lows they fell to post-crisis.  This is one of the outcomes that the Fed had hoped for with a cheap (free?) money  policy. 

The sales recovery of items big and bigger is driving companies that make big things to do well and increase hiring. In turn, this drives better confidence and ultimately more spending on big things.  Well, little things, too, as demand for small-ticket items is fine.  But it’s the pace of the big-ticket recovery that is breathtaking.  We truly look to be in a stock-picker’s market, with big differences in how companies are executing and winning market share.  How long can it last?  Stay tuned. We can hope that we’re singing a different Dylan tune:  “Don’t think twice, it’s all right.”

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You Want Me to Do WHAT with my Inventory?

By Stephen Roseman

July 31, 2013

It's not only investors who have been risk-averse since the credit crisis. Of late, it seems that plenty of company managements, especially in retail, have been similarly concerned about repeating their collective experience of the credit crisis.

The only difference is that instead of investors underweighting equities, many companies have decided to reduce "inventory risk," at least with respect to their corporate balance sheets. Inventory risk is a euphemism for buying too much of something that doesn't sell. Really what these companies are doing is asking vendors and manufacturers to hold more inventory on THEIR balance sheets and take on more inventory risk themselves. With friends like that, who needs enemies, right?

The problem is that not unlike investors who have underweighted equities, the decision to buy too little inventory (read: future potential sales) means that many companies are underperforming the economic potential of their business in exchange for better managing quarterly earnings. Of course, this is bad for everyone when it happens. It's unfair to the vendors that need to earn to their potential so they can design/invent/create new products. The retailers generate lower revenues, which in turn means they create fewer gross margin dollars to offset operating expenses. This leads to management cutting expenses (including jobs) to preserve their bottom line, ostensibly to make investors happy with lower-than-potential earnings. Not a great outcome for most stakeholders.

It's not surprising that the retailers that have excelled historically have followed a fairly simple formula: They have what their customers want to buy, in stock when their customers want to buy it, and at the price that their customers will find sufficiently compelling while also allowing the retailer to generate attractive gross profits. Typically these businesses were focused on being the best retailers they could be, without regard for quarter-to-quarter reporting.

I know that one can make a reasonable argument that being underweight inventory is a great way to protect that bottom line in case of another slowdown. The issue at hand is that, as investors, when we invest in companies that can grow and thrive, it is out of our "risk bucket." We WANT companies to take the risks that made them interesting and/or differentiated businesses with the potential to generate high returns on capital. Otherwise we could all be better served keeping our money in the relative safety of Treasurys, which are likely a better bet than an under-inventoried retailer, if it's safety we're after. But that won't allow us to compound capital so that we may outrun inflation or build wealth. Here's to hoping that retailers build more inventory.

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When Analysts Get Mad at the Companies They Follow

By Gary Black

July 17, 2013

I always find it hilarious when I read a research report where an analyst gets mad because a company didn’t communicate to them that it was going to blow a quarter.

The company isn’t supposed to do the analyst's job. The company's role is direct analysts and investors to publicly available (hint: past) information that allows us to make our own forecast of earnings, cash flows, and ultimately intrinsic value. Under Reg FD, companies can't feed analysts anything material and non-public, or they would have to tell everyone together.

I recently read a report where an analyst bemoaned the fact that a company provided downward guidance without warning him first. I thought, "what planet is this analyst from in thinking that the company should tell investors that the company’s guidance was off?" That's surely the job of the analyst, not company management.

Great analysts get into the weeds of a company's business to figure out what is going on in the underlying market, predicting share trends, assessing product innovation, pricing, competitive plans, spending, etc. so they can be in front of a company missing or beating guidance. It’s not the job of company management to spoon feed analysts information. When analysts start getting mad that a company didn’t tell them it was going to miss, they should look in the mirror and ask themselves, what value are we adding here?

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On Hogs and Opportunity

By Gary Black

June 24, 2013

“Big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they'll go after it.”
-- Richard Fisher, Dallas Federal Reserve President

It should come as little surprise that market volatility has surged in the wake of Chairman Bernanke's comments about tapering quantitative easing (QE). Fast money chasing the latest move may open up a big opportunity to buy great growth names at 5% to 10% off. In my view, the Fed has presented us with two outcomes: Either (1) the economy improves sufficiently for the Fed to throttle down QE and let long rates rise to 3 to 4% (which I see as a long-term positive) or (2) the economy stays sluggish and QE continues.

I'll choose either option.




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Less Fed Intervention Would Be Good for the Economy

By John P. Calamos Sr.

June 16, 2013

With 15 consecutive quarters of economic growth, a strengthening housing market and other improving data, investors are now increasingly focused on what happens when the QE (quantitative easing) party begins to wind down. I think markets are—as they often do—looking at things from a "glass half empty" perspective. The Fed will be most likely to back away from QE because the economy is showing sustained signs of improvement. It would be time for the crutches to come off the patient.

Yes, when the time comes, tightening the spigot will be complex given the magnitude of the easing. But that same magnitude also provides the Fed with considerable flexibility. QE isn't an "on-off" switch. Decision makers at the Fed are well aware of the task at hand and I believe that they will act deliberately.

If history is any guide, a reduction in QE will likely cause choppiness in the markets, but I believe that ultimately, less Fed intervention will benefit the economy, longer term. While decisive action in response to the Great Recession was understandable, the ongoing role of QE3 in the recovery is debatable.

As the chart below shows, the Fed's actions have contributed to a dramatic increase in money supply. The problem is that money hasn't moved through the economy at anything close to a commensurate rate, as illustrated by a decline in the velocity of money.

The amount of money in the U.S. economy has increased, but the money hasn't moved.

The amount of money in the U.S. economy has increased, but the money hasn't moved

Too much of the money from QE is sitting in the banks. Smaller businesses still struggle to get capital because there’s little incentive for the banks to lend to them. So, how do we speed up that velocity? Moderately higher rates would provide the much-needed carrot. More normal rates (say, a yield of 4% rather than 2% for the 10-year Treasury) have historically been associated with higher P/Es. (For more on this, read the recent post from my Global Co-CIO, Gary Black.)

Of course, inflation is a concern. The worse-case scenario associated with an end to QE would be a repeat of the 1970s, when inflation came roaring back. But inflation seem seems well contained within the U.S. economy at this point. As we noted, the Fed doesn't have to take an all-or-nothing approach, and instead can moderate its course as it goes.

Inflation remains below 2% target

Inflation remains below 2% target

To look at it another way, think of the economy as a train. The Fed may think it's driving the train—and many investors may think so as well. But small business is the engine of job creation, and in turn, lasting economic health. Stoking the engine of small business is overdue.

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P/Es have Risen in the Wake of Rate Increases

By Gary Black

June 13, 2013

For those concerned about the potential negative impact of rising rates, here's some encouraging research on the relationship between P/E ratios and U.S. Treasury yields during the past 60 years. P/Es were actually higher when long-term Treasury yields were in the 4% to 6% range than when they were in the 2% to 4% range, given that long-term Treasury yields under 3% are usually associated with high tail risk uncertainty. So, while an increase in long rates from 2% to 3% or even 4% may unsettle the markets near term, it may portend better economic growth and less tail risk ahead, which historically has been good for both earnings and multiples after the initial shock.

SP 500 Trailing P/E Ratios and 10YR Treasury Bond
Past performance is no guarantee of future results.
Source: Empirical Research Partners Analysis via Federal Reserve Board Click Here to Send Feedback to the Investment Team

Welcome to the Calamos Blog

By John P. Calamos Sr.

May 31, 2013

On behalf of the Calamos Investments, I would like to welcome you to our new blog. The goal of this blog is to enhance our ongoing dialog with you, and we look forward to sharing our perspectives on investing, the economy and the global financial markets. Reflecting the depth of our organization, in the months to come, you’ll find posts from a number of our investment professionals, as well as from me and Global Co-Chief Investment Officer Gary Black. Please feel free to submit your comments or questions, which we will seek to address in future posts.

We hope that you enjoy the blog and visit often.

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What Type of Investor is Your Value Fund Manager?

By Jeff Miller

May 29, 2013

The Great Existential Question (no, not "what is the meaning of life?"—that's easy): What Type of Investor is Your Value Fund Manager?

So you think all value managers are the same? In theory, you're right, just like all steaks are the same (Kobe and chuck are both beef), all cars are the same (a Ferrari and a Hyundai will both get you to your destination) and all planes are the same (I'll take the Boeing over the Tupolev, thanks). All value investors are also the same, since we all want to buy stocks that are cheap.

In reality, just as in other aspects of life, the answer is more complex. In value investing, there are generally three types of investors: deep value, relative value, and opportunistic value. Deep value managers focus on liquidation or asset plays—what they can get for selling off the pieces of a company. In our view, this type of investing is quite risky, as it relies on a few concentrated bets in what are usually fairly poorly operating businesses (if they weren't poor businesses, they wouldn't be in their situations in the first place). Relative value investors look at the price of stocks versus a benchmark and try to buy companies that are cheaper than their peers, usually without regard to the overall level of prices (hence the "relative").

The Calamos Value Strategy is different. The Calamos Value Team utilizes an opportunistic value approach, looking for strong operating businesses that are temporarily undervalued by the market. We focus on the operations of the business: how it makes it money, its defensible barriers to entry and proprietary technologies, and the near-term outlook for those cash flows.

When we find companies that meet our fundamental operating criteria, we wait until the market gives us the opportunity to buy them for a low price to those free cash flows. Some great operating businesses never get cheap enough for us to buy them. Those are like the $300 beef tartare at Nobu. It looks amazing, and I'm sure it tastes amazing as well, but as a cheap-at-heart value manager who still uses a Blackberry, there's no way I am going to order it unless it's on sale. But if I stumble upon an amazing French bistro serving the most amazing charcuterie plate with foie gras, rare sliced strip steak and yes, some steak tartare, all for $14, as I did during a rainstorm on a quiet Sunday in Greenwich Village a few years ago, you can bet I'm going to order it not just once, but every chance I get, along with some mussels and more steak. Oh, and the house red for $6 a glass—it's a great value as well.

What would a deep value manager do if they stumbled across this bistro? Would they splurge on a great meal at a reasonable price? Or would they pass, and instead, if the restaurant were to go out of business, try to buy the tables and chairs cheaply and resell them at a higher price to another aspiring restaurateur? A deep value manager is most likely to wait for the going-out-of-business sale, skipping the bargain to be had inside. An opportunistic value manager is likely to be inside eating an awesome dinner and would continue to do so every week until the restaurant gets discovered, becomes the new "it" place, and raises its prices. I'd keep going for a little while to soak in the limelight of being a regular at this newly discovered gem, but eventually it would get too expensive my price-conscious nature; and anyway, I'd find myself being elbowed out by the growth managers looking for the proprietor to open her second and third locations.

However, if the food quality and service started to deteriorate, the opportunistic value manager would quickly move to another place; our focus is on quality for a good price. If things got really bad and the place started offering frequent specials and discounts, then you'd see the deep value managers popping in for a bite or two, hoping for some adequate nutrition at a bargain price. But in those situations, the cheap eats would come with the higher possibility of food poisoning. Some things just aren't worth the risk.

(In case you read this far only to find out what the meaning of life is, it is really quite simple: a healthy family, a life rich in time not just money, and chocolate croissants, strong coffee, and the weekend edition of the Financial Times on a quiet Sunday morning. That's it. The rest is just noise.)

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Dr. Fed

By Gary Black

May 23, 2013

When a doctor takes a patient off his meds, he does so usually only after the patient has shown sure signs of recovery. Generally, the patient himself realizes when he no longer needs the meds.

What the market seems to be implying in today’s sell off is that Dr. Bernanke and his colleagues at Hospital Fed will begin tapering before the patient (the U.S. economy) is sufficiently healthy. And that is where the market has got it wrong– Bernanke made it clear in his testimony yesterday that the Fed won’t begin tapering until there is clear evidence that the economy is strong enough to sustain itself. Tapering by itself is not the issue. If the patient has recovered, he won’t need the meds. Based on his record over the past several years, we can trust that Dr. Bernanke and his colleagues will know when to withdraw the meds.

We should use today’s weakness to buy names we like.

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A Tale of Two Markets

By Jeff Miller

May 17, 2013

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair."

—Charles Dickens, A Tale of Two Cities

The U.S. stock market, as measured by the S&P 500 Index, is up 17.3% year-to-date through May 15. This is pretty impressive, given the doom and gloom in the newspapers about Europe's recession, slowing growth in China, and the U.S. government's sequestration cuts (anyone remember the sequester?).

Somewhat lost in the discussion about the market's heights is that 2013 has been a tale of two markets. Earlier in the year, the S&P 500 Index was driven by big moves in the utilities, health care and staples sectors, while the financials, materials and consumer discretionary sectors lagged. The increase in the consumer staples sector has led to some price differences that border on outrageous. Earlier in the year, the S&P 500 Index was driven by big moves in the utilities, health care and staples sectors, while the financials, materials and consumer discretionary sectors lagged. The increase in the consumer staples sector has led to some price differences that border on outrageous. We've seen household and personal products companies trade at close to 20 times 2013 estimated earnings (with some companies even higher), while a number of large cash-rich tech companies are trading at closer to 10 times estimated earnings.

Initially, this made some sense. Conservative investors seeking yield have turned to stocks, since bonds don't currently provide much of it. Which is more attractive to a saver: U.S. 10-year Treasurys yielding under 2%, junk bonds yielding less than 5%, or utilities and staples stocks yielding 4% to 5% with the potential to grow their dividends a bit over time? As the yield chase continued during the early part of 2013, the stock prices of companies that investors viewed as stable dividend payers rocketed higher.

To All Things There is a Season
S&P 500 Index Performance, by Sector
January 1 – May 2 versus May 3 – May 15, 2013

S&P 500 Index Performance, by Sector January 1 – May 2 versus May 3 – May 15, 2013

Past performance is no guarantee of future results.

The "seasons" in the market abruptly changed on May 3 as two events caused investors to shift their mindset from "safety first" to "all aboard." First, European Central Bank Chairman Mario Draghi gave a speech where he basically said "cheap money is here to stay." Second, initial jobless claims in the U.S. came in at a level not seen since the early days of the recession, which gave investors hope that the U.S. economy was getting stronger.

When this happened, it was as if a bell went off. The market shifted focus from "safe" dividend income to companies with a lot of cash and the ability to increase the returns of that cash to shareholders through higher dividends and buybacks.

Throughout the stock market, companies with cash are in demand as investors seek not only nice dividends today but also the opportunity to grow that dividend in the future. A focus on current yield has morphed into a focus on growth in payouts, at least for now. For the nine trading days from May 3 to May 15, the utilities sector declined 1.7%, while the S&P 500 Index was up 4%. The laggards from earlier in the year, industrials and materials stocks, gained 5.5% and 4.8%, respectively. Industrials generated one-third of their year-to-date gains through May 15 since May 3, while materials earned more than half of their year-to-date return in that same short time.

We think that in the near-term the market will continue to favor large companies with excess cash on their balance sheets and lots of free cash flow that they can put toward dividends and buybacks. Capital management is the new king.

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Past performance is no guarantee of future results.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Materials contained on this page are historical and as such Calamos Advisors LLC undertakes no obligation to update.

Investing involves risk, including potential loss of principal. Diversification does not insure against market loss. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities.

In addition to market risk, there are certain other risks associated with an investment in a convertible bond, such as default risk, the risk that the company issuing debt securities will be unable to repay principal and interest, and interest rate risk, the risk that the security may decrease in value if interest rates increase.

Investments in lower-rated(high yield) securities present greater risks than investments in higher-rated securities. This is because there is a greater likelihood that the company issuing the lower-rated securities may default on income and principal payments.

As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility, and difficulty obtaining information. Investments in emerging markets may present additional risk due to the potential for greater economic and political instability in less developed countries.

Important Information

S&P 500 Index—Is generally considered representative of the U.S. stock market.

Merrill Lynch All US Convertible Index (VXA0)-Is comprised of approximately 700 issues of only convertible bonds and preferreds of all qualities.

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.

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