CTSIX’s Nelson Sees the Stock Market as a 'Coiled Spring,' Poised for a Positive Bounce

First published: March 19, 2020

In a turbulent period for the markets, Calamos has been hosting a Calamos CIO Conference Call for financial advisors. Below are notes from a call Tuesday, March 24, with Brandon Nelson, CFA, Senior Portfolio Manager of the Calamos Timpani Small Cap Growth Fund (CTSIX). To listen to the call in its entirety, go to www.calamos.com/CIOsmallcap-3-24

Brandon’s comments build on what he had to say on a call last Tuesday, March 17. Highlights of that call are here. To listen to the March 17 call, go to www.calamos.com/CIOsmallcap

Brandon Nelson, Senior Portfolio Manager of the Calamos Timpani Small Cap Growth Fund (CTSIX), says he remains constructive on small caps and sees growth opportunity.

March 24 Update

• Although the recovery will take some time, Brandon Nelson continues to believe that the economic downturn will be severe but not long lasting, noting his outlook is much more bullish than most.
• Stock prices have dropped to levels that would be expected heading into and during a recession. Many financial market signals seen today are bullish indicators and often occur near stock market bottoms.
  

  “Right now, the stock market is like a coiled spring. The most likely scenario is a short-term surge, a re-test of the low, and then, a sustainable recovery.”

• Six factors could trigger a near-term rally: fiscal stimulus, media coverage, a slowing growth rate of new COVID-19 cases, less restrictive social distancing, the emergence of greater clarity from March earnings announcements, and vaccine/treatment progress.
• Right now, the stock market is like a coiled spring. The most likely scenario is a short-term surge, a re-test of the low, and then, a sustainable recovery.
• The bottoming process will likely take several days and weeks, but it is impossible to predict. For example, there was no double-bottom in Q4 of 2018, just a straight shot higher after December 24.
• The Calamos Timpani portfolios reflect a secular tilt but are also diversified into cyclical growth beneficiaries.
• Having both secular and cyclical growth within the portfolios is especially important right now. Brandon’s expectation for recovery sets the stage for significant rally in cyclical growth stocks with strong balance sheets.
• The liquidity conditions today are reminiscent of 2008-2009, but the team has been able to navigate and execute in this environment.

Additional Details

• Brandon’s belief that the downturn will be severe but not long lasting reflects expectations that (1) the health care system is able to reasonably cope as the virus runs its course, and (2) monetary and fiscal stimulus efforts successfully help bridge the gap for the many people who will need assistance during this economic downturn.
• Clearly, there has been a shock to the system. A negative domino effect is in motion and a recovery will take some time.
• In only a few weeks, a lot of economic damage has already been done, and the social distancing and statewide shutdowns will cause more near-term economic weakness.
• Importantly, the stock market also knows this. In a stunningly short period, stock prices have already dropped to levels that would be expected heading into and during a recession.
• There are signs of capitulation across the financial markets (e.g., extremely high VIX and put/call ratios) and outside of the financial markets (e.g., empty club superstore shelves and other end-of-the-world-like behavior).
• Many of the financial market signals we are seeing today are bullish indicators and often occur near stock market bottoms.
• There are six factors that could trigger a rally in the short term, including:
  1. Congressional approval of a robust fiscal stimulus package, which Brandon believes is imminent.
  2. More reassuring media coverage, such as more reports of additional and necessary medical equipment and supplies getting delivered to hospitals.
  3. A slowing growth rate of new COVID-19 cases.
     1. Even as the absolute numbers keep rising, the market will soon positively focus on fatigue in the numbers.
     2. It is naïve to assume the stock market will keep falling as long as the number of cases keeps rising. The rate of change is the key leading metric; worldwide, excluding China, it is already showing signs of fatigue.
  4. Less restrictive social distancing guidelines as a direct result of hospitals getting more inventory of necessary medical equipment and supplies.
     1. The White House’s “15 Days to Slow the Spread” guidelines expire in seven days, and Trump has indicated an interest in loosening guidelines, which could be well received by the market.
  5. As Brandon discussed last week, March quarter negative pre-announcements with the removal of guidance could get short-term bad news out of the way and give investors more courage to buy.
  6. Progress in developing COVID-19 vaccines and medications would boost sentiment.
• Brandon is focusing on having proper diversification within the Calamos Timpani portfolios, including by sector and style.
• CTSIX has a secular growth tilt but also has exposure to several high-quality cyclical growth names that Brandon believes are likely to see business improvements once the economic data points get better. These positions have industry drivers as well as stock-specific drivers.
• More specifically, cyclical growth exposures are tilted toward semiconductors, semiconductor capital equipment, housing and building products, transportation, and a few select industrial and consumer stocks.
• On the secular growth side, communication-enabling cloud-based software for business is one prominent theme.
• The push toward the cloud has been happening for years, but the move to “work from home” activity accelerates the trend toward cloud communication.
• Stocks like RingCentral, Five9, NICE, and AudioCodes are examples of stocks in CTSIX that provide or enable cloud-based communication for business customers.
• Within healthcare, Brandon highlighted sleep apnea as a secular growth theme the Funds are investing alongside. A serious and chronic disease that is significantly under-diagnosed in North America, sleep apnea has been proven to cause numerous cardiovascular issues and can actually add to respiratory complications in COVID-19 patients. Inspire Medical Systems and Itamar Medical are two stocks in CTSIX with exposure to the multi-billion dollar sleep apnea market.
  • Inspire Medical Systems sells an implantable device that uses neurostimulation to treat sleep apnea patients. Inspire’s innovative approach is far more patient-friendly than traditional CPAP masks, which has enabled the company to grow rapidly, and gain market share and reimbursement traction with commercial payers.
  • Itamar sells an at-home sleep diagnostic test that replaces the inconvenient, traditional overnight in-lab sleep study and has many avenues for growth.
• Housing and homebuilding products are another cyclical growth area the team likes, especially as low interest rates provide an incentive for people to take out mortgages. Many names have been meaningfully beat up and are set up for a strong snapback if the macro environment plays out in line with the team’s expectations.

Summary of Key Views (As of March 17, 2020)

• The U.S. economic downturn is likely to be severe but not long-lasting, setting up for a V-shaped recovery supported by fiscal stimulus, monetary stimulus, and a release in pent-up consumer-driven demand.
• Q1 GDP growth will likely be flattish; Q2 will undoubtedly be negative; Q3 will likely be positive.
  

  “Q1 GDP growth will likely be flattish; Q2 will undoubtedly be negative; Q3 will likely be positive.”

• Earnings estimates have much more room to fall in the near term. The good news is that, broadly speaking, stock prices have already adjusted for the current economic downturn and the upcoming negative earnings revisions.
• Once the short-term bad news is out of the way, we may see some relief for companies that come out with negative updates, including the potential for neutral to positive responses.
• It is too late to sell. Investors should be looking for entry points to add to the equity markets, especially in small caps, where stock performance tends to be strong coming out of economic downturns.
• The stock market is an anticipatory entity. Soon, it will anticipate a slowing growth rate of COVID-19 data points. Soon, the market will anticipate the V-shaped economic recovery, well before we see evidence of it. Soon, investors will look past the poor 2020 earnings profile and will begin to value the stock market based on the more normalized 2021 earnings profile.
• Although there are differences, this downturn is reminiscent of October 2008. In the midst of the Great Recession, headlines were horrible, the short-term earnings outlook was poor, the roadmap to recovery was murky but the stock market entry point was excellent—although investors didn’t know it at that time.

The Case for the V-Shaped Recovery

• The U.S. entered an economic downturn beginning in mid to late February, which started on the West Coast, extended to the East Coast, and is now in full swing in the Midwest.
• The expectation that the downturn will be severe but not long lasting reflects what we have learned about COVID-19 and how things played out in China, along with the monetary stimulus that has already gone into effect, and fiscal stimulus that will soon begin.
• While stimulus won’t fix the health care issues, it will soften the economic hit and will likely create pent-up economic strength once the health care issues subside.
• A V-shaped recovery seems very believable, framed by a combination of low gasoline prices, cash savings from mortgage refinance activity, and pent-up demand for consumption.
• Before all of this started, the consumer was the strongest part of the economy, and Brandon and his team suspect that will again be the case once we get through this crisis.

Earnings Estimates Have Further to Fall, but Relief May Be on the Horizon

• Many are debating whether or not there will be a recession (two consecutive quarters of negative year-over-year GDP growth). Ultimately, whether the downturn meets the definition of a recession is not something the team is focused on.
• Over the near term, the economic downturn is going to negatively impact earnings. Earnings estimates have begun to fall but likely have much further to go. The team expects to see negative pre-announcements for the March quarter and either lowered guidance or the removal of guidance for many companies, given poor short-term visibility.
• As companies come out with negative updates, the team will be carefully watching the price action in those stocks. Because the stocks have fallen so far in advance of the bad news, Brandon would not be surprised to see a neutral to positive response in these stocks once the short-term bad news is out of the way. The team will be watching stock price action very carefully.

Opportunities in Small Cap Growth Companies

• Small caps are especially interesting given they have lagged large caps for three years in a row prior to entering this recent economic downturn.
• Small caps have also been hit harder than large caps year to date. But, over longer time periods, small caps have outperformed.
• Relative to large caps, small caps are trading quite a bit cheaper than normal.

Positioning

• Brandon maintains high conviction in the positioning of the Calamos Timpani portfolios.
• The team is favoring names with strong fundamental momentum, with an overall bias to secular growth. Names include software, where visibility is strong. Other areas include home health care services and medical devices.
• The team has also identified pockets of cyclical growth, including semiconductors, semiconductor capital equipment, and select exposure to homebuilding.

Financial advisors, if you’re doing the work now in anticipation of a potential market recovery and small cap rally, talk to your Calamos Investment Consultant about CTSIX’s process for identifying companies with high, sustainable growth potential. Call 888-571-2567 or caminfo@calamos.com.