By John P. Calamos Sr.
Investors have grown increasingly confident that the worst of the global financial crisis may have passed. As the tide of negative economic data ebbed somewhat during the third quarter, the equity, high yield and convertible markets extended their rebounds from a strong second quarter. With this backdrop, the question often being asked these days is: how should the economy and the financial markets develop over the next few years?
Going forward, I believe the capital and fiscal and monetary incentives that have been largely responsible for the recent market gains should change gradually. As a result, the longer-term outlook appears less certain. I also believe that over the foreseeable future financial markets and the economy will likely benefit from several factors. The year-over-year data for revenue growth, earnings-per-share and many economic statistics should provide favorable comparisons, primarily because the numbers are no longer falling off a cliff. For example, the auto and building industries are stabilizing, and although these industries have yet to rebound meaningfully, they are no longer the huge drags on gross domestic product they were just a few months ago.
A more stable economic outlook, however, is only part of the equation when considering the future direction of asset prices. Another intertwined but separate variable is risk. This is a twofold variable, comprising the actual risks associated with an investment, and investors’ attitudes toward the perceived risks. This year’s strong price rebounds in financial assets could not have materialized without a major shift in investors’ risk appetites. This is not a bad thing, and is a prerequisite for the market’s recovery. Consider, however, that past performance may attract future asset flows, and investors’ attitudes toward risk may become a considerable risk in itself. Recall that asset bubbles are byproducts of excessive risk tolerance. How investors manage risk in general, tends to vary significantly.
Some investors would try to capture each bit of potential incremental return before the market turns, hoping to exit right before it happens. This is a very risky proposition, especially if you are investing an individual’s lifelong hard-earned assets. Based on my experience of more than thirty years in the investment management industry, I recommend a more conservative, contrarian approach. Pay less attention to what markets are doing, and maintain a consistent risk posture throughout the market cycle. Your posture should factor in several variables, including (but not limited to) age, investment goals and objectives and attitudes toward risk taking.
This approach requires fortitude, as an individual’s portfolio returns may lag the market’s return over short-term intervals. In the recent market rally, for example, speculative bonds outperformed higher-rated investment grade bonds. In the near term, the higher returns compensated investors for the additional risks taken, but the higher probability of default associated with these bonds may reverse this quickly. Over the past few months, however, a portfolio with low or no exposure to the most speculative bond offerings would have underperformed the broader market. I advocate avoiding lower-quality investments because I am convinced they add undue risks when the objective is to maximize longer-term returns.
Going forward, slow economic growth appears to be the mostly likely scenario, but financial markets are leading indicators. The rotation into higher-quality assets should eventually occur, and opportunistic investors could benefit from what may be a protracted period of heightened market volatility. I believe that investors seeking to capitalize on potential opportunities that arise should focus on bottom-up stock selection, a key driver of relative performance in volatile environments. Investors should also maintain a global focus, to potentially benefit from many opportunities available beyond the U.S. border. Based on our research, these potential opportunities are surfacing primarily in technology and other cyclical sectors such as energy and materials.
In short, we believe that a focus on high quality, global opportunities, and bottom-up stock selection should effectively help investors manage risk and potentially benefit from the uncertain investment climate.
For questions or comments contact John: 888.857.7604, JPCsr@calamos.com, www.calamos.com
The opinions referenced are as of October 2009 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.
How Investors Perceive and Manage Risk in Volatile Markets.
