Animal Spirits Podcast - Talk Your Book: The Bull Market in Stupidity

Episode Date: July 4, 2022

On today's Talk Your Book, we spoke with Michael Grant from Calamos Investments about the Fed, the economy and managing a long/short fund in this environment   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Calamos Investments. Go to Calmos.com to learn more about their Calamos Long Short Fund, which according to Morning Star through the end of May, was one of only 19 funds in the long short category with positive year-to-date performance. Pretty impressive. We get into that on the show today. It's calamos.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Batnik and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions.

Clients of Ritthold's wealth management may maintain positions in the securities discussed in this podcast. Ben, there was an article this morning in the Financial Times. U.S. long short equity funds are down 14% on average this year. The first five months marked the worst start to account their year for equity long short funds on record. Okay, no offense. I know stock picking is so difficult, but like, wasn't this the year? One of the hard things that I learned from tracking hedge funds back in the day is that long short funds have a lot of ways to be wrong because it's not only about picking the right sectors and the right stocks

and then which ones to go long and which ones to go short, but it's how much do you short? How much do you go long? What's your net and your gross exposure? Do you have leverage on? How do you balance out your longs and shorts? You could be the best stock picker in the world, but your net exposure is off sides one time, and it doesn't matter because the market goes against you. There's a lot of ways to be wrong. And I think a lot of long short funds probably are long funds and drag, and the shorts just kind of hurt performance. They're not moving things around enough. So we talked to Michael Grant today from Calamos, and it sounds like he does make these regime shifts. And through the end of

May, they were positive on the year, which is pretty impressive. The idea of like a traditional long short where you go along, the quality, short, the junk, that's just not real life. That's a thing that people on Twitter say. First of all, if that was the case, you blew up every year for the last five years. Right. Yeah, you have to do it almost opportunistically because there's a lot of times where the junk does way, way better than the quality stuff, and it's not always going to work out like that.

So you could be wrong twice. Now, one of the things that we've been talking a lot about on the podcast lately is kind of looking at the bad side of things. The Fed's going to put us into a recession. Demand is slowing. Oil prices are high. Inflation is high. There's not really a lot of people looking at the positive side of thing. And Michael Grant, who we talked to today, who's the portfolio manager of the Calamos Finius Long Short Fund, said he thinks that the Fed has a sporting chance of achieving a soft landing where we avoid a recession until maybe 2024, 2025. I don't think there's many people who think that right now. Some people think we're in a recession already. Some people

think it's 20-23 for sure. I don't see many people saying no, a recession is like two to three years off, right? And there's a probability for everything. If that did happen, I think some people's brains would explode. I think some people would be mad if we just aren't in a recession now we're in one in in 2020. It almost seems because there's people that want that to happen. Well, what if we do avoid a recession? Who would the bears blame? It depends what the Fed does, I guess. But I mean, if the Fed threaded the needle and they did give us a soft landing. Part of me almost thinks, though, if we didn't just rip the band dead off and do it in, say, 20, 23, but it was two or three years later, that that one would probably worse than doing it now because consumer balance sheets are so strong right now.

I don't know. I think that would be an interesting case study to see what would happen. You're right. People's brains would kind of explode. We ended a lot of this stuff. We spent a lot of time with Grant about the Fed and what's going on and interest rates and how that impacts and then sort of move into how he He uses that macro stuff to manage the portfolio. Here is our talk with Michael Grant from Calamos. We are joined today by Michael Grant. Michael is the co-CIO at Calamos Investments. Michael, welcome to the show.

Thank you very much, Ben. Okay, so I'm going to start off the show with some kind of good news because there isn't a lot of that these days. So in a recent piece, I'm going to quote here, this is you, believe the Fed has a sporting chance of achieving a soft landing as the economy slows but avoids recession until 2024, 2025. that's maybe looking at things as glass is half full. What does that scenario even look like where the Fed could avoid a recession or at least

put it off for a few more years? Because the other Michael and I, Michael Badnick, I've been talking for a while. It seems like everything the Fed's doing is really pointing us towards no other conclusion than a recession is coming. So how would that even look? What would that scenario look like if the Fed actually did put things off for a little while? I think the Fed has a sporting chance of a soft landing. Let's ask ourselves why everyone is convinced that.

the hard landing is around the corner. And the answer is that the pullback in financial asset prices has been so extreme over the past six months that it has generated the kind of trauma for investors that they normally associate with economic recession. But if you stand back and look at the data today, it is not consistent with a recession around the corner. It's consistent with moving from above trend growth to below trend growth. And that's what the data is telling us. That's what the signals from the financial markets are telling us. Now, one of the reasons why investors are so concerned is because the Fed itself has talked

hawkishly. And we have to make a judgment about what the Fed is thinking. the Fed unfortunately got terribly behind the curve and not because it's bad at what it does or it's incompetent but because the COVID experience was new to everyone. People didn't know what COVID was. Our health care system went left and then right and then left and then right and the Fed was in the same boat. In any case, given what we now know about the economic data, the Fed looks negligent with interest rates anywhere near the zero bound. And the Fed's priority is to get out of what I call the negligent zone into the neutral zone. And that's what the Fed is set. It's to find

neutral rates somewhere between two and three percent. And one of the conundrums for markets today is that until it gets there, the Fed's back is to the wall. The Fed has no choice but to talk hawkish until it gets to that neutral position. Now, I think the Fed ultimately believes that this inflation is transitory. It cannot say that for political reasons. But by the end of July, or at latest by September, the Fed will be in neutral zone, and it can begin to say things like, well, there's a lot of uncertainty in our world. We're going to pause and wait to see how this actually flows through into the economy. I think that pause is important because if the Fed follows the market expectations and continues to tighten into spring of next year, then I think we're probably

in recession by late 2023. If the Fed pauses this autumn, I think the soft landing is still the best bed. It's a warm take. It's not quite hot, but you saying that the Fed can't say that it's transitory for political reasons, and I think you're on to something there. However, on the other side of the equation are consumers, investors, CEOs. I think that there is a psychological component of inflation where people start to put their head in their shell like a turtle and start to pull back and that can become self-fulfilling. So even if the Fed does pause, what would you say to all of the layoffs that we're first starting to see? I think JP mortgage just announced a big layoff in their mortgage department, and obviously the housing is going to contract or a pause. What do you think about that part of it, that this can

become self-fulfilling? Well, I would say that so far, all of this is consistent with a downshift from above trend to below trend. So there's no question, for example. Miami real estate is going to be hit by the crypto crash. No question the VC private equity world is hitting the wall on the east coast. But that's very different than a scenario of self-fulfilling recessionary conditions. If a recession was about to happen, we should be seen it in indicators of credit stress. We are not. Every recession in history was preceded by the three months to two year or three month to 10 year curve being inverted, every single one. We're nowhere near that point. So could we talk ourselves into recession, I think it would be very unusual. We have to step back and

recognize that consumer finances today are in great condition and the employment markets are very, very good. Corporations too. And corporations too. The whole private sector is in a remarkable condition. And I think the question to ask is, is it possible that COVID and the pockmarks from the COVID experience are still playing out through the economy? I mean, we know COVID's behind us, but is it possible that the ruptures of that experience could take two more years before we get to a normal cyclical state. Because throughout the COVID experience, any time you try to apply traditional,

cyclical, economic analysis, it failed. You had to go back and recognize that we haven't had an experience like this since the Second World War. It was a fake downturn and a fake upturn, almost. We created it. Yeah, it was a government-induced supply constrained shutdown. You saw this weird thing

where at first it was inflation and goods and not enough, just not enough supply, and then they overcorrected. And now you're seeing people are still thirsty for travel, and so the travel industry is buckling a little bit under the demand side of it. And then I was looking at a chart today of subway turnstile in New York City, not even close to where it was. So while the virus, thank God, cases are down in most cases like entirely, we're still very much dealing with the economic fallout of all of this. Yes, and I would say that going back to the inflation issue, which is the paramount question at the moment, I think inflation is still predominantly the outcome of all the supply issues generated by the pandemic, not just in terms of goods, but equally in terms of employment. And you talk to Boeing, they say, well, our supply chain is not going to be fully back to normal until late 2023.

Now, this begs the question, what should the Fed be doing if this is still a supply chain-dominated problem? Open factories. So here's the conundrum. If the Fed hits the economy too hard and doesn't give the economy time to rebuild and reconfigured the supply side, all it means is that when the economy eventually recovers, inflation comes back and it could come back worse. Wait, from where? Could you explain more on that? Well, basically, right now, there's too much demand. We had COVID pent-up demand, and we have this dynamic of going from goods back to services. And the way you ultimately resolve this inflation is to build out the supply properly again. If the Fed cuts off that process by hitting the economy too hard, and then it ultimately releases that pressure and the economy, recovers from the Fed-induced downturn, inflation's going to come right back because you haven't solved the supply side. So you need the economy to expand for another two or three years and then capitalism works. Are you saying that if we hit demand too much, that will not allow supply to do

what it has to do? Is that what you're saying? That's right. And then you're back to this more cyclical inflation dynamic that just comes back in the next cycle and possibly worse because that balance of demand and supply has not been sorted out. My theory is the Fed is raising rates now so then they can lower them in the future. But to your point, what's the point of doing that if they're not going to solve any problems? It's kind of a band date on a gusher of a cut. That's right, which is why I think the Fed's first priority is to frankly cover its backside. So it needs to get rates to two and a half percent, which it will be in September. Now, at that point, I think the Fed should pause. And politically, the Fed will be able to pause, especially if it can start to see the inflation

numbers in different parts of the economy improving. And I think that's likely at that point. And let's go back to this idea that this is still really about COVID. So a year ago, you were out there spending $500 on a couple of iPods. That's a really profitable transit. action. Amazon delivers it with a worker that's being paid $25 an hour. Now you're spending the $500 on a visit to the dentist or trying to get on an airplane, which is a big labor component with workers that are paid $15, not $25. That shift in spending character has a dramatic footprint on nominal and real GDP. Nominal GDP may be strong in both cases, but real GDP may look a lot more sluggish because we're now shifting back to the service part of the economy, which we know is

less productive. Well, Ben just went to the dentist last week, so you're 100% right. Okay. Ben, right? That's true. You never know exactly what's priced into the market at any point in time, but you think at this point the stock market has already basically priced in a recession in the near-term future, right? No. I don't think there's a recession on the horizon. I think the surprise is that there's no recession. There might be sluggish real GDP, but there's no earnings recession in particular. Earnings surprise everyone by holding up. If we have an actual... Do you think the stock market has sort of gotten ahead of itself, and the stock market is saying,

all right, we think there's a recession coming and we're going into a bare market immediately? Well, I think there's a big part of the investment community that believes that. Look, if we have an actual recession with a 25% downturn in earnings, I think the S&P goes down to 3,500 or below. So my view is that the surprise here is that real recessionary risk is a 24 or 2025 phenomenon. And between where we are today and then, there is a lot of wood to chop. Now, the market at the moment is hostage to the U.S. 10-year yield and all these inflation perceptions. But if we can get to the point where it looks like inflation is taming down and the Fed feels more comfortable with its policy and says, you know what, we're done for now. And there's two more years left on the expansion. I think stocks can

go higher. Michael, let me ask you this. I think that bad economic data, which we haven't really seen yet. We're seeing some manufacturing surveys come in. But I think that bad economic damage will be cheered by the stock market because it will be a sign that inflation is going to come down. What do you think of that take? Are you buying or selling that take? I would buy that take.

All right. I think real economic numbers are going to become disconnected from nominal economic numbers for a period of time, possibly the next 18 months. Because final demand is good. Nominal demand is good. Nominal incomes today are very healthy.

But because of the pricing issues, real economic growth is looking sluggish. And investors have been so trained to focus on real economic growth. That's part of the reason they're concerned about the profit cycle. But the surprise, of course, is, as we know, corporations eat nominal economic activity, not real. And that's a big reason why I think the profit cycle holds up well into 2024. for. In terms of looking at where we are with inflation today, I was looking at these charts this morning, looking at soft commodities, agricultural commodities. They're all coming in pretty big time. You see like base metals coming in a ton. Agriculture, like cotton is crashing. I'm not

quite sure why. Lumber is down quite a bit. The thing that's still stubbornly high is energy besides for natural gas and meat prices are still high. But a lot of the other commodities are rolling over big time. Do you think that we have already seen peak inflation? In the actual data, yes. In other words, not the core, but the full final CPI, we've already seen peak inflation. And I think the debate is how quickly it comes down and the extent to which the labor component of inflation also begins to ease. And I think there's a silver lining here. I referred earlier to the fact that when the goods part of the economy was on fire, an Amazon worker makes $25 an hour.

Now, what's happening now is that the parts of the economy, which are service-focused and demand is strongest, are actually telling us labor is loosening up, okay? And that labor in hospitality or airlines and so forth, that's $15 an hour labor. Okay, and that's part of the reason why the labor numbers are going to start to improve. And let's go back to the point we made earlier about COVID, until a parent is sure their kid's school is not going to shut, that second income earner will pause to go back into their hospitality job or back into their airline job. And we know a lot of those service industries are very female dominated, and they were handicapped from re-entering the labor force as long as the pandemic was still front and center.

So you mentioned before the consumer balance sheet being so strong. Michael and I talk about this a lot. Cash levels are way high. Checking and deposits are really high. People paid down credit card debt throughout and they built up their savings. Savings rate went parabolic. Does the Fed have a margin of safety because of that? Do you think that that's why they could go a little harder now? Has a consumer ever been in better shape heading into a possible recession before? This has to be right up there, right? Yeah, not in the last 30 years, for sure. The Fed has a lot of wiggle room, but unfortunately, in a world of 24-hour news, I think it's confronting a lot of political pressures at the moment. If you look at wage growth, the recent wage

numbers, first of all, depending upon how you look at it, wage growth has been slowing, which is a positive. And year over year, wages have been up, let's say, 5%. Well, let's assume trend productivity of 1 to 2%. That implies, you know, wages are growing 3, 3.5%. Now, is that really a problem? Now, if you listen to a central banker who lives and breathes with other central bankers and they win when inflation is zero to two percent, they freak out. But the truth is whether inflation is 2 percent or 4 percent is just a case of who's winning and who's losing. And Main Street wins when wages are growing 4 percent, not 2 percent.

So there is a real political judgment to be made here with respect to what the Fed will live with. And I think the Fed will do what Alan Greenspan did in the 1990s. Alan Greenspan said, if I want inflation to be 2% plus, it's higher than it should be today, but rather than hit the economy down, I'm going to wait for an exogenous shock to come and slow things. It was what he called opportunistic disinflation. Politically in today's world, I think the Fed will get to the point where they'll say, wages are going a bit too hot for us, three to four percent. We don't really like it.

It's above our target. but we're going to sit back and wait for an exogenous shock to ease things rather than actually try and raise unemployment, which I think would be unacceptable. So, Michael, we've been spending a lot of time talking about the macro, and I'm being curious as we pivot the conversation to the global long, short fund that you all manage. How does the macro inform portfolio construction? It has a big impact without question. And I'll give you just one example.

we had three decades of price stability, and that implied that corporations didn't have to worry about their labor costs, their input costs, their oil costs. They were all stable. So firms focused entirely on top line growth. That's how you differentiated yourselves to investors. Grow the top line. We're now shifting to a world of quasi-price instability, which means, corporations have to pay attention to their cost of goods sold in a way that they didn't in the past. If you look at some of the recent earnings reports like Amazon or Target or Walmart or Lyft, their problem was not the top line. Their problem was that they no longer control their cost of goods sold. And the love affair that investors had with gross stocks in that era of price

stability will never come back to that degree if it's correct. that quasi-price instability is the norm, that radically changes the kinds of companies and models that can do well if the economy grows another few years. We looked at the piece on your long short fund. Through the end of May, Europe, like 3% on the year. The category average for long short funds is down 5. The S&P is down 12 or 13. What do you attribute that to?

Is it sector selection? Did you go long value, short growth? Is it stock picking? Did you screw around with your gross and net exposure? How do you explain that performance is here? As usual, there are several themes. One of the big themes, of course, is that we stepped away from the long duration parts of the equity world. The growth technology concept names that could be dramatically repriced if interest rates went higher. Because the truth is we had a bull market and stupidity because of all this free money. So being underweight that part of the market meant that if we got something wrong, this was down 20%, not 70%. We know the damage that's happened in that part of the market. But the other part of the question is, what's the real value of a long, short model?

And unfortunately, many long short funds are what I call long light. They promise you sort of 70% of the upside for 60% of the downside, and they don't try and actively manage their equity risk. Whereas I think that deciding whether we're properly paid to engage. risk, equity risk, is the core of anything in our industry when you start calling yourself an alternative. So, for example, we can be 80% net long or we can be minus 20. In other words, we can be out right short. So our willingness to lean into equity risk or lean out of equity risk, as we did late last year and the early part of this year was a key reason why

we were able to protect capital. How often do you guys pull those levers in terms of the gross and net exposure. Because I agree that that can have a huge waiting because I know a lot of long, short fund managers will maybe have a static exposure from a gross or netics perspective. And it sounds like you move things like like, how often does that allocation regime swift happen? So it doesn't happen frequently because the equity cycle is tied to the business cycle. And we know the business cycle tends to move slowly and to have persistent features. Typically, it's a three or four year cycle. So when we get involved, with a name on the long side or the short side, we take account of the macro, and if we're right,

it can mean we're holding a stock, for example, in the long book for a good two, three, four years. Let's shift to bottoms up. So how do you all think about constructing a portfolio? We start bottom up and we're fundamental because earnings and sales matter over time. And I would argue that to some extent, this is what was forgotten by investors a year ago. Our industry is 80 years old, and the best minds have asked themselves, how do we get our clients to their destination? And the accumulated wisdom of that is that without earnings and without cash flows, all you have at best is a promise or at worst, a Ponzi scheme. You take Google. Google is only off its high by 25%.

Why? Because Google has very high quality earnings and cash flows on next year's numbers. It has a free cash flow yield of 6% plus. And in contrast, there's an enormous range of companies that have declined 70% plus from their peak. And even today, they are not near the point where you can properly value them on earnings or cash flows. Fundamentals is the starting point because, look, we're always going to be wrong. We're going to make a misjudgment. either but a stock or the economy or the financial cycle. But if you pay attention to what you're buying and you do it in the right way, you can recover from that mistake.

Bine a stock like Juniper Networks in 1999 in $250 a share, it declines to $50, and it still had 80%, 90% to go on the downside. It didn't bought until it was $5 a share. That kind of mistake, you and your clients don't really. recover from. And without mentioning names, we know there's a lot of stocks in the last 15 months that have gone through that same decline. You mentioned selling a lot of those long duration stocks. Do you think that this shift from value stocks and cash flows mattering again? Is that a cyclical thing? And then if the Fed does decide to lower rates in the coming years, then we'll switch

back to growth? Or do you think this is more of a secular change where those cash flow plays and value stocks can outperform growth for a while? I think that it's both. When we get to the point that the 10-year yield is stabilizing and the inflation backdrop is normalizing post-the-COVID experience, of course, some of those quality growth names with real earnings and cash flows, they will come back. But that part of the universe, that 70% part of the concept world, that still cannot be valued on earnings or cash flows, I think that's done and dusted probably for the rest of our professional careers. And in that sense, a lot of this is structural. And it goes back to the point

that there's a chance that long era of deflation post 2008. It is over. Inflation is going to go down, but there's a host of structural issues in the economic backdrop, which argue that this cycle will have a firmer demand footing than the entire post-2008 era. That's a big statement. I don't necessarily disagree with you. In terms of shorting stocks is very difficult. As we've seen many short sellers get run over and throw in the towel over the last decade plus, how dangerous is it to short some of these really garbage companies? Because they could, at least from these levels, there's nothing stopping them from just doubling just based on an easy balance. Like these names have gotten beat up so badly. So are some of these names in your short book,

like the Zooms and DocuSines of the world? Or is it more you're going to buy Coke and short Pepsi, like that type of thing. What does the book look like just generally speaking? There are a few moments in financial history where the alpha opportunity on the short side is brought, 2000, 2008, and then 15 months ago. But outside of those windows of time, shorting is for losers. Now let me clarify what that means. What it means is the real money in the U.S. economy is always on the long side of some economic value equation. The short, book can be important at times to reduce risk or to reduce beta and to control the volatility tails in the financial cycle. Absolutely true. But the real money is still made in the long book.

And therefore, what you want to do is when we enter these periods of financial asset repricing, which is what we've gone through in six months, we want to behave like a market neutral fund. We want to use the short book to cut off that volatility tail. But after that storm has passed, after the ferocity of it is largely done, it's far better for us to say, where can we really make money on the long side at this point? Because everything's been taken down. And as you pointed out, it doesn't take much of a bit of a short covering rally in some of these garbage names on nothing to force you to cut your losses.

We talk a lot about sometimes the worst thing that happened to an individual investor is they nail the timing on something like this right and then they think they can do it again and again or they get caught just stuck in a negative camp because, hey, I went to cash before the market took a dump and now I'm going to just hold that cash for dear life and never go back in. So you guys have obviously done really well this year. And by going to more defensive posture, how do you get over the psychological hurdle of wanting to stay there because it feels more comfortable than going out and taking some more risk again? I would flip it around and say, I feel far more comfortable taking risk than sitting on cash. What I have to do is fight the temptation to buy into the decline too early. And the reason is that at the end of the day, we believe in equities. And we tell our clients to believe in equities. And therefore, in the middle of the storm, we have to have the courage to embrace that and start leaning into risk again. And when people think about alternatives, they think, oh, good, avoiding risk. No, no, no, no. If you avoid risk, you avoid return. The key is to understand

when you're paid properly for taking that unit of risk. Because if I'm paid properly, I should be leaning aggressively into it. And that's the world we're now in, given everything that's happened in six months. It doesn't mean you can make money easily. Doesn't mean everything is going to go up, but there are material opportunities on the table again. Michael, was there anything that we didn't get to that you wanted to cover? Well, there's a lot. There's so much going on. It's such an unusual time because a lot of these rules of how the economy should be working, one needs to sit back and avoid that dogma and try and say, COVID has affected things. How does this really play out at least for the next 18 months? So it's an extremely interesting time to be in the business.

Yeah, I would echo that. We've been saying a lot lately, I can't wait to see what the future holds, just in terms of what does inflation look like in 2023? What do earnings look like? I'm just, I don't know that I've ever been more excited to see what the future holds. So we appreciate you coming on today, taking the time. You were an excellent guest. So thank you very much. We'll send everybody to the website, which is calamos, investments.com, calamos.com. Where do we send people? Yes, calamos.com. Callamos.com. All right, Michael. Thank you. Michael. Thank you. Thank you so much for coming on. Thanks very much, everyone. Thank you, Michael. Thank you, Calamos. To learn more about Calamos, go to calamos. Go to calamos.com.