Craig Callahan, president and founder, ICON Advisers, a value manager based in Denver, is bullish despite the recent 16 percent drop from the April highs to the early July lows. Recently, Registered Rep. editor-in-chief David A. Geracioti sat down for lunch with Craig to get his—as usual—quant-influenced and very often contrarian views on the stock market. (We also wrote about Craig and Icon back in 2004.)
What is your outlook for the stock market?
We are bullish for the next year based on our valuation methodology. In early July, we measured stock prices, on average, to be about 30% below our estimate of intrinsic value. Under our system and methodology, we expect prices could be at least 30% higher next year than they are today--even higher if some supportive conditions occur.
Do you favor any industries or sectors?
At ICON, we believe markets experience themes, meaning certain industries lead for typically one to two years. Cyclical industries were part of the leadership off the market low of March 9, 2009. Although that theme was interrupted briefly earlier this summer (from roughly the end of April through the first week of July), we expect that leadership to resume over the next year. A cyclical theme involves industries in several different sectors including materials, industrials, consumer discretionary, and information technology.
What about international equities?
We’re just as bullish internationally as we are domestically over the next year. Our valuation readings internationally are quite similar to those in the U.S. Even our sector expectations are similar, favoring cyclical sectors internationally.
What about emerging markets?
We do not view emerging markets as a separate asset class. We look first for industry themes and then look to put our money in companies based in countries with favorable valuation readings. Our recent pull toward cyclical industries, which include infrastructure-related products and services, has resulted in exposure to emerging markets. This exposure, however, is not the result of any kind of emerging market mandate. Rather, it is a consequence of emerging markets providing products of international appeal. When we identify an industry theme at ICON, we tend to follow the theme wherever it takes us geographically.
Earlier you mentioned “supportive conditions” for equities. What did you mean?
I was referring to corporate bond yields. Corporate bond yields are the basis for the required rate of return in our valuation equation. Under ICON’s methodology, equity valuations rise if corporate bond yields drop. In fall 2008, corporate bond yields soared after the Lehman Brothers bankruptcy and recession-related fears surfaced. Between late 2008 and April 2010, we saw a tremendous rally in corporate bonds. The rally was interrupted this spring but we expect it to resume, as we believe corporate bonds are generally still priced below our estimate of their intrinsic value. In our opinion, bond investors have priced in an excessive amount of default risk. A corporate bond rally is not only good for bonds; it gives a boost to equity valuations as well.
Many observers are skeptical of the economic recovery. What is your view?
I am a value investor, not an economist, but broadly speaking I believe many investors miss opportunities during a recovery because they fail to both anticipate the recovery and to participate in the subsequent expansion. Investors spend their time looking for a recovery and expansion that has characteristics similar to the previous recovery and expansion. But that generally doesn’t happen. Each economic recovery and expansion is unique, and one recovery is rarely similar to the next. In the 1990s for example, the expansion was heavily driven by technology, a sector which would later experience its own unique bust. By the early 2000s many investors kept asking, “When is technology coming back?” Incorrectly thinking the recovery and expansion of the 2000s had to look like the technology-driven recovery and expansion of the 1990s, many investors missed the opportunities before them. Now, many observers think housing, which fueled the last expansion, needs to rebound before we can experience any kind of economic recovery. I disagree. I don’t have a strong feeling yet as to whether any single sector or industry will be responsible for the next recovery, but, as I suggested earlier, it probably will not be housing precisely because each recovery and expansion is different from the previous one. In fact, I actually think an abundance of housing, which should provide home-buyers and renters with lower mortgage payments and rents, could act as a stimulus. Lower cost housing allows individuals more discretionary income, like a tax cut.
Any final observation?
I think investors are making investment decisions looking in their rear-view mirrors. In time, I believe they will regret these decisions, which are driven by fear and uncertainty. It is a difficult task, but in this setting I think advisors can be a critical value-add who can help guide their clients.