Apr 30, 2014, 3:20 PM ETConference Presentation, Panel

Reading the Tea Leaves: Where Are Markets Headed?

Justin Slatky (Shankman Capital): High-yield spreads have compressed inside 400 basis points for the first time since 1998–1998 and 2005–2007; historically, periods of sustained tight spreads yield high single to low double-digit returns, though current lower all-in yields may limit outperformance.
Jim Latinsky (JHL Capital): The market is in the "middle" of a cycle characterized by muted growth and moderate returns, not the "ninth inning," though momentum-driven blow-ups suggest a potential shift in capital flows to overvalued small caps and conglomerate stocks.
John Kalamos (Kalamos Investments): Forward P/E multiples on the S&P are roughly at the crest of the last four to five cycles (excluding the late 90s); the current environment features no historical parallel for five consecutive years of negative real rates.
Michael Sembelos (JPMorgan Asset Management): Corporate profit recovery is the strongest of the post-war era while revenue recovery remains the weakest, driven by cost declines in interest, credit, and wages; future returns are projected at 8–10% based solely on earnings growth as multiple expansion has likely ended.
Morris Mark (Mark Asset Management): Small-cap forward earnings multiples are approaching asymptotic levels, with street expectations implying an 80% earnings growth rate that would require 5% GDP growth and aggressive Fed hiking to justify.

Leverage and Covenant Standards: Triple-C rated leverage has risen 43% over the last two years, and "covenant-lite" structures with "pick-toggles" have returned to the market, raising concerns about a lack of creditor protection.
Retail Participation: Significant retail capital inflows into leveraged loans and high-yield bonds are creating indiscriminate buying behavior, with investors often ignoring credit analysis in favor of fund flows.
Regulatory Arbitrage: Financial sponsors are allegedly gaming Fed and OCC regulations by inflating EBITDA projections (e.g., 30% increases) on transfers between sponsors to maintain leverage ratios while the underlying credit quality remains unchanged.
LBO vs. Refinancing Mix: Unlike 2007, where leveraged buyouts (LBOs) constituted over 30% of new issuance, current new issues are driven by refinancings (over 50%), which extend maturities and lower interest expense rather than increasing systemic leverage.
Bank Loan Floors: Approximately 86% of the bank loan market now features LIBOR floors around 1%, contrasting with 0% in 2007; this limits the asset class's upside in a rising rate environment if rates remain below that threshold for 12–18 months.

Active vs. Passive Management: As stock correlation declines and individual stock performance diverges, active management is expected to add value relative to passive strategies, contrasting with the last four years where high correlation benefited passive funds.
Secular Growth Stocks: A basket of 75 "secular growth stocks" (often internet and biotech) doubled their price-to-sales multiples from 6x to 11x in under two years, a historical signal of an approaching self-correction due to a lack of new buyers.
Buyback Sustainability: Companies are increasingly buying back stock at free cash flow yields of 3–4%, which may be value-destructive compared to the 9% yields seen in 2010–2011 if normalized interest rates return.
Tax Inversions and Conglomerates: Low interest rates and a speculative deal environment are fueling a "conglomerate boom" similar to the 1960s, driven by tax inversions and acquisitions that may eventually collapse if interest rates rise.
IPO Market Dynamics: The IPO market has slowed due to momentum corrections; while "roadshows" are no longer just for immediate flipping, the volume of speculation has decreased as banks face limits on distributing new paper.

Key Economic Data Points: The most critical data for forecasting include manufacturing PMI surveys (correlating with profits 3–6 months later), corporate profit growth, and Capital Expenditure (CapEx) trends.
Fiscal vs. Monetary Policy: Panelists argue that fiscal policy (tax reform, regulation reduction) and infrastructure spending are more critical for job growth than monetary policy, noting that banks lack incentive to lend to small businesses during a flat yield curve.
Inflation and Fed Targeting: The Fed is viewed as targeting 2% inflation (potentially tolerating 2.5–3%) to ensure full employment; this policy stance keeps rates lower longer but risks future inflation if not managed as the economy recovers.
Energy Policy Risks: Accelerating LNG export approvals is flagged as a risk that could raise domestic electricity prices by 50–60% relative to the rest of the world, negating U.S. cost competitiveness.
Housing Policy Risks: Proposed restructuring of Fannie Mae and Freddie Mac could raise the cost of conforming mortgages by 0.5%, potentially slowing the housing recovery.

Bullishness Scale (1–10):
- Justin Slatky: 7–8 for the current year; 10 for the 10-year horizon.
- Jim Latinsky: 5–6 for the current year; 5–9 for the 1–3 year horizon.
- John Kalamos: 8–10 for the current year; 10 for the 10-year horizon.
- Michael Sembelos: 7–8 for the current year; 8–9 for the 1–3 year horizon.
Risk Management Consensus:
- Investors should avoid leverage, as it creates excessive risk and forces sales at inopportune times.
- Diversification across asset classes is critical to survive potential corrections while retaining cash for opportunistic entry.
- The market may be disjointed from fundamentals in the short term, but long-term equity returns (5–6% real) remain superior to fixed income over 20–30 year periods.
Specific Warnings:
- If earnings miss expectations or GDP growth fails to reach 5%, small-cap multiples could collapse.
- A spike in defaults and a recession, rather than high valuations, are the primary catalysts that will end the current credit cycle.
- The "TEA" (There Is No Alternative) strategy driving capital into stocks from bonds is creating exposure to multiple risk factors.