At Cognios, Angrist uses two measures of valuation and profitability to guide his investment decisions on both the long and short side of his portfolios: return on tangible assets (as a measure of profitability and quality) and return on market equity (as a measure of valuation). This method tends to identify companies with strong balance sheets and reasonable levels of debt.
Using his metrics, Angrist creates a set of 75 long positions from the most profitable and best value stocks, and 150 short positions from the least profitable and most expensive stocks.
Using the measures, Angrist has determined that the stock market is slightly expensive under normal conditions—and that amid low-but-rising interest rates, it becomes very expensive.
“With the 30-year Treasury now yielding 3.2 percent, that should cause a 30 percent reduction in stock and bond prices if there’s no corporate growth. What that tells us is that no longer is corporate growth a path to returns. We’ll need corporate growth to continue to see flat returns from the market.”
Despite central banks’ slow convergence toward tighter monetary policy, interest rates remain low, said Motamed, because of the legacy of quantitative easing and buybacks catalyzed by tax reform in the U.S. The tax cuts have led to at times impressive earnings growth in fundamentally weak companies.
The situation is not sustainable, said Motamed.
What Interest Rates Will Do
“There’s a massive liquidity cliff coming in the next year as buybacks fade away,” he said. “There’s been $1 trillion or more flowing into the U.S. market every year since the financial crisis, but that’s going to go to about $200 billion or less, all in repurchases, in the near future. The truth is that there’s no one to buy these Treasurys and we’re blowing out deficits. The key question moving forward is whether the central bank will lose their independence.”
If U.S. policy makers can’t prompt the Federal Reserve to maintain lower interest rates for longer, interest rates are going to rise dramatically over the next few years, said Motamed. Ten-year Treasury yields could rise from their current level, slightly above 3 percent, to over 5 percent.
If the 10-year Treasury pays more than 5 percent, money will begin to flow out of the equity markets, said Motamed, and central banks will not be able to respond quickly enough to prevent a correction or crash.
Motamed sounded alarm about the depth of the potential market crash, noting that interest rates will eat into earnings multiples immediately and lead to negative earnings for many companies. Firms trading at price-to-earnings multiples of 23 could suddenly go down to a p/e multiple of 14. The S&P 500, currently around 2,900, could lose 500 points quickly. All of this could happen in the next year and a half, he said.