While they intended to contrast their investment styles, long-short investors Jonathan Angrist and Ali Motamed ended up sounding a stern warning on U.S. equity markets on Monday.
In “Different Flavors, Market Neutral Vs. Long-Short” a panel discussion at the 9th Annual Inside Alternatives and Asset Allocation conference at the Wynn Las Vegas on Monday, Motamed, managing partner at Invenomic Capital Management, warned that patterns in the U.S. equity markets may portend a crash in the future.
“People haven’t cared about value, and thus we’re on a 10-year run of growth outperforming value,” said Motamed. “The last few times that’s happened, we walked right into 1989 and 1929. I think taking the time to discern good opportunities will pay off.”
Motamed, a star long-short strategist, is still finding good long opportunities in U.S. equities. He said that he liked cable companies and companies running data centers, noting that cable companies’ businesses were shifting from television to broadband where they could exercise broad pricing power and potentially the ability to act as gatekeepers to the internet.
Angrist, president and chief investment officer at Cognios Capital and himself a manager of a market neutral long-short strategy, agreed that there were good opportunities for investors, but added that they’re few and far between—which is good news because a smaller opportunity set means easier choices for investors. But he added that rising rates will cause stock prices to go down, which should expand the universe of solid investment options.
Angrist argued that, currently, many U.S. stocks are severely overvalued.
“There are 271 companies in the Russell 3000 now trading at 10 times sales or more,” said Motamed. “That is the highest in recorded history except for in one quarter, the first quarter of 2000. … If you look at the median valuations, it blows people’s minds. The median enterprise value to sales ratio in the first quarter of 2000 was below 1.2. The median enterprise value to sales ratio right now is 2.5.”
Unlike the market in 2000, the market today is being led by a handful of strong companies, said Motamed, who added that there were $500 billion market cap companies leading the market in early 2000 that had absolutely no earnings. Today, there are $1 trillion companies leading the market, “but a lot of junk underneath that.”
Motamed said he doesn’t put much stock into the argument that tech stocks like the FANGs were worth their valuations because of the data and intellectual property they held.
“At the end of the day, these companies have to make money off of what they sell,” said Motamed. “We look at labor costs going up and interest rates going back up, and this all keys into earnings. If you move interest rates up another 106 to 107 percent, that will take earnings down.”
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.
Angrist noted that rising rates were one of the unsung causes of the 2008-2009 global financial crisis—as rates rose, adjustable rate mortgages increased above levels that consumers could afford, “and then the dominoes fell.”
ETFs, which have proliferated across global equity markets over the past 20 years, could exacerbate the fall since they are commonly used by do-it-yourself investors who often lack the support of a financial advisor and the discipline of more professional investors, said Motamed. Any sign of profound weakness in the equity markets could cause many of these investors to sell simultaneously.
The argument, then, is that investors should be wary of focusing on long-only equities, said Motamed.
He warned that many long-short managers concentrate on creating alpha through stock selection on the long side of their portfolios while merely shorting an index like the S&P 500 on the short side of their strategies.
“I think it’s a shame,” said Motamed. “I’ve been doing this for 15 years and we’ve been able to make money on the short book, even while the S&P 500 has been going up on average. At the end of the day, if you’re paying someone a higher fee, you should want them working for that higher fee on both sides of their strategy.”
Angrist agreed, noting that short selling can give managers insight into the weakness of certain companies.
“You’re paying the manager to truly generate alpha, but anyone can short an ETF,” said Angrist. “Shorting is the hardest part of what I do—everyone in the world is trying to pick the best long stocks, but when you short you learn that there’s a big steam engine coming right at you in certain areas of the markets.”
Darlings Demystified
Angrist noted that short sellers uncover highly valued but fundamentally unsound companies, holding out Netflix as an example. While some analysts believe that higher valuations for companies like Netflix are justified because of the value of the data they collect, Angrist notes that the company is not really profitable and could struggle from subscriber attrition if it raised prices or started to implement commercials, which would likely lead to bankruptcy.
Motamed noted that Apple, a darling of the tech stocks for value investors, may turn out to be not as good an opportunity as it seems when competitors from China and other emerging markets begin to rise.
“Apple now makes a phone, and that’s pretty much all they do,” said Motamed. “They do a great job, but they’re about to become the fourth largest phone manufacturer in the world. You’ll get to the point where people will say they don’t want to spend $1,200 on a phone when they can get the same thing from a competitor for $300. If that happens, Apple is done. They have nothing, nothing at all. It’s at $1 trillion and it could go to $30 billion. Be ready to run like hell when it turns against you.”
Yet Motamed does not currently short Apple because of its policy of ongoing massive share buybacks.
One reason stocks like Apple have remained popular is that, as they age, they have become dependable dividend payers. Over the past decade, as bond yields have plummeted, many investors have turned to dividend-paying equities to create cash-flow-generating portfolios.
“Because of the investors’ increased interest in dividends, many companies have changed their dividend policies,” said Motamed. “Back five to 10 years ago, dividend payout ratios were in the 30s. Now we find payout ratios in the 50s.”