Keith McCullough, founder and CEO of Hedgeye Risk Management, has been bullish on gold, silver and utilities since the start of the year, when economic models at his investment research firm turned bearish on stocks. and bonds.
This defensive move is the result of the Hedgeye models jumping early on a change in the US economic climate. The models noted a slowdown in US corporate earnings year-over-year and assumed inflation was near a peak.
The Federal Reserve waiting to raise interest rates because inflation was only “transient” and then tightening monetary policy directly into a downturn is a major policy mistake for McCullough – and not surprisingly: “The Fed always makes mistakes,” he says. “Their policy is too strict, too late.”
The Fed may be late for the game, but you don’t have to be. In this recent interview, which has been edited for length and clarity, McCullough – who prides himself on being a contrarian investor – tells investors how to position investment portfolios now for the bear market he waiting for summer. It then outlines what to watch out for from the Fed, so you know when the central bank is ready to stop pummeling investors and hand them the punch bowl.
Market surveillance: The bearish outlook for stock and bond markets that you have maintained since January has materialized. The Federal Reserve’s interest rate hikes are inflicting great pain on investors.
McCullough: When economies slow down in what we call the “Quad 4”, governments step in. Quadrilateral 4 corresponds to when the rate of change of growth and inflation from one year to the next begins to slow down at the same time. Our Quad 4 call this year is for a drastic slowdown in earnings growth, which is driven by slowing growth and inflation at the same time. One hundred percent of the time, when the Federal Reserve tightens in Quad 4, the US stock market drops 20% or more. We expect this to happen in the S&P 500 SPX,
when this is done.
Market surveillance: A 20% drop in stocks is the definition of a bear market. Is it the Fed’s fault?
McCullough: The Fed is tightening in a Quad 4 slowdown: Growth and inflation are slowing at the same time, and credit and equity markets don’t like it. We are therefore short on both the high yield and the junk on the credit side. It’s the same as shorting US growth on the equity side.
If you go back to June 2020, when we started reporting that inflation was going to pick up, it wasn’t until 12-18 months later that the Fed realized it wasn’t transitory. They play catch-up. The Fed is always wrong. Their policy is too strict, too late.
Market surveillance: Inflation slowing down? Most people would be different.
McCullough: At the height of the inflation cycle, everyone sees only inflation. We see inflation on an aggregate basis peaking by the end of the second quarter and then picking up. Doesn’t roll too hard, but in the fourth quarter, drops towards 6%. It doesn’t matter how fast it slows down but doesn’t speed up.
The longer the Fed remains vigilant, tightening in a downturn, the faster stock prices fall. You will really deflate asset prices. I can’t wait to see how the Fed views the stock market at 20x earnings.
The market has a reflexive impact on the economy — consumer confidence, the wealth effect. BitcoinBTC USD,
RUT Russell 2000,
and the Nasdaq COMP,
all peaked in November 2021. That’s about as rich as anyone is going to feel. The economy was then coming out of Quad 2, the economy and inflation were accelerating in a healthy way. From there to now, you have to deal with the reflexivity of falling asset prices and the perception of wealth and consumer confidence.
If the Fed maintains six or seven rate hikes, it will invert the yield curve and real economic growth in the United States will threaten recession. I’m more concerned about the expectation of a recession and the effect on consumer spending behavior than an actual call for recession. Recessionary conditions are already priced into the yield curve.
Market surveillance: With such a negative outlook, where should people put their money now?
We really like gold here. I was bearish on gold last year. Gold loves the Quad 4. We love gold, gold diggers, silver — SLV SLV,
the ETF on this, GLD GLD,
for gold. We still love the energy although this is probably where I’m going to get off the bus first. I just watch inflation try to find its peak, and oil and energy stocks are an indicator of that. Basic consumer goods, in general, but currently they have too much inflation, so we don’t expect them long. We have very little exposure to equities, as we believe the stock market is going to crash. Currently it’s Gold, Silver, Gold Miners, Utilities – XLU XLU,
is the ETF.
We are returning to the upside on long-term Treasuries. TLT TLT,
is the ETF of long-term Treasury bills and SHY SHY,
short term. Where I think we get paid in the Treasury market is the Fed cutting those interest rate hikes. If I’m right on Quad 4 and the odds of a recession increase, the Fed can easily pull back two, three, four of those rate hikes.
“ “Personally, I don’t think the Fed can get away with much more than two rate hikes.” ”
Personally, I don’t think the Fed can get away with much more than two rate hikes. If their second rate hike is at the May meeting, I think that could be it.
If I’m wrong and the Fed doesn’t fix its policy mistake, then I’ll have even more reason to short US credit and equities. They will continue to tighten as markets fall.
Treasuries won’t go higher until the market begins to believe the economy is slowing at an even faster pace and/or the Fed becomes dovish. The market is usually good at detecting this, usually one to three months before the turning point at which the market will price it in.
There are also opportunities in emerging markets. We are short in China and we love Indonesia and South Africa. South Africa is exposed to precious metals. Emerging markets came through the pandemic last, so their recovery is still in its infancy. So the economic acceleration in places like Indonesia is very clear and it is not yet affected by Russia or Europe. IDX IDX,
which is the Indonesia ETF, is our favorite emerging market.
Market surveillance: You are optimistic that the Fed will not be as aggressive as threatened. What gives you this idea?
McCullough: Suddenly everyone thinks the Fed has a one-sided policy on inflation. It is a three-legged stool. There’s the employment component, which I think will deteriorate precipitously over the next three to six months, along with corporate earnings. Put two or three numbers on bad jobs, then you have the third leg of the stool, which is where is the S&P 500? If it’s down 20% or more and the job market is deteriorating, it is. The precipitous slowdown in corporate earnings and deteriorating employment gives the Fed a broad run, especially if equity and credit markets are down, to say “done.”
Market surveillance: If and when the Fed ends the pain, will investment conditions immediately drop from Quad 4?
McCullough: If the Fed pulls back and markets start to climb again and confidence returns, we could easily get what we call Quad 1, which is a modest drop in inflation and consumption growth. This is our current cast if the Fed becomes dovish. Quad 1 is growth without rising bond yields. Basically, my two favorite shorts, tech and consumer discretionary, would then become longs. Bonds would be nice but not as good.
The problem is that you’re going to have a stock market crash first, because for the Fed to become dovish, the stock market has to crash.
If you go back, 100% of the time I made a Quad 4 call, with this Fed and the two Feds before, the stock market crashes, they come in and get dovish.
Market surveillance: What should investors watch out for now to know when to go bullish?
McCullough: The conditions are always different but the behavior is always the same. The stock market and the credit market are falling, and the Fed is becoming dovish. We are in the final innings with the labor market being strong and interest rates being high. This is why it is so important to pay attention to whether the Fed becomes dovish or not. If they remain hawkish during the downturn, the market decline will be more prolonged. If they pull back, it often ends up being the bottom. If the Fed raises rates in May, sometime after that companies will pre-announce Q2 results on the negative side. So the end of the second quarter, June, is the landing point I’m looking for. But, if the Fed does not provide the landing point, then there is no landing point.
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