Keith McCullough, founder and CEO of Hedgeye Risk Management, has been bullish on gold, silver and utilities since earlier this year, when his investment research firm’s economic models for stocks and bonds turned bearish.
This defensive move was the result of Hedgeeye’s models reacting early to a shift in US economic sentiment. The models noted a slowdown in US corporate earnings year-on-year and suggested that inflation was nearing its peak.
For McCullough, for the Federal Reserve to wait to hike rates because inflation was only “temporary” and then tighten monetary policy straight into a slowdown is a major policy mistake — and unsurprisingly, “The Fed always sucks.” , he says. “Your policy is too strict, too late.”
The Fed may be a latecomer, but you don’t have to be. In this recent interview, edited for length and clarity, McCullough – who prides himself on being a contrarian investor – tells investors how to position their investment portfolios now for the bear market he expects through the summer. He then points out what to look for in the Fed, so you’ll know when the central bank is ready to end the beating of investors and put the punch bowl down again.
Market observation: The bearish outlook for equity and bond markets that you have maintained since January has materialized. The US Federal Reserve’s interest rate hikes are causing investors great pain.
McCullough: When economies slow into what we call “Quad 4,” governments step in. Quad 4 is when the annual rate of change of growth and inflation begin to slow simultaneously. Our Quad 4 call this year is aimed at a sharp deceleration in earnings growth, driven by a simultaneous slowdown in growth and inflation. One hundred percent of the time the Federal Reserve tightens in Quad 4, the US stock market falls 20% or more. We expect this to happen in the S&P 500 SPX, -0.06% when it does.
Market observation: A 20% drop in stocks is the definition of a bear market. Is this all the Fed’s fault?
McCullough: The Fed tightens into a Quad 4 slowdown: growth and inflation are slowing at the same time, and the credit and stock markets don’t like it. So on the credit side, we are short both high yield and junk stocks. It’s the same as shorting US growth on the equity side.
If you go back to June 2020 when we started proclaiming that inflation was going to accelerate, it wasn’t until 12 to 18 months later that the Fed realized that this wasn’t temporary. They play catch-up. The Fed always messes up. Your policy is too strict, too late.
Market observation: Inflation slowing down? Most people would see it differently.
McCullough: At the peak of the inflation cycle, everyone sees only inflation. We see headline inflation peaking by the end of the second quarter and then rolling over. Not rolled over much, but falling towards 6% by the fourth quarter. It doesn’t matter how fast it slows down, but that it doesn’t speed up.
The longer the Fed remains vigilant and tightens into a slowdown, the faster stock prices fall. They will really drain asset prices. Can’t wait to see how the Fed feels about the stock market at 20x earnings.
The market has a reflexive impact on the economy – consumer confidence, wealth effect. Bitcoin BTCUSD, +0.29%, the Russell 2000 RUT, +0.37%, and the Nasdaq COMP, -1.22% all peaked in November 2021. That’s about as rich as anyone will feel. The economy was coming out of Quad 2 then, both the economy and inflation were accelerating in a healthy way. Going from there to now, you have to grapple with the reflexivity of falling asset prices and perceptions of wealth and consumer confidence.
If the Fed sticks with six or seven rate hikes, it will invert the yield curve and US real economic growth will face a recession. I’m more concerned about the prospect of a recession and the impact on consumer spending than a major recession. Recession conditions are already embedded in the yield curve.
Market observation: With such a negative outlook, where should people invest their money now?
We like gold very much here. Last year I was bearish on gold. Gold likes Quad 4. We like gold, gold miners, silver – SLV SLV, +0.17% of ETF on it, GLD GLD, +0.49% for gold. We still like energy, although that’s probably where I get off the bus first. I’m just watching inflation trying to peak, and oil and energy stocks are an indicator of that. Typically consumer staples but currently they have too much inflation so we don’t hold them for long. We have very little equity exposure as we believe the stock market will collapse. Currently it is Gold, Silver, Gold Miners, Utilities – XLU XLU, +0.81% is the ETF.
We are becoming optimistic again on long-term government bonds. TLT TLT, +2.01% is the ETF for long-term government bonds and SHY SHY, +0.06% for short-term. Where I think we’re getting paid in the Treasury market is with the Fed cutting those rate hikes. If I’m right on Quad 4 and the recession probabilities are rising, the Fed can easily back off 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 comes at the May meeting, that could be it I think.
If I’m wrong and the Fed doesn’t reverse its policy mistake, then I’ll have even more right to short credit and US stocks. They will continue to rise when markets fall.
Treasuries will not be bid up until the market begins to believe the economy will slow down even faster and/or the Fed will become accommodative. The market is usually good at sniffing this out, usually one to three months before the turn the market will price this in.
There are also some opportunities in emerging markets. We are short China and we like Indonesia and South Africa. South Africa is exposed to precious metals. Emerging markets have recently weathered the pandemic, so their recovery is still in its infancy. So the economic acceleration in places like Indonesia is very clear and is not yet being affected by Russia or Europe. IDX IDX, +1.62%, the Indonesia ETF, is our preferred emerging market.
Market observation: They are optimistic that the Fed will not act as aggressively as threatened. What brings you to this idea?
McCullough: Suddenly everyone thinks the Fed has a one-legged stool policy on inflation. It’s a three-legged stool. There’s the employment component, which I think will deteriorate sharply over the next three to six months, alongside corporate earnings. Line up two or three bad job numbers and 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, that speaks for itself. Plunging corporate earnings and deteriorating employment give the Fed ample opportunity to say done, especially when equity and credit markets are lower.
Keith McCullough
hedge eye
Market observation: If and when the Fed ends the pain, will investment terms immediately shift from Quad 4?
McCullough: If the Fed pulls out and markets start to rally again and confidence returns, we could easily get what we call Quad 1, which means slightly lower inflation and slightly lower consumption growth. This is our current forecast should the Fed turn 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 fine, but not that good.
The problem is, you’re going to have a stock market crash before that, 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 it, the stock market crashes, they come in and they go dovish.
Market observation: What should investors be looking for now so they 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 fall and the Fed becomes dovish. We are in the very late innings of a strong job market and high interest rates. This is why it is so important to pay attention to whether or not the Fed will be dovish. If they remain hawkish during the slowdown, the market decline will last longer. Quite often when they pull back, that’s the bottom point. If the Fed hikes rates in May, companies will pre-announce negative earnings for the second quarter sometime thereafter. So the end of the second quarter, June, is the landing spot I’m looking for. But if the Fed doesn’t provide the landing pad, then there is no landing pad.
More: Why the ‘inflation craze’ makes the 10-year Treasury a buy when the yield tops 2.8%: Bank of America
Plus: The Fed may need to become even more aggressive on inflation as US household cash exceeds debt, Deutsche Bank warns