The Economic Undercurrent of a Rallying Stock Market (w/ Raoul Pal and Keith McCullough)

19:07
Where will the Bs meet the Cs?
They will end up in the same place and it could be violently, it could be suddenly.
To me, that really is the point about corporate profits.
If corporate profits remain negative on a year over year basis, labor continues higher
as it always does at the end of the cycle and companies continue to push out, guiding
down because of a proposed Chinese bean deal.
Yeah, that could be your eye opener, is not that getting the T-minus three to six months
from now, this thing should look a lot different than where it looks today without the year
to date dynamics of people chasing the spreads.
RAOUL PAL: Yes, there’s a couple of things observations on that.
CCCs, there’s obviously this shenanigans going on in the funding markets right now.
There’s basically a lack of domestic liquidity in the funding market, because the massive
new issuance is coming the out of the Treasury, but that illiquidity, the Fed started printing
more money again to do it to try and alleviate some of that strain.
At the far end of the strain curve is the CCCs and they’re going, no, no, no, there’s
a problem here.
They’re not getting the funding they need so they’re blowing out.
The BBBs, because they’re supported still by the pension funds sector, are not feeling
it.
Meanwhile, there’s the corporate profit slowdown.
What’s in that bunch of BBBs?
Ford, GM, AT&T;, General Electric, and Dell.
Those five are enormous part of that market.
Any one of those and Ford one got downgraded, one of the agencies downgraded to junk but
one of those who actually falls becomes the fallen angel and falls into the CCC category.
The whole thing’s over.
Because the markets will seize up because they can’t– the junk bond market doesn’t
have enough buyers already and it’s widening.
If one, God forbid, if one of these come through and get downgraded, the whole thing’s going
to seize up.
KEITH MCCULLOUGH: What is the discussion in the boardroom to avoid that?
For all of them, it’s to fire people.
RAOUL PAL: Or usually, General Electric, the other one is equally as bad, restructure the
pensions.
KEITH MCCULLOUGH: Yes.
Somebody has to take a markdown.
RAOUL PAL: Someone’s going to get screwed.
It’s always the little guy, it won’t be the CEO.
It’ll be everybody else, those who get fired will lose the benefits.
KEITH MCCULLOUGH: Well, it’s interesting like GM.
If you look at GM, the last time they had their strike was in ’07.
Again, the dynamics are the same.
After you hit the peak in profitability, the people say, I want a piece.
Now, they’re going to get their piece.
If you get more and more of this into the election, the dynamics are real and labor’s
coming off basically a 15-year low relative to corporate profits, this is a period that
no money manager, certainly the ones that are illiquid and levered which would include
all of private equity, have had to deal with.
Again, every other cycle, labor has been high and rising.
That’s what always perpetuates a recession because the Fed can’t cut people’s wages,
and they certainly can’t fire people.
That’s what labor is going to do, but it was always high and rising.
1980s, 1990s, that’s why people like or at least they can, or at least a macro person
should like the 1980s and 1990s, irrespective of your political party affiliation, because
we had very good relatively low cost of living, we had really economic growth and labor was
high and rising.
Now, it’s been blasted to 15-year lows, again, put off paying the people, corporate profits
were big, fat and happy and labor’s rising from the ashes.
This is probably the most important secular turn in labor that certainly anybody our age
or older has seen.
You’ve never seen it before.
What could possibly go wrong?
Anyone who’s levered long assets that have people facing businesses are going to have
to face the reality of having to pay their people more and/or just getting lower quality
higher and seeing reduced corporate profit margins and reduced corporate profit margins,
negative year over year corporate profits is the catalyst to what you just year marked
as a ring of fire, if you will, of companies that really aren’t “secular growers”, I can
go off on that, but these are cyclical companies that have bloated cost structures to begin
with.
RAOUL PAL: Yeah, exactly right.
Also interesting in the margin is you see delinquencies in cars.
They come to new highs.
You’ve got– yeah, on 60 days, 60 days or more, delinquencies are at new all-time highs.
It’s like, okay, that’s something, that’s an interesting data point, the consumer’s
not quite as happy as people think they are.
You look at the credit card borrowings, and then you look at the rates credit cards are
charging, which is the highest all-time rates, considering interest rates, and that’s the
data that goes back to 1990 or something and credit card rates are high not at 17% than
they were back then when interest rates are 8%.
It’s like, okay, there’s something going on here for people– the only reason they can
do that is demand is high enough that people need the credit.
It’s the only source of credit they can get because they can’t get any other credit.
There’s something telling you, there’s bits creaking at the seams here, so how do you
think it plays out– and again, neither of us are interested in the politics of it but
the election side of it, it sounds like you don’t think that the administration can keep
the economy floated into the election.
I’ve got different view that I don’t think they want to, I think they’d rather have a
recession.
I don’t think it’s as a shoo and that they really necessarily need to keep it in the
way that it is.
Because I thought today, Trump was very clearly again, blaming the Federal Reserve, it’s nothing
to do with me, look how they screwed you.
How do you think from a nonpolitical standpoint, how you’re seeing it play out?
24:47
KEITH MCCULLOUGH: My political lens is always explicitly affected by my quad outlook.
24:52
We are right on the screws.
24:55
I’m not a believer that any politician central planner or otherwise can part the heavens
25:00
and give us a new path underneath the seas of economic gravity.
25:06
The economy is going to continue to slow and if it continues to slow into what we call
25:09
Quad 4 which is the most damning of market conditions by Q2 of 2020, that’s the worst
25:15
place for Trump to be for a period of time.
25:19
Because that’s when Elizabeth Warren’s chances or Bloomberg or whoever’s are going to start
25:23
to rise and again, it’s more about the probabilities change.
25:26
There are very few money managers on Wall Street who actually, even if they hate the
25:31
guy like the Bourbonic Plague, they still believe in some way, shape or form, that Trump
25:35
has a good chance to be reelected.
25:36
RAOUL PAL: Almost everybody.
25:37
KEITH MCCULLOUGH: Yeah, if you don’t– like I have raging Democrats telling me that I
25:40
live in the state of Connecticut, I have plenty of exposure to them in non-money market, like
25:44
nonmarket people won’t have that view but if you’re running a portfolio today, you can’t
25:48
tell me that you expect the tax rates and the truncation of tax reform, which is the
25:53
biggest thing for corporate profits that the modern era has ever seen.
25:57
Like you can’t possibly say that that’s in the market.
25:59
I think that that is a big shift, too.
26:02
You get your zero percent handle on GDP in late January, the economy continues to deteriorate.
26:07
We take a look at Quad 4, the last two times the market’s taken a peek at Quad 4, not good
26:11
for Trump, not good for the stock market, which is one and the same thing.
26:16
It’s almost like I think that– and I think now Ferguson said this, if the market starts
26:21
to go down for real for once, God forbid, actually, it’s done it multiple times, but
26:26
again, if it goes down for real, her chances go up.
26:28
It’s the Soros reflectivity view, which is, again, the faster you go down, the higher
26:34
her chances, and you could wake up one day where people are right scared of that, and
26:38
Trump gets reelected just for that reason.
26:39
Then you get the mother of all rallies from a much lower point again.
26:43
Again, that’s way out there but I’m using my quads to instruct what the political and
26:50
reflexive human response would be to just negative economic conditions.
26:54
RAOUL PAL: Now, my view is somewhat different.
26:57
I think economically, we have the same view, but my view is on the Trump side, if you can
27:01
anger the American, the middle American, because they can’t be screwed over and if you can
27:08
blame it on the Federal Reserve and the Chinese and the Europeans, then if you are going to
27:13
a recession, first, you say I will save you with some MMC John Spinning package and secondly,
27:18
it gets them mobilized because they hate everybody else.
27:22
That’s a typical thing and Elizabeth Warren will use the same tactics, will say well,
27:26
it’s all his fault and blah blah blah.
27:29
It’s going to be a very interesting election and I never trade markets on elections but
27:35
it’s just interesting.
27:36
Talking about elections, what do you see in the UK?
27:39
KEITH MCCULLOUGH: Well, we see Quad 4 in the UK.
27:42
That’s where we started and again, seeing the UK through the lens of the quads and what
27:47
are the prevailing conditions of growth and inflation has been absolutely the way to trade
27:52
the UK from a gilt perspective, long gilts Quad 4.
27:56
RAOUL PAL: Yeah, you just ignore all of the noise and just look at the economics.
27:58
KEITH MCCULLOUGH: Yes, exactly.
28:00
Short the pound, Quad 4.
28:02
Now, the pound is actually trying to have a breakout here relative to the dollar, which
28:06
is interesting.
28:07
However, it’s based on a catalyst which is this expectation which I have zero edge on.
28:12
Plenty of things I had zero edge on but one of the big ones I’m certain of is the political
28:17
outcome in the UK and when this Brexit catalyst actually can be finalized, it’s just not what
28:21
I do, but the market is saying there’s a chance, like there’s– as long as there’s a catalyst,
28:27
it’s closer.
28:28
That catalyst is also aligned in terms of the quad timing that I have for the US economy
28:32
to slow at a faster pace, then that would be bearish for the dollar and bullish for
28:35
the pound anyway.
28:37
That’s an interesting one, because I’ve not been long the pound for a long time.
28:39
I’m long Canadian dollars against the US dollar for the first time in a while, but I’ve been
28:43
willing to go there in the UK but broadly, UK data is Quad 4.
28:48
RAOUL PAL: Talking about fiduciary responsibility.
28:49
You’ve got a situation in the UK where the economics is relatively clear it’s Quad 4,
28:55
but you’ve got this huge overhang of something else, which of which you have no edge, is
29:01
the right answer to the [indiscernible], just keep out of it?
29:04
KEITH MCCULLOUGH: I just stay away.
29:06
Yeah.
29:07
RAOUL PAL: It makes no sense otherwise.
29:08
KEITH MCCULLOUGH: Yes.
29:09
I think that this is a point that you made earlier that’s critical to understand.
29:11
Wall Street isn’t like the person that’s watching this.
29:15
They aren’t like you and I.
29:16
We, until somebody removes it from us, maybe the CCP governs us and we can no longer have
29:22
any legal right to make our own decisions on our own free will, we can decide to buy
29:27
whatever we want, whenever we damn well please.
29:30
Wall Street is siloed into these are the people that trade the pound, these are the people
29:34
that do the UK, these are the people that do the US consumer.
29:37
These are the people to do US healthcare.
29:40
They have to have a view.
29:42
All of the time, think about how hard that must be.
29:46
In fact, it’s rendered itself useless.
29:48
There’s an oversupply of money managers, and you’ve basically made everybody a silo expert
29:54
of nothing.
29:55
What I intend to do is I’ll wait and watch.
29:59
I wouldn’t been able to tell you a year ago that I’m going to be long cattle and cocoa
30:02
today.
30:03
Are you kidding me?
30:05
We’ve seen negative supply dynamics, I see the volatility of the volatility of volatility,
30:09
the signal changing within the commodity space.
30:12
I see two dynamic situations that wow, this is perfect.
30:15
The crowd’s definitely not there and that’s when I go.
30:18
As opposed to feeling like I have to have a view that the crowd is having fumble on,
30:22
or tweeting about, or God forbid, reading CNBC view of every day.
30:26
RAOUL PAL: Spinning a bit more around the world and then we’ll come back, we’re going
30:30
to come to the dollar later.
30:32
There’s two markets that we’ve all looked at and thought at some point, they’re going
30:36
to enter trouble; Canada and Australia.
30:40
Where are we with those?
30:41
Is everything in the same sink right now?
30:42
Is everything in that Quad 3, moved into Quad 3?
30:44
KEITH MCCULLOUGH: No.
30:46
Well, in Canada, in particular, we have back to back Quad 2s coming.
30:51
If there is a country that looks like inflation accelerating, it’s Canada, and they are the
30:56
recipient of it, like within the Toronto Stock Exchange Composite Index, the heavyweights
31:00
are Quad 2 exposures, which include energy companies and the banks.
31:05
Canada for the first time, if only for six months, and the Canadian currency for that
31:09
matter, that’s why I’m long it, because it’s hard to find.
31:12
First of all, Canada only has twos because they’re comparing against borderline recessionary
31:17
Quad 4s that they’re coming out of.
31:18
That’s why you have that, but you also have the dynamics that they are hooked to headline
31:23
US inflation’s acceleration and the broader breakout in commodities.
31:27
Canada to me, it looks like we’ve been long it since the beginning of October.
31:31
It’s a relatively new position, but it’s the same position that I have across the board.
31:35
I bought TIPS instead of being as long as I was of duration.
31:38
I flipped the Dalio move and flipped into some of that.
31:41
It’s a cheater.
31:42
He knows it, that’s why he created it.
31:45
If you want to outperform people that are permanently long duration, let’s have a different
31:50
thing to be long while they’re still long duration and inflation accelerates.
31:54
TIPS.
31:55
It’s like the old adage, just you don’t have to outrun the bear, you just have to outrun
31:58
your friend.
31:59
Again, I’m just trying to isolate that view of inflation accelerating particularly North
32:04
American inflation accelerating, so it’s long energy, which is I think the most concerned
32:08
position that we have in equities, long Canadian energy, long Canadian equities, broadly long
32:13
the Canadian currency, and like I said, long the proteins, long lumber, which is another
32:17
way to double up on our– RAOUL PAL: You’ve got the full on reflation trade on?
32:21
KEITH MCCULLOUGH: Yeah.
32:22
Yeah.
32:23
Well, there’s no mincing words about that.
32:25
I’m short the consumption curves and software, which are, it’s a very– I have a higher beta
32:31
setup than I’ve had for a year.
32:34
Because I’m long things that are classically what I call phase transition coming out of
32:38
bearish trend, Quad 4, do not buy energy, do not buy commodities, short both to buying
32:43
what I was short, which can be somewhat unnerving, but exciting.
32:48
On the same token, consumer staples, which was a long, we’re shorting though.
32:52
RAOUL PAL: There’s a psychology that’s difficult here.
32:55
Your prevalent view is that we’re in the downside of the cycle, but what we’ve got is not faced
33:02
within a down cycle.
33:06
You have to trade against your view, which I don’t ever do.
33:09
It’ll either the out or outsize it so I could just sit with the longer term view, just different
33:15
way, different time horizon.
33:16
I find it particularly difficult to trade against my own view, that personal view.
33:21
If I know there’s some confusion, I just bail it, but you’re doing it.
33:26
How do you do that?
33:27
How do you find your plan still with that?
33:29
KEITH MCCULLOUGH: Well, my model, the way that my model is set up is not A or B, there
33:33
are four different economic outcomes.
33:35
It’s an explicit bet on what we call Quad 3.
33:37
RAOUL PAL: No, I understand that.
33:38
KEITH MCCULLOUGH: Yeah.
33:39
That is a six -month view.
33:42
That’s not against my view.
33:43
That’s my view for six months.
33:45
The hardest part will be to get back to the– RAOUL PAL: You are in the down cycle of which,
33:51
that goes on longer than that.
33:52
It’s based on your view and it’s all about time horizon.
33:56
KEITH MCCULLOUGH: Yeah.
33:57
If I only go back and look at how could I have traded ’08 better?
34:03
Crushed it in ’08 by just staying with the view that we’re in the down cycle.
34:06
How could I have done better?
34:09
Well, I would have bought commodities in the early parts of Bernanke going dovish, and
34:13
stayed long– RAOUL PAL: That whole correction that we had, the reflation correction we had
34:17
in the middle of 2008.
34:18
It was brutal.
34:19
KEITH MCCULLOUGH: It helped my consumer shorts, which is where I made all my money in ’08.
34:23
I just kept shorting every bounce in every story stock, every loved, broadly held story
34:27
stock, consumption oriented shorts.
34:30
That’s where my, I guess, my formal training came as a hedge fund analyst and then a PM
34:35
in the consumer space.
34:36
If I could do it all over again, I would have been long crude futures on top of that, that
34:41
the alpha is manifest when you have the cost curve piece on for that six-month period of
34:48
time.
34:49
It is an explicit view of stagflation.
34:51
Every time– like, again, for me, and God willing, I get to live through a couple more
34:55
cycles.
34:56
I might be 90 years old at this point if they keep [indiscernible], but it is classic late
35:01
cycle, where labor and you get that final push of inflation.
35:04
You can make money on the long side of that while you maintain your bearish view on the
35:09
consumption curve or the proper, as you said, the down cycle.
35:12
RAOUL PAL: From my perspective, I’m not so short as long term correction.
35:17
I’ve looked at the history of, of these moves in the down cycle and there’s two which makes
35:22
it somewhat complicated.
35:24
There’s one and I look at it through the lens of Eurodollars you and I’ve talked about.
35:28
That’s been a big thing for me at the moment because for me, I find it’s the best way of
35:32
trading the down cycle as well as– the up cycle tends to be equities and commodities
35:36
better.
35:37
The down cycle tends to be rates, which is why you’re not short rates right now particularly,
35:42
but you are long commodities because you’re in the reflation.
35:44
Anyway, so I look at this and both 2001 and 2007, both had 70 basis point pullbacks in
35:55
Eurodollars, which were the gut check reflation trade.
36:00
They didn’t last that long, they lasted three months, which is where we are now.
36:08
Then in 2008, and 2001, late 2001 going into 2002, before the 9/11 were these huge pullback
36:17
in rates, which was the Fed have done enough, the cycle’s over, oh no, it’s not phase.
36:24
I don’t know which one of those we’re in.
36:26
I feel like it’s too early for the bigger one, which will be the sixmonth, nine-month
36:30
trade but I hear what you’re saying and also can see that okay, maybe it’s a hybrid.
36:37
I don’t know.
36:38
It’s very interesting for me but I’m staying in the short end and just hiding out there
36:41
waiting because I was in a long time ago, and something we talked about before is if
36:46
you’re not doing monthly mark to market or even annual, then it doesn’t really matter,
36:51
you’d look at what price do I buy it, at what price do I sell it?
36:54
KEITH MCCULLOUGH: 100%.
36:55
RAOUL PAL: The entire world’s gone mad because they don’t even think about it.
36:58
When I was running a hedge fund, literally, it didn’t matter what price I bought anything
37:01
or I sold it at.
37:02
It was how much money I made that month.
37:04
If I was going to lose money that month, had to change, get rid of the position even though
37:08
I’ve made for x in it.
37:09
It’s crazy.
37:10
KEITH MCCULLOUGH: Yeah, well, great example and you absolutely nailed that was obviously
37:14
the Eurodollar trade, by the way, everybody a year later agrees with you because the net
37:18
long position there is like one and a half million contracts.
37:21
Net interest [indiscernible] just epic.
37:23
RAOUL PAL: But all the other problems are short.
37:25
That’s a part of it.
37:26
KEITH MCCULLOUGH: On that piece, that’s actually the point I was going to make, which is on
37:29
the short end of the curve, which is I like to think of, okay, we got into short term
37:35
treasuries on October the 17th of 2018.
37:40
That’s good.
37:41
We like that cost basis, but when do I go big again?
37:44
When do I grow set position up again?
37:47
That clock because I’m making a T-minus six months call on inflation accelerating, I’m
37:51
not willing to run the clock up six months, because the GDP number is T-minus four months.
37:57
That’s the January number.
37:59
I think that that’s the beginning of the Fed, because again, the short end of the curve
38:02
is what the Fed does, the long under the curve is what the market thinks the cycle’s doing.
38:07
If the Fed actually sees that and goes to where Fed Fund Futures are, their dot plot
38:13
is as wide as it’s ever been going back 12 years since the inception of the dots, and
38:18
again, a highly inaccurate dots of process or whatever you want to call that forecasting
38:22
process to do that, but they will have to acknowledge at some point that their dot’s
38:26
going up this way in terms of economic expectations have to come down.
38:31
That’s where I think I cannot, you cannot be big enough on the short end of the curve
38:36
into that.
38:37
RAOUL PAL: No, when that happens, it becomes the crisis trade.
38:40
KEITH MCCULLOUGH: Because you can take the 2-Year Yield down 100 basis points from where
38:43
it is today, which is a monster move relative to the long end of the curve.
38:45
RAOUL PAL: Yeah, and the leverage you can take in something like that is enormous, too.
38:48
KEITH MCCULLOUGH: Yes.
38:49
I’ve spent a lot of time with clients, and we can talk about it later but clients are
38:53
all asking, okay, what is it?
38:54
Should I use swaptions?
38:55
Should I do use this?
38:56
Should I use that?
38:57
Eurodollars, they do see it as having been a little bit more crowded than they would
39:02
like, that’s the discussion within this discussion but it’s pretty simple.
39:06
If we’re right on the economic projections the Fed is going to have to at some point
39:10
in early 2020, look like they are actually completely politicized relative to the Trumpia.
39:16
RAOUL PAL: I just think that the yield curve is telling us something.
39:21
Now, the yield curve goes negative into recession, we’ve seen.
39:25
The swaps curve got to zero, which is the same as it did every single, actually went
39:30
negative which was actually rare for the swaps curve 2s, 10s, and it seemed to steepen.
39:34
The prerequisite for a recession is steepening curve.
39:38
Everyone thinks it’s the negative curve.
39:40
It’s not, it’s the steepening curve.
39:41
KEITH MCCULLOUGH: Post the inversion?
39:42
RAOUL PAL: Post the inversion.
39:43
Yes.
39:44
Which it’s now doing, which plays into, as we’re both saying, somewhere within Q1, Q2,
39:51
it’s going to start getting ugly again.
39:52
KEITH MCCULLOUGH: Yeah.
39:53
Well, that steepening is just based on the Fed catching up to our view.
39:56
They’re the last one to figure it out.
39:59
Once they do, they steepen the curve by cutting the short end out and I think that if they
40:05
don’t do that, then they perpetuate having to do more when they finally do do that.
40:10
They are the catalysts for their own panic if they don’t acknowledge it soon enough.
40:15
That’s why I do think that that GDP number if we’re right on the headline, in conjunction
40:20
with profits slowing and jobless claims rising, there is no case to be made for jobless claims
40:24
rising for the first time in a decade for the Fed to not go incrementally dovish, and
40:28
probably aggressively so if I’m right on that.
40:31
Again, that would just be washing through Q4’s earnings season into the Q1 of 2020 outlook,
40:37
where the street is way outsized on earnings expectations.
40:40
They’re actually looking for earnings to be up 5%, 6%, 7% in the first quarter of 2020,
40:44
which I think is mathematically impossible.
40:46
RAOUL PAL: Yeah.
40:48
They’re just looking at, they just want a hockey stick up every time.
40:51
They just don’t want to believe the fact that things can trend lower.
40:57
Where are you most excited about in the world?
40:59
Is there anything you see different that’s not in the same cycle?
41:03
Because that’s the key thing.
41:04
Because most of the world, give or take is in the same cycle, some leads, some lags.
41:08
Is there any way you would say a great thing about this is just entirely different.
41:13
It’s a breath of fresh air.
41:14
KEITH MCCULLOUGH: Well, on the short side, yeah.
41:17
I’m feeling it’s not– I shouldn’t say feeling, if I ever say that again to you, Raoul, just
41:21
take me off Real Vision.
41:22
RAOUL PAL: Basically, there’s nothing in it.
41:24
KEITH MCCULLOUGH: There’s no feelings, there are cycles.
41:29
I think this software bubble that built within the cycle is potentially like this thing that
41:34
can almost make you giggle, or things trade at 15 to 20 times revenues with these TAMS
41:40
as far as the eye could see.
41:43
They’re seeing rate of change slowdowns in revenue growth, and massive, bloated cost
41:48
structures.
41:49
That’s like, in short selling space, that is easily bee– by the way, the software stocks
41:55
are down depending on what day you’re looking at them, they’re down 8% to 10% already since
42:00
July.
42:01
I like it when the movie already starts and the index doesn’t agree with that setup.
42:06
Actually, consumer discretionary, broadly, is the other one that’s down since the July
42:11
highs.
42:12
You have this concept of secular growers which has never happened before.
42:16
It’s only something Wall Street could make up, a secular grower is something that’s never
42:23
seen a cyclical slowdown.
42:24
Great.
42:25
To me, that like from a short seller’s perspective, because let’s be clear, you’ll find them at
42:30
Real Vision, but the art of short selling has been shot for dead.
42:34
That, to me, is the most exciting thing.
42:36
Having an independent research team with 40 different analysts.
42:39
We’re finding some really interesting shorts and very low short interests, which reflects
42:45
the broad interest that people have in story stocks, or in these TAMS, these total addressable
42:50
market stories.
42:51
It’s all about stories, and again, as they become cyclical, I think that that’s probably
42:55
the most exciting thing in terms of opening the envelope to the downside because we’re
42:59
already seeing that actually in this earning season in particular.
43:02
RAOUL PAL: Just a side story to that, it does worry me, because obviously a bunch of hedge
43:08
funds are more than skilled at short selling, but there’s the short sellers, people like
43:14
Marc Cohodes and stuff that we all know and love, are very skilled at this but it’s a
43:18
very, very skilled business, particularly if you’re fraud hunting, as opposed to trading
43:24
a directional view based economic views or whatever it is.
43:28
We saw that the amount of tourists, short selling tourists, I think more than Macro
43:32
Tourist, they all flooded into Tesla.
43:36
Then people have lost fortunes in stuff like this.
43:39
There’s a whole bunch of these stocks that they were like, they’re definitely going to
43:42
zero, they’re definitely going to zero.
43:44
It’s all a fraud, because they became market vigilantes.
43:49
A lot of them came out of the gold crowd, the same vigilante stuff.
43:53
It really concerns me that people have been pushed into stuff like that, because they
43:56
don’t really understand that short selling as you know is not easy.
43:59
KEITH MCCULLOUGH: If you don’t have, and I know that this is going to ruffle feathers,
44:04
and maybe the first time I’ve ever done so, but if you don’t have a macro process to overlay
44:10
when the cycle is in your favor as a short seller, I think you need to really rethink
44:14
that.
44:15
If you think about– RAOUL PAL: Well, unless you’re an expert short seller who writes a
44:18
whole thesis on the thing and everything else, because it’s so difficult.
44:22
KEITH MCCULLOUGH: Even that, when the cycles not on your side, and I don’t need to name
44:26
names, but they lost their hedge fund.
44:29
Since the financial crisis in ’09, I think 50% of hedge funds that launched on the Goldman
44:36
system are gone, because people start with shorting valuation.
44:43
Valuation is not a catalyst.
44:45
The cycle slowing is the catalyst and expensive stocks within a slowing cycle is the ultimate
44:52
short seller’s dream.
44:53
It made many short sellers famous, those that have ignored the economic cycle.
44:58
2017 is a great example.
45:00
I was born a short seller.
45:01
The first thing I learned how to do is short a stock because my first job on the buy side
45:04
was in 2001.
45:06
I come to my boss, John Dawson, I said, well, they’re going to miss again.
45:10
They’re going to what?
45:11
They’re going to miss again.
45:12
I just listened to what they said at the conference.
45:13
I put it in the spreadsheet.
45:14
Their margins are going to be down.
45:16
The revenues are going to slow.
45:18
He’s like, short it.
45:19
Like, okay, this is cool.
45:20
Short it.
45:21
I thought it was just like buying something.
45:22
I thought that’s what you did.
45:23
Because it’s when I was born into the business that mattered.
45:27
Anyone who’s done something well over time can tell you that.
45:30
There is a significant amount of luck in terms of when you were put in that seat to do a
45:34
certain thing.
45:35
RAOUL PAL: You have a boss.
45:36
KEITH MCCULLOUGH: Yes.
45:37
Okay.
45:38
Then the rate of change went bullish in 2002 of all the shorts, I come back to John and
45:41
I say, well, they’re going to beat it for the first time since I’ve worked for you.
45:44
They’re going to what?
45:46
Cover that short, we’re going to buy that stock and lo and behold, growth was accelerating
45:50
from obviously late ’02 all the way until 2007.
45:54
I think most people that got blown up in the story socks high multiple.
45:58
Again, there’s some epic things that have gone on, we weren’t fully loaded Tesla’s Elon
46:03
storytelling, but people were shorting them into the 2017 tax reform acceleration and
46:08
top line growth that perpetuated these multiples.
46:11
Software growth, software CapEx, for example accelerated all the way into the end of last
46:17
year, into the end of– and into actually the first quarter of this year, of 2019.
46:22
There was no backdrop to short sell software stocks in rate of change terms until this
46:26
year.
46:27
RAOUL PAL: How did you guys get on with Tesla, because you guys were Tesla shorts in that
46:31
period as well?
46:32
KEITH MCCULLOUGH: Yeah.
46:33
Well, we came into it literally, Jay Van Sciver came into it rate as it was topping.
46:36
He was looking– and I’ve taught all my analysts, if you can’t show me the rate of change slowdown
46:41
in their business within three to six months, this is not going to have a hedge on name
46:45
on it.
46:47
You can argue till you’re blue in the face but the batting averages are very low.
46:51
If you tell me you found a fraud, like our analysts, Kevin Kaiser did with multiple MLPs
46:57
and by the way, those frauds weren’t revealed until oil blew up.
47:00
RAOUL PAL: Yeah, same reason, micro, macro changes.
47:03
KEITH MCCULLOUGH: That’s when it was easier to get loud on deflation Quad 4 type theme.
47:09
I have an analyst who’s super buried up on a bunch of frauds in the MLP space.
47:14
Go.
47:15
I think that timing part, I’d humbly submit that that’s a part when I say the art of short
47:18
selling has been shot for dead.
47:20
It’s because you haven’t had the macro meets micro.
47:24
The rate of change now, your timing’s good.
47:26
Now, your batting averages are going to go up.
47:28
If you show me a software company, we found one that basically filed an S1 with two years
47:33
lookback in terms of revenues when the revenues have only gone this way up.
47:37
Post tax reform, through tax reform.
47:39
It’s a 20-year old IT services company.
47:41
It’s like hello, McFly, you slowed every single time we had a cycle but you’re not showing
47:46
the lookback.
47:47
These are the kinds of things that Wall Street underwrote.
47:49
This is why you know short selling now in a lot of these high multiple stocks is a much
47:54
more appropriate time, high multiple stock prevailing condition is slowing as opposed
47:58
to accelerating.
47:59
RAOUL PAL: Right.
48:00
You just been out seeing clients that’s why you were in a suit and tie.
48:04
KEITH MCCULLOUGH: It’s the only time I wear it.
48:06
RAOUL PAL: What are you hearing?
48:09
What are people doing?
48:11
What are they thinking?
48:12
Where are the pain points?
48:13
Where are they– I don’t think it’s been a straightforward year for many.
48:16
KEITH MCCULLOUGH: No, but if you’re having a good year, the happiness factor is back.
48:21
I do have clients that are macro aware.
48:23
They’ve been on the right side of the cycle.
48:26
Generally speaking, I’d say that the clients that if they’re paying us, they’re aware of
48:30
the view that we’ve had, certainly the Quad 4 views, their batting averages on the short
48:34
side have gone up tremendously if they are of that ilk.
48:37
If they’re long only they’ve been leaning on proxy, which they’re quite happy about,
48:41
but I’d say that, like, in particular, this last couple weeks of meeting, there’s the
48:45
markets punch to new highs throughout earnings season.
48:49
There’s an uneasiness to it.
48:52
It’s like– RAOUL PAL: That’s my opening question, uneasiness or uneasiness.
48:55
KEITH MCCULLOUGH: Uneasiness.
48:56
RAOUL PAL: Yeah, hence my opening question to you when we started this is nobody really
49:00
knows quite what’s going on.
49:01
KEITH MCCULLOUGH: Happiness becomes uneasiness when you start to underperform the bench.
49:07
That’s what’s happening.
49:08
Peak happiness was coming out of the October lows in the S&P; 500 or August and October,
49:13
our clients would be doing fine because the things that they’re long were going up and
49:17
their shorts are going down.
49:18
Now, everything’s going up.
49:19
In fact, the things that have gone down a lot are going up more., so you’ll have that
49:22
uneasiness.
49:23
There’s an absolute consensus to not be able to fade Trump’s tweets.
49:29
Therefore the value or the resurgence of these PMIs and ISMs a bottom trade.
49:36
They’ll wait to see the data point until they believe that the cycle is properly continuing
49:40
to slow.
49:42
There’s an uneasiness about that.
49:44
There’s always an uneasiness about your compensation.
49:47
A lot of people– RAOUL PAL: It’s always a difficult time of year because you’ve got
49:52
six weeks to make a decision.
49:53
Do I do anything else or do I not do anything else?
49:55
KEITH MCCULLOUGH: Yes.
49:56
There are plenty of money managers long only and long short that have set their yearend
50:01
in September, October, November, those months for that reason because they didn’t want to
50:08
be beholden to chasing the ace into yearend markups.
50:12
It’s an interesting one, but again, don’t forget that the S&P; 500 stock going up in
50:15
November of ’07, it didn’t wait till the end of December.
50:19
There’s an uneasiness associated with that as well.
50:21
The more macro where you are, the more ’07 questions I’m starting to get, which doesn’t
50:26
have to mean we’re going to have an ’08 but that’ll certainly– if it doesn’t make you
50:29
feel uneasy to some degree, I think it absolutely should.
50:32
RAOUL PAL: The hedge funds themselves, what is the appetite for risk now?
50:37
Are they gun shy?
50:38
Because they’ve had, yeah, it’s been a flip flop year.
50:41
It’s been one of those years where they came in short of equities, equities rallied, okay.
50:46
Anybody who got the bond trade got it sorted out, then it flips again later in the year.
50:50
It’s been a complex year for many people.
50:52
How are they feeling in this?
50:54
KEITH MCCULLOUGH: The better the research teams and most specifically on the short side,
51:00
the better they are doing right now.
51:02
Don’t forget, just like the high yield index or where high yield spreads are is not where
51:06
the rest of the market is.
51:08
You have multiple blow ups going on.
51:11
Think of some epic story stocks imploding and for the valuation oriented short seller
51:17
that got the timing right, I think that the batting average is going up their– or building
51:23
a confidence that wow, I have the benchmark index SPYs at the all-time high and I can
51:28
make money on my shorts at the same time with the president trying to trump up the bench.
51:33
Like it’s almost like licking the chops times for this– somebody who’s had a successful
51:38
career short selling across cycles, not somebody who’s just getting lucky.
51:43
RAOUL PAL: Final question, the dollar.
51:47
You’re, I think, majorly negative the dollar right now, do you think the dollar cycle is
51:52
turned for good, or is this part of the reflation in Quad 3 theme?
51:59
Where do you stand on the whole dollar view?
52:01
It is crucial to a lot of things.
52:03
KEITH MCCULLOUGH: Yep.
52:04
If you take the trade weight of dollars at a 20-year high, again, back in 2001, same
52:09
point, what could possibly go wrong?
52:12
Sustainably strong dollar is also one of the many negatives to corporate earnings growth
52:17
for the fourth quarter and the first quarter, so it’s the same sixmonth outlook.
52:21
No longer buying dollars– RAOUL PAL: Okay.
52:22
It’s off the same– it’s not a separate construct for the dollar.
52:26
KEITH MCCULLOUGH: No.
52:27
Quad 4 is where the dollar goes up, so the next time I’ll buy the dollar is when I think
52:30
the market’s setting up the price in another Quad 4, so I have a six-month window, might
52:34
be four.
52:35
RAOUL PAL: When do they start– when did the clock starts here?
52:38
KEITH MCCULLOUGH: October.
52:39
That’s when dollar– RAOUL PAL: End of December, January, February, March.
52:41
KEITH MCCULLOUGH: Yeah, our call was it’s pretty straightforward, it’s hashtag peak
52:45
dollar.
52:46
I don’t mince words.
52:47
The dollars peak, but again, the dollar– RAOUL PAL: The peak dollar sounds to me secular,
52:51
but you’re saying cyclical?
52:52
KEITH MCCULLOUGH: Yeah, it’s just my six-month pivot.
52:56
Again, I want to cancel– RAOUL PAL: That’s what I wanted to ask you about it.
53:00
My thinking, I’m a much longer term person so I was thinking okay, if you’re saying that
53:04
you think the entire dollar construct has now changed for the world, okay, that’s very
53:09
different than the view I have which is like okay, and this has been trading accordingly
53:14
to your view, it may had broken down or broken up but it’s– KEITH MCCULLOUGH: It made it–
53:18
it’s been like literally right on the screws played out in our playbook and this doesn’t
53:22
happen all the time obviously.
53:24
When it does, you like to know just like a good golfer makes a birdie putt, you expect
53:28
to make the putt, you hit three good shots on a par four, well done.
53:32
That’s what the process say.
53:34
When Quad 4 is you’re in the thralls of Quad 4, the dollar should rally to new highs, which
53:38
it did, Quad 4 ended in Q3.
53:40
Now, we’re not in Quad 4, the dollar should start to make lower highs for six months.
53:47
That’s pretty much it.
53:48
I don’t think that it’s like some big bang call.
53:50
I still do think that there’s some asymmetry to the Fed waking up to that GDP number in
53:54
February, and then cutting their dots.
53:57
I think that that’ll probably be wherever the dollar corrects to, that’d be the beginning
54:02
of the end of the negative dollar view.
54:05
Then I go back to being long the dollar in start of second quarter.
54:08
RAOUL PAL: Final, final question, when you’re looking at the rate of change to assess where
54:13
you are in in your framework within the quads, you’re looking at the rate of change, are
54:17
you looking at the rate of change of asset prices, rate of change the economic data or
54:20
a bunch of both?
54:21
KEITH MCCULLOUGH: Both, and that’s what I call my AB test.
54:25
A is various in the research team constantly measuring and mapping the rate of change data
54:29
across 50 different countries.
54:32
RAOUL PAL: Economic data.
54:33
KEITH MCCULLOUGH: Economic data, and then there’s me, that is measuring and mapping
54:36
the rate of change of price, volume and volatility, the relationship of all three, especially
54:41
the volatility of volatility is what I really care on, and something like that.
54:45
Like we just saw what I call phase transition in oil volatility for example.
54:48
Oil volatility or the vol of vol has now gone from bullish volatility, very negative for
54:53
the price to now bearish volatility, which is very short term bullish for the price.
54:58
We’re starting to see that too.
55:00
It’s classic.
55:01
I think, Bridgewater, Dalio to a degree, assets flow towards falling volatility, assets low
55:08
the rising volatility, and that’s why I spend so much time on that.
55:11
It’s the most humbling of experiences as it was for Mandelbrot when you had Big Blue,
55:16
the machine measuring and mapping cotton prices in all historical prices, because you have
55:22
to wait for a moment where that signal becomes real, because there’s lots of Brownian motion.
55:27
If you’re looking at it like I do, and measuring and mapping the volatility of volatility daily,
55:33
Brownian motion 101, there is nothing to do until there’s something to do, because volatility
55:38
will cluster and then become a new trend.
55:42
That’s what I’m essentially on the lookout.
55:44
RAOUL PAL: Because it’s interesting.
55:45
We’ve just interviewed John Bollinger.
55:47
I haven’t seen the interview yet, but Bollinger Bands, the technical analysis.
55:50
It’s basically based around the same concept.
55:53
KEITH MCCULLOUGH: Really?
55:54
RAOUL PAL: Yeah.
55:55
It looks like it basically looks at the volatility of an asset and if the volatility is increasing,
56:00
the band’s increasing, if it’s decreasing and usually when it decreases after a while
56:04
and you get a breakout, you’ve got to change your volatility regime.
56:07
KEITH MCCULLOUGH: Well, that’s right.
56:08
Bollinger Band would be a Gaussian standard deviation and when the volatility changes,
56:15
the standard deviation of vol comps change.
56:17
RAOUL PAL: Essentially, yes.
56:18
KEITH MCCULLOUGH: Actually, that’s a good example of what I call our risk range process.
56:22
I published daily risk ranges and people are like, wow, I can’t survive without it and
56:26
I’m like, no shit.
56:27
I couldn’t do– I couldn’t trade without it.
56:30
Again, when I see the volatility of volatility rising, what happens is my probable range
56:35
widens.
56:36
RAOUL PAL: Of course.
56:37
KEITH MCCULLOUGH: Similarly, when the range is starting to tighten, what that means is
56:40
that the volatility is starting to go away, or potentially undergo phase transition, plenty
56:45
of head fakes.
56:47
Again, when I take the AB test, this is critical.
56:50
The signal is always raw, front running the quad, the market signal’s going to get it
56:55
before the quad does.
56:57
If my quad outlook reflects what the market sees, and it’s a change of face- – RAOUL PAL:
57:02
The problem is that the market also does a lot of false signals, just keeps reading for
57:06
something different, and it gets it wrong, and it reverts.
57:08
KEITH MCCULLOUGH: 100%.
57:09
RAOUL PAL: That’s endlessly testing the narrative, the markets or indices, so yes, it’s the test
57:15
between the two is dead right.
57:16
You can’t do it without the other.
57:17
KEITH MCCULLOUGH: Which is why my hair is grayer and I’m getting fatter because I have
57:20
to do this.
57:21
That’s what I signed up for, like Hedgeye, I don’t get to have days off from Brownian
57:27
motion.
57:28
I have to deal with that damn thing every day.
57:30
Moreover, I have to try to explain it, which is unexplainable some days, but it certainly
57:35
makes– it’s made the experience of what I do, and trying to teach what I do, if only
57:41
I’m teaching myself actually, I’m sure people have realized that, wow, this guy’s not as
57:46
dumb as he used to be.
57:48
It’s a rate of change.
57:49
If you have to teach yourself through your mistakes publicly, every day, you will get
57:53
less dumb.
57:54
God forbid, you get a little bit better at it and better and better at it, but you’re
57:57
quite right.
57:58
The amount of head fakes, they’re just manifest.
58:01
RAOUL PAL: Yeah, that’s a lot of filtering.
58:03
Keith, super interesting.
58:05
I think it’s been– you’ve had a great year so well done.
58:08
Hands down to you.
58:09
KEITH MCCULLOUGH: Thank you.
58:10
RAOUL PAL: Let’s see what next year brings because it’s going to be another really interesting
58:14
macro and the great thing for us, for both of us is it’s a macro world and macro world
58:19
is the most interesting of all, because that’s what I find the big returns lie.
58:23
This whole period of time, we have low volatility, choosy, well, the grinding high prices and
58:28
that’s never the easiest to make money.
58:30
Well, you can’t easily make money if it’s never exciting.
58:33
Let’s see how it pans out.
58:34
Thank you ever so much for coming and do this.
58:36
KEITH MCCULLOUGH: Yes and congrats to you, you had a great year as well.
58:38
I appreciate you having me on.
58:39
RAOUL PAL: Yeah, and it’s all good.