Shownotes
Keith McCullough, Founder and CEO of Hedgeye Risk Management, joins Alan Dunne in this episode for an in-depth look into Keith’s distinctive approach to global macro analysis and tactical trading. The conversation explores Keith’s background as a hedge fund manager and his views on how markets have evolved, especially in relation to option flows. Keith breaks down his four-quadrant framework for macro analysis, explaining how pinpointing the economy’s position within these quadrants is as much an art as it is a science. His framework currently signals continued strength in the US dollar and US equities. A fundamental aspect of Keith’s approach is his respect for market signals and the need for these signals to confirm his macro views. He also shares valuable insights into the behavioural challenges of investing and emphasizes the importance of a disciplined, repeatable process to drive long-term success.
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Episode TimeStamps:
02:23 - Introduction to Keith McCullough
05:01 - From hedge fund to research
07:29 - Being a retail investor is an insult
09:56 - How McCullough has reacted to the rise of 0DTE options
13:48 - Have stocks become more macro driven?
15:54 - Where are we currently in the 4 quads?
19:22 - The challenge of lag in macro signals
21:26 - McCullough's framework for monitoring signals
24:25 - When can herding be a distraction?
26:54 - The current market from a quad perspective
31:09 - Reassessing the narrative of the deficits
35:50 - The outlook of the dollar
38:16 - The (un?)importance of valuations
41:07 - How the state of China influences McCulloughs model and framework
43:15 - Getting on the right side of the K
45:12 - The market from the 3 pots perspective
48:33 - Developing a respect for the markets
52:07 - McCullough's advice for preserving your wealth
56:01 - McCullough's philosophy to investing
58:33 - McCullough's perspective on systematic trend following
59:50 - Advice for other investors
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Transcripts
You know, we're in new territory here, and much different levels. Like I said before, if you're of Mandelbrot school, it's this particular thing that's happening to the deficit. Cutting it instead of building it to the mother of all bubbles, you know, at this particular point in cycle time that matters the most.
And I think people should be… At least for me, I have to have the humility to understand that I don't know what the hell's going to happen, other than what's already happening. Like I said, the dollar signal to me is the most explicit signal out there. Unless you can show me where the rate of change of their deficit decisions are going to change, then I'm not going to change my position.
Intro:Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.
Before we begin today's conversation, remember to keep two things in mind. All the discussion we'll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here's your host, veteran hedge fund manager Niels Kaastrup-Larsen.
Niels:Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle. We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations. Please enjoy today's episode hosted by Alan Dunne.
Alan:Thanks for that introduction, Niels. Today I'm delighted to be joined by Keith McCullough. Keith is the founder of Hedgeye Risk Management. Prior to founding Hedgeye, he was a successful hedge fund manager at Carlyle Blue Wave Partners, Magnetar Capital, Falcon Hedge Partners, and Dawson-Herman Capital Management. He hosts a daily macro show on weekdays and he's also the author of Diary of a Hedge Fund Manager. Keith, great to have you with us today. How are you doing?
Keith:Really good, thanks. Thanks for having me. It's good to have a chat with another Irishman.
Alan:Yeah, we were just saying you have your Irish heritage, so it's great to have a fellow Irishman on the podcast. I mentioned a whole host of different hedge funds that you worked at earlier in your career. It'd be great just to give us a sense on how you got interested in markets and what was your route to starting Hedgeye Risk Management.
Keith:Yeah, that was jumping lily pad to lily pad in the hedge fund industry was essentially my experience. And that's why if you want to eventually run your own fund, that's the way it goes. So, I started as an analyst, as a buy-side analyst at a hedge fund named Dawson, which used to be called Dawson Samberg, you might remember that. Then they split into Pequot Capital Management and Dawson kept his firm. So, I was there, and it ultimately became Dawson-Herman Capital Management.
I had carved out the book by: profile launches, I think, in: ing their first hedge fund in: Alan:Nice. So curious, you've kind of made the leap from the hedge fund world into the whole world of research and obviously risk management. And, I suppose, offering your services to, I guess, retail and types of investors, was that something that you wanted to do? Were you just part of the hedge fund space or was there a particular motivation for going down that route?
Keith:Yeah, it's interesting and maybe not ironic, but I didn't plan this at all. I mean my number one plan, as I said, was I'm going to work for myself. So, what I did was I actually just started trading my own book, my own capital, and doing it out loud.
I actually called it MCM, or McCulloch Capital Management, on a block. And what I do every day is post all my positions; the full transparency project that you and I would be used to doing, or anyone who runs real money or trades their own book. But to the outside world that was, evidently, kind of interesting.
So, my friends on the buy-side in particular at hedge funds, mutual funds, pension funds were like, you know, people would pay for this. I'm like, well, pay for what? It's like, just to copy you and/or what you're saying or doing because you're better than bad at writing and you communicate okay. So, so that's how it really started.
I got lucky in a lot of ways, as I have in life. And it's a blessing, life's been for me. A lot of the technology, fully loaded with YouTube, Twitter in particular, and ways to communicate in real time, and have that transparency accountability mechanism, really made it evident to me that to run my own money, but not run institutional money, and have all institutional managers pay me as one of their independent research sources was a great trait. I could never get fired. I’ve got a subscription business where people are paying for my process.
And lo and behold, it just really manifested, over the years, into what Hedgeye has ultimately become, and I still don't know what it's ultimately going to be. That's the beauty of it is that we're building a community, we're showing people how to use our process and it's a great learning environment. So, I'm always open to what it's going to become but I certainly didn't plan it that way.
Alan:Okay. Okay. So, it's just a process of evolution, I guess. Yeah, interesting, I mean I mentioned that you have a book, are the author of Diary of a Hedge Fund Manager. But also, on your website you have this kind of guide to markets, Mastering the Markets I think you call it. In there you say that you think we'll see more kind of self-directed investors over time and that's kind of partially the motivation for your business. I’m curious to get your perspective on that. And also more generally, obviously you've been in the hedge fund investing world for two or three decades. What have been the big changes? How is that shaping the investing landscape?
Keith:Yeah, and thanks for that. It's called Master the Markets and I made it free, you know, because I guess as Jack Bogle would say, I've got enough, you know, I don't really care if I'm a billionaire or whatever. That's not what this is about. It's more like can you change the world? Can you help self-directed investors? Can you help the people with a real process that they wouldn't ordinarily have access to? So, Hedgeye, the name by the way is, you know, if you could look inside of a hedge fund, what would you see? Hedgeye: you'd see their models, you'd see their analysts, you'd see their macro top-down views, macro positioning, you'd see their sectors, factor exposures, sector styles and all that.
That last part that I just said, of course, is the game that we're in now versus the game that I started in. The game that I started in was just flat out stock picking, block trading, stock picking, you know, making sure that the street knew what you liked and didn't like and try to get them to buy, which you have so maybe you could sell into it, I don't know.
But the game now, I mean it's materially dominated, as I like to say, by the flows of the machine. And if you don't understand factor exposures and how to use options and options flows to trade your book, you really put yourself at a complete disadvantage to what you could be. Right. I mean I like to say self-directed investor is a compliment, whereas being a retail investor is an insult.
If you're called a retail investor, I mean that generally means that you're macro unaware. You don't use algos, you don't use stochastic models, you don't know how to apply AI to the current model that you're using. There's a whole host of issues that you have, not the least of which is just chasing narratives and stock charts.
So, you know, I think there's a huge difference and that's why I think there's a big opportunity for people who are willing to be self-directed and put in the real work.
Alan:And you mentioned, you know, options, etc. I mean we have seen this rise of zero DTE options trading, greater participation from retail, I guess you call it, in the likes of Robin Hood, et cetera. I mean, are you noticing that day to day in terms of executing your own investment strategy? Do you have to modify that for that kind of shift in the market microstructure?
Keith:100%. I would have never had like six times a day… I mean, as we go through this conversation and we get to know each other, you'll figure out that I'm all about my process. So, how can I tweak and how can I evolve the process? It's rules based, it's systematic, and how do I take these options flows?
So, for example, you know, six times a day I'll be looking at where is the ODT picture, where's the most heat in terms of volume, in particular with SPYs and QS. And then also pay acute attention to the most active options board on weekly options because there's a bubble inside of that bubble which is clearly trading Tesla calls, yolo, Nvidia calls. For example, yesterday alone, people are chasing like the Nvidia 150s, the weeklies, and the stocks at like 148, and you could just see the bulling of the market.
So, if you don't understand how gamma works and how dealers have to reposition, then that's one thing. We do. We partnered with a company called Tier 1 Alpha, that you may have heard of, that again systematically shows the flow of the market from an options perspective every single day. So, I have some pretty unique looks, and I think the most important thing is that I've incorporated all of that into my process. I would never make a decision without looking at everything I just said.
Alan:We'll get into the process in a little bit, but does that account for what we're seeing in markets these days? I know it seems to be some days like the Fed cuts rate, there's no reaction, and a day later there's a big reaction, these types of things. Is that driven by the options market, do you think?
Keith:Yeah, I mean you have a pretty concentrated network of dealers. Now like you’re post GFC, you took out all the sell-side risk takers. We actually ended up with some of them at Carlisle. That's how we blew up.
It's basically Goldman, Susquehanna, Citadel, you know, Jane Street and, and they are quite sophisticated. They're very good at ripping a certain kind of retail investor or client off, by the way, which I'm sure you’re well aware. But you just have to be in it, and you have to be able to see it.
You have to understand that if I call you, Alan, and you're on the Goldman desk, and I say, hey look, I want you to buy me 10,000 of the Nvidia weekly calls that expire in two days. All of a sudden, he's going to be short. He's going to have to either be short that, or he's going to have to buy both the stock and/or more calls. So, it's self-perpetuating. So, the flow really perpetuates, up and down moves. That's why you have to understand where gamma is. You have to understand where all these trades are.
Quite often it has nothing to do with anything fundamental, which would go back to what I taught myself all the way back, which is, I'm of the Benoit Mandelbrot school of thought where it's not the average of things, or the simple moving averages of things, or the valuation of things that moves markets. Quite to the contrary, most of the time it's just Brownian motion.
But it's the particular thing that happens at that particular point in clock, or cycle, or market time that matters. You need to know when it's time to act and you need to know to not act. Doing nothing is obviously a very good strategy sometimes too.
Alan:And in the Master to Markets book you mentioned, or you suggest that markets are more macro driven now. Is it that you're saying that stocks are more influenced by macro factors and fundamentals, Is that it?
Keith:Definitely. So, we call them the quads. So again, I invented this thing called the quads. So, we can go through that if you want. But the basic assumption is that the economic cycle, again, is being driven by reported data, and the machine is going to adapt to whatever those macro conditions are. So, I have a two-by-two model: the rate of change of growth, the rate of change of inflation. The biggest risk in markets is when we hit what we call quad four. We have four different quadrants.
But when the market is sniffing out a rate of change slowdown in both growth and inflation, whether or not you're going to have a recession is irrelevant. What ends up happening is that the dollar goes down, bond yields go down, utilities go up, rate sensitive equities go up. The sector styles obviously take note, and you have yourself, your macro, it's staring you right in the screen. So, when we go through this, the most important things that happen, from a macro perspective, are really perpetuating the incremental flow of the machine. It either stays with the trend, whatever quad you're in, or it quad shifts. And that's where the big moves happen.
We just had a huge one in inflation expectations. Our model picked that up. Instead of quad four, the opposite of that is quad two. So, in quad two you have the rate of the rate of change of growth and inflation accelerating at the same time. So, buying yields go up, the dollar goes roof, you get this massive breakout in small caps. Financials love quad two.
So, we backtested, basically, everything that ticks in macro against these four quadrants. We have a playbook. We don't always go with every single thing that backtests. It has to have a signal that supports it. And that's really my principal orientation. Where's the signal, where's the quad? And then I go from there.
Alan:Okay, great. So just to recap, it's kind of four quads. One is kind of goldilocks growth below inflation. Two is reflation, so higher growth, higher inflation. Three is stagflation, so growth weakening, inflation staying elevated. And four is deflation, so growth deteriorating and inflation deteriorating.
I mean it's all very, it's very intuitive and I think people like that. I guess with these things the devil is always in the detail. And I mean it'd be lovely if we went from 1 to 2 to 3 to 4 and then repeat it. But I guess it doesn't work that easily.
So, you know, sometimes the economy is kind of chugging along. It mightn't be accelerating, it might be decelerating. You know, we had inflation out today, we're recording on the 13th of November, it was kind of the same year on year. Now, you mentioned inflation expectations, so I'm guessing you're not just looking at the headline CPI Rate. But presumably there is a lot of nuance to determining where exactly we are in four quads.
Keith:Oh, yeah, there's a lot of modeling, there's a lot of nuance. You know, there are the monthly quads, there are the quarterly quads, and they can be different. You can have, so for example, we currently have the US in quad 3 for the fourth quarter, but we had a monthly quad 2 for October. So, you have to understand the difference. And the market has gotten really, really good at nailing what we call the monthly quads.
We've always modeled it that way, but we started publishing it, in the last couple years, just because people really wanted to… They had to adjust to the shorter term.
So, the 30 days or less duration, which I call my medium-term trade duration, is far more important than it's ever been. But again, the trade impacts the trend three months or more. So that quarterly, you know, where are the quads?
In the end, the market tends to go with the bigger, more obvious trend. But there can be some jarring moves from quad to quad. I mean, we went from quad four in July, which was a really good one for us. If you came into July, short QS, the only, the only quad to short bitcoin and QS, for example, from a macro perspective, which most people own, is when you hit a quad four. So that worked perfectly. And it doesn't always work perfectly, but it worked when that July quad four hit.
Then you had another quad four hit in September, with a quad one in August. So, you had this quad four, quad one, quad four. And then right from that low, which was quite literally, mathematically, the low for a lot of macro things in September, going to quad two in October, it wasn't magic, it was math.
And then, of course, all the Trump trades take hold, and they ended up forming around what we call, these are fractal patterns. I call them fractal patterns. But again, when we take everything inside the system and you look at it, and the market is now calling the Trump election a quad two event.
So, there are lots of subtleties. The signals are critical in helping risk manage those things because, like you said, everybody wants it to be in a nice blue Tiffany box. It's like we go from quad to quad, and it's a nice easy thing, and glacial. That's clearly not it.
There's devil in detail as you said. I'm an Irish Catholic, I believe in the devil. He's there, it's in my machine every day. So, you know, you’ve got to really pay close attention.
Alan:What are the pushbacks in all of this kind of macro driven analysis, I guess, particularly if you're kind of modeling it? Is it the challenge of, okay, it doesn't happen too often, but when something like, say, Covid comes along and something left, where the macro data is slow to pick up what's evolving in the economy, was that problematic for your models or is that just part of the territory?
Keith:No, it would be if I didn't have my signaling process, that's for damn sure. So, the signal front runs the quads. To your point, economic data is reported on a lag to when it's actually happening. Sometimes it's a month, sometimes it's a week, most of the time it can be a quarter, on quarterly GDP with another month tied on top of that.
So, the signal is constantly telling you what its probability weighted view is of the future economic reality that's about to be reported. So, the pandemic is an excellent idea. I didn't know anything about pandemics, but my signal in January of that year went explicitly quad four. And this was well ahead. So, I'm positioned for a pandemic. And I didn't even know a pandemic was going to happen.
It's just like I'm not a Republican or a Democrat. I'm, like I said, an Irish Canadian. I wasn't positioned for Trump trades. I was positioned for what the machine said I should be positioned for, which is the probable economic outcome. And I believe in that for this reason alone. Markets do discount the future, and they're very good, in particular, one to three months ahead of time of giving you plenty of opportunity to learn about where you're about to lose money. I always say that if I'm losing money in the quad that was working, that means the quad's changing. So, I better change.
So, it requires a lot of mental flexibility and agility, really, to use our process, but it really works at those quad four turns, irrespective of having to be the smartest person on the planet about every single topic, like most macro tourists.
Alan:Yeah, and you mentioned the signal lead. So, when you're talking about the signal is that this idea of trade trend tail? Which sounds very much like technical, it sounds a bit like Dow theory or something like that in terms of kind of short-term, medium-term, long-term trends. Is that kind of the idea you have?
Keith:Yeah, well I mean it's my own so it's not Dow theory, it's not whatever. I call it multifactor multi-duration. So, multi-duration, you just nailed it.
I use three different windows of time that I care about. What is the immediate term trade which is three weeks or less. I built it that way, by the way, because I wanted to front run my boss. Because when I was at Magnetar most of the one-month momentum shifts on any factor in, in a borrow model and on one month, I would have to change my position. So, I'm like, screw this, I'm going to front run it by a week. That's why I came up with three weeks or less.
And people are like really? Is it that simple? I'm like, sometimes it is. Being a week early actually matters quite a bit in a system that momentum driven. Trends are three months or more. So that's quarterly type investing which a lot of people do. And tails, I call them tail risks, are three years or less. We're far less accurate on tails because it's further out in time. But I've never predicted anything beyond three years. If I had, it was pure luck.
So, then on the multifactor point, which is the real differentiator, I use the relationship and I built, it's a fractal model that uses three factors. When I say multifactor, multi-duration, the three factors are price, volume, and volatility, the rates of change they’re embedded within and their relationships and how they're tied together. So, good example.
So, that's where I essentially, when I say, I don't have to know a pandemic's coming, the market knows it's coming. What's happening there is that the prices of things are going down as the volume ia going up and the volatility is breaking out on a trending basis and rate of change terms. So, that's where I get my edge.
I could tell you, yesterday, I mean, CPI got leaked at 9:45 in the morning. It was like my signal just jumped like a fish out of a boat, you know. And that's what happened. The volume, the price action, everything did what it does when somebody gets information that they're acting on. So, I built it that way, of course, because from a practitioner's perspective, you know people are trading on inside information. You know you don't want to trade on inside information and put on orange jumpsuit risk. So, you want to be able to front run that people either believe something is to be true or actually know that it is true.
I know that's a lot, but I've spent my entire career building this bloody thing. It does attempt to simplify the complex, but it's not like anything traditional, so to speak, that you could just get off the shelf.
Alan:Yeah, I get it. I mean one thing I always think about with these is, you know, you’ve got two different concepts. One is the wisdom of the crowd, which makes sense. And then at the same time you've got herding and irrationality. So, at times the market is telling you something and sometimes the market is getting carried away.
know, in January, February of: Keith:Well, herding typically, I don't know if I'm going to define it the way that you define it, but the crowd eventually shows up chasing the same quad. And then you get this coagulation of types of investors: day traders, short term, intermediate term, long term. They all come to agree and herd around something that is now yesterday's news. And the biggest danger is when that's about to change, so, you're about to shift out of the quad.
A great example is coming out of the pandemic, when oil was at a negative price, you know, it's at extremely low prices. My model really isn't set up to pick bottoms. I call that a very stinky business. I don't want to be in that business because I've tried it and I'm average at best at it. When you're trying to pick a bottom, you're probably using some bullshit valuation view. If you are successful, you're probably lucky.
Whereas a bottoming in cycle terms, you know, against the herd is a process. Bottomings are processes in as much as tops are processes. So, I have a way to measure and map that. I don't mind being a little late on a cycle turn. I don't want to be really early because that means you're losing money the whole way. But being a little late is okay in my process because the herd can be very much right for a tangible period of time. You can only have a healthy respect for that if you've lost money on the short side as many times as I have.
It's learning by doing. The answer is not easy. If it was, most people would have a better answer.
Alan:Okay, maybe translating all of this into the current markets. Obviously, you know, you touched on the Trump trade and policy is also part of your framework too. So, as you say, I mean going into the election, it did seem like the market was signaling a likelihood of a Trump win. I mean that was evident in betting markets as well. So that was kind of consistent, but that was the way the market was trading. And obviously, we've seen an accelerated move since then. So, from a quad perspective, what are you seeing? What do you think from a policy perspective, and is the market action signaling anything interesting at the moment, would you say?
Keith:Yeah, the technical name for the quad model is called the GIP Model because as I said, growth and inflation, it's a two by two model. But if you get the rates of change of growth and inflation right, you can front run the P in the GIP, the policy moves. And the market is very good at sniffing that out.
So, let's just use what just happened with Bitcoin and Dogecoin, of all things. So now we have, “Oh, that's what Elon was doing.” I mean he was buying the shit out of a meme coin knowing full well that he's going to be appointed czar of something that he's going to name by the name of the meme. I mean, just look at the price, volume, and volatility on Dogecoin.
It has nothing to do with anything an intellect could tell you is right or wrong about that. It has nothing to do about people's moral code or compass. It has everything to do with what the policy was going to be. And people make policy.
So, the market now, I think, is… So, from here what happens? I mean, quad two is clearly what ended up being… The empirical fact is that October was a monthly quad two. That's the beauty of the quads.
You can go back in time and these are stated empirical facts that are not like fake news because they're reported numbers. Somebody might say, well, the inflation numbers are fake news too. And I don't quibble with that. But I still use the ones that are reported because of work, in terms of front running things.
But I think what's going to happen here, the implications of cutting the deficit are pretty straightforward. I mean, I would have never guessed that that was going to be on the table. But that's the beauty of not being a narrative driven macro guy. I don't tell markets what to do. I do what they're doing.
If you think it through within the lens of the quads, first of all, the quads are saying that November and December are going to be quad three, and then we'll go back to quad two when Trump's inaugurated in January, that'll be a quad two. But for a couple months here, the market would most likely, or as of today, it has shifted a bit, it said, okay, look, I see that deficit cutting would be negative for GDP. The most incremental buoy to GDP, pre the election, was the big G, the government spending components.
So, it has very difficult comparisons, as we say in our model, or tough base effects: G, and the C plus I plus G equation, for GDP and growth. So again, you'd get stagflation. You'd have rising inflation, which we got reported today. We also publish a weekly and monthly Inflation Now Cast. That number, I mean, it's crazy, it doesn't even sound like I'm full of shit, but I mean, we literally nailed that CPI number, three months ago, to the decimal point. And that's a super valuable tool, that Inflation Now Caster that we built. And we have it going up to 2.83% next month, so, from October to November.
So, the number went from the cycle low of 2.44% to today, 2.60%, to next month, which Wall Street's going to have to play catch up on if we're right, and they did this time too. We're at 2.83%. So, all of a sudden you're almost like 40 basis points of inflation going up.
And that's why we think the policy, during that kind of a stagflation, is going to be that Powell's probably done after the December rate cut. It's kind of a token rate cut at this point, I think, given today's inflation report. But there are a lot of implications to higher for longer on inflation, and higher for longer on interest rates across all of macro. It might even be the most important thing.
Alan:And you mentioned deficit cutting. I mean, as you say, going into the election the view was that both candidates were going to have higher deficits, it’s going to be negative for bonds, higher for longer. I suppose now you've got the Doge being formed and talk of efficiency has been found, et cetera. And also the forerunner for being Treasury Secretary, Scott Besson, talking about 333, which is a 3% deficit.
Do you think markets are starting to reassess that narrative that it's definitely going to be enormous deficits, and where would that put us in the quads?
Keith:Well, big time. I mean, Scott Besson, a lot of respect for him, a client of Hedgeye over the years, and just a really thoughtful and most importantly accurate investor over long periods of time. People obviously, as you know, in this business are smart, so they can be thoughtful, but they can be dead wrong. He's also quite thoughtful from a macro perspective. That's his principal orientation. So, I think you couldn't, I couldn't think of, certainly in terms of human beings that I know, you couldn't think of the more polar opposite of Janet Yellen in Scott Besson.
You have somebody who is pretended to not be political, who headed the Federal Reserve, who ran the Treasury within a modern monetary theory policy without even calling it by name. To that, to cutting the deficit? I mean, like I said this morning, my number one asset allocation is on that because it looks like Besson's the front runner.
And Besson, by the way, is good friends with people like Stan Druckenmiller, who also knows exactly what he's doing and is very hawkish about the deficit. The implications of that are an extremely strong dollar. So that's my number one asset allocation.
I'm short euros, I'm short yens, I'm short any country that will not cut their deficit. I mean, I'll shave my head if the Japanese make fiscal cuts or if that becomes the European story. The currency market doesn't believe that, and I don't believe that.
I really think that you need to, and I wonder if you agree or disagree, but I mean, at least according to me (I say this in my, in my books as well) if I could only get one thing in macro right, like if you were to lock me in a dark room by myself with only one quote, I would take the US dollar index all day, every day. If you get that right, you get so many things in macro right, from interest rates to commodities, et cetera, et cetera. And it may be on a path here that few people, in particular if they're politically polarized on the other side, can't yet see.
Alan:Okay. And talk us through the logic for a strong dollar. Obviously, you have had scenarios in the past of large deficits, so lax fiscal policy, tight monetary policy, early ‘80s we had a strong dollar in that scenario. Equally under Clinton in the ‘90s we had deficit cutting and Ruben strong dollar, and we had a strong dollar for different reasons.
Is it more that type of scenario of a strong dollar coupled with strong demand for Treasuries because of the deficit being cut or what's your logic?
Keith:Well, the deficit being cut has not been a thing in our careers. I mean I can go back and pretend that I traded through the Volcker years, but I didn't.
year low by:To using cowbell as the answer for any economic threat, including ones that are imposed by the government themselves, like the great financial crisis. You know, we're in new territory here, and much different levels. Like I said before, if you're of Mandelbrot school, it's this particular thing that's happening to the deficit; cutting it instead of building it to the mother of all bubbles, at this particular point in cycle time, that matters the most.
And I think people should be… At least for me, I have to have the humility to understand that I don't know what the hell's going to happen, other than what's already happening. Like I said, the dollar signal to me is the most explicit signal out there. Unless you can show me the dollar, because the dollar isn’t just the dollar, it’s trading against all the other currencies in the basket, unless you can show me where the rate of change of their deficit decisions are going to change, then I'm not going to change my position.
Alan:But obviously we've got a lot of uncertainty about what's going to happen. We don't know who's going to be Treasury Secretary.
I mean, what else, I mean is that dollar call very much linked to a view on deficit reduction or are there other signals? Obviously, the trend in the dollar is positive over the last couple of months. I mean, from your trend trade tail perspective, is that dollar positive?
Keith:I never start with the narrative. I may know Scott Besson, but up until a couple weeks ago I had no idea he was even interested in the job.
Alan:Sure, yeah.
Keith:But I was long the dollar and I don't always know why. That's the important thing. I think that's a really important thing, by the way. I think a lot of people that try to trade macro, they need to know why. Like everybody's like, well why, why, why? Because they're all so smart. But I don't really care about the why.
I need to know when. I need to know when the signal is telling me to do something and to have the humility to know that I don't need a narrative that, I need to execute on that.
So, this is really just manifested out of a dollar position I had anyway, and I didn't really get why the dollar was going up while gold was, you know, you're pinning new all-time highs. Now I do. And now you're also starting to see very different correlations fall out of that. Gold has very much an inverse correlation to this strengthening dollar which we have a position in gold that's starting to become a bit of a problem. Even though we're old enough to remember the all-time highs of a couple weeks ago. But, but that's okay. I mean I have no problem selling my gold. I mean, to me they're just tickers.
And what's happening is that the dollar has an extremely high positive correlation on my immediate term trade duration to both Bitcoin and the S&P 500 in QS. So, dollar up and this is consistent with history. That I do study, obviously. I'm not a fortune teller, I'm not an astrologer, I'm not a chartist, but a decent history student of what has actually happened.
If you go back to the:The last point on this is that Trump, of all people, probably doesn't really want that. But the people he's putting in the seats imply that, which is interesting.
Alan:Yeah, I mean you touched on that correlation between the dollar and equities. I mean equities obviously it's been a relentless rise actually into the election weekend. It looked like the trend might be moderating a bit, but it jumped up since then. I mean you don't mention valuations so much. Are they not a factor? Is it because valuations don't influence the markets over short periods of time or how do you think about that?
Keith:Yeah, markets, I mean valuations are opinions whereas the rates have changed, are facts. My trade trend tail levels signals risk ranges are, to me, facts. No market goes up or down because somebody tells it it's expensive.
I mean that's, that's ridiculous. Now there was a time where valuation mattered more. I'm not saying it doesn't matter at all. That would be equally ridiculous. It's a component of what we do. If I can show you a rate of change acceleration, like we did in Japan before we got long it years ago, then and something that's cheap, well, to a large community of macro investors that's going to be more compelling. Value with the catalyst is always compelling if the catalyst actually plays out.
But when I look at markets that are going vertical, there's only one answer to the question, which is what is the fractal dimension in my risk range say it's going to do next? It doesn't say, like, let's use Bitcoin, which is probably the best example.
Bitcoin, you'll have all these yo-yos tweeting about, when are we going to see 100,000 and it's like 100,000 you're using because, A, it's a round number and, B, it's a lot higher. Whereas I'm looking at, like today the top end of my risk range for Bitcoin is $92,951. So, that's where I think it could go next. I don't tell the market what the valuation is on that, the market tells me.
So, I take the price, the volume, and the volatility on Bitcoin and that's what the math says we're going to next. If that changes to a lower high tomorrow, that would tell me that the popping process may be about to begin or a consolidation process. So, I use the fractal dimension embedded in my risk range, which I publish every day for like 30 or 40 things in macro, from gold, to Bitcoin, to QS, I'm long QS.
I don't say, I feel really bad about this valuation scenario that's getting us paid. It's like saying that you feel really bad that your house went up in value. Are you going to leave? No, you stay with it because you own it. And if there's no causal factor, i.e. the quads, to change that then you just stay with the signal.
Alan:Okay, so it sounds like the scenario, at the moment, we've been flipping between, what is it, quad two and quad three, and quad two is reflation. So, that's obviously favorable. One thing within that, reflation would normally be associated with positive say commodity markets, isn’t that fair to say? But obviously, how has that changed say with the growing influence of China?
Obviously, we've seen copper prices, say, declining over the last few months, which you would say that's kind of inconsistent with a reflationary scenario but it's understandable given what we're seeing in China. Has that kind of dynamic of the growth of China influenced the modeling at all or your framework or not?
Keith:Yeah, so we model 50 different countries with these quads. We don't just do the US. China, interestingly, bottomed, their economic cycle bottomed albeit for a quarter in the third quarter. And the trending correlation between the Shanghai Composite index and copper, which is one of my main signals, you know, that said exactly what you said.
Then China puts up the stimulus. We had them in quad two, actually, here in the fourth quarter. Copper, actually, had a pretty good move to the upside and now it's starting to fail again. I think the reason for that is because China's going to come out of quad two and slow again in the first half of next year.
That's a good example. You call it an excellent example where okay, the backtest says that quad two or quad three should be long inflation. So, that typically means commodities, which is true, but it hasn't meant oil for us. We've not been long oil because the trend signal has been bearish despite everything in the Middle East, or anybody's opinion embedded therein.
You know, copper, we went from long it to we sold it all and I'll probably short it next, to being short corn, now long corn. A lot of commodities… Many more commodities are breaking out than are breaking down. It just so happens that two of the biggest ones, oil and copper, are bearish trend. And those two, don't forget, given China's growing demands to import oil, I mean that's not inconsequential either.
So, when China slows, then that's not positive for the oil price. So, there's a lot to think about, but we definitely incorporate the quads of China in all that we do.
Alan:Okay. And in relation to the equity market and the economy, I mean you touch on the fact that the signal leads the markets, but obviously the markets influence the economy as well in terms of the wealth effect. So, is that something that you model as well or is that just kind of implicit in the analysis?
Keith:No, no, so if you dig in, like I have a big team. We're almost 100 people and going on 50 analysts. Then if I add our data scientists, our software engineers, which are like your modern day analysts now anyway, because they're replacing human, their tools are, we do some really deep dives like what we call our macro themes deck. We're going to present it actually tomorrow at the quarter update. And in that deck, we've been referencing this for a long time and I think that this is partly why Trump won, in the US we have what we call a K shaped economy. I always say it's not K for Keith, it's K. If you're on the right side of the K, you're big timing it, you're getting richer with asset prices, you know, inflating or reflating. And if you're on the wrong side of the K, which is about two thirds of Americans, you're paying the bills, you're eating it, you don't have any money left.
So, you know, in a way what's happened here is that this is only amplified, this most recent move in asset prices has only amplified the divergent path that Americans are on within their income stratus. So, if you look at only real estate value for Americans alone, we've gone to all-time highs here. It does perpetuate consumer discretionary purchases on the right side of the K, and on the other side not so much.
So, there are a lot of single stock longs and shorts that are born out of that and we try to make sure that the analysts are on the right side of the case.
Alan:I mean you've talked about the quads. The quads originally developed out of the pods, isn't that right, which was more of an equity framework? So, maybe just talk a little bit about the pods and anything interesting you're seeing in the markets from the three pods perspective.
Keith:There are three pods. There's pod one which is revenue growth. And to your point, Alan's point, this is more fundamental stocks company analysis. What is the rate of change of pod one revenue growth doing? Is it accelerating or decelerating?
You'll note that everything that I model is modeled in rate of change terms. It's not modeled in absolutes or on a valuation basis. pod two is where our margins and/or associated cash flows are accelerating or decelerating. And then pod three is your capital allocation pod which is a little bit more boring. So, we won't get into that so much. Basically, it’s what are you doing with your free cash flow? What are your returns associated with that?
So, if I can tell you what companies that have rate of change pod one accelerating for two or three years, and then I could tell you what quarter they're going to have their first deceleration and, by the way, the next quarter that they could guide down, you want to be out of that long position and short it. So, that's my discipline, the pods. That's what I learned first, throw that upside down like I said, value with the catalyst is show me a cyclical company whose pod one base effects, or comparisons, are easy and the business is accelerating. Well, I want to be long that because the stocks come down and we have catalysts for the rate of change of pod one revenue growth to accelerate. So, those are going to be My longs.
So, I learned that basically what I did was I took the pods, and that the architecture of my quad framework comes from basically taking pod one revenue growth and replacing that with GDP. Taking pod two and replacing cash flows with headline inflation CPI because it back tests the best against bond yields. And really, I use the P instead of pod three. Given those growth and inflation parameters or conditions, what is the policy likely going to be?
Alan:And obviously applying those directly now to the market leaders, the Nvidia's, the Microsoft's, all of those, do they still look favorable from those metrics or are there any signs of a softening there at all or any sectors that are emerging to kind of lead the next phase of the rally?
Keith:Yeah, it's uncanny. We published this thing called the Momentum Tracker. It's basically the Mag 7. What are my trade trends? What are my signals and risk ranges on all those, every day?
And there's been some recent divergence and it's not surprising because it was born out of Microsoft, for example, reporting a slowdown. So, Microsoft has revenue growth decelerating. Therefore, on our trend signal it's breaking down. That's all I need to know. As my analyst models Microsoft, he's like, yeah, it's a deceleration. Whereas there are other companies that are showing accelerations. Then there's Tesla, which is on its own path. So, it's not about what the fundamentals of that model are doing. But the model has an uncanny ability to sniff out rate of change accelerations and decelerations in the MAG7 revenue growth.
Alan:So obviously, I mean listening to you, like you place a lot of emphasis on what the market is saying, the trend. I mean you referenced Mandelbrot, I mean in your book, you referenced lots of other books like Daniel Kahneman, etc.
Is this just what you picked up from your time in the markets that this is how they work, Markets lead, that the price action leads first. Or when you came into markets first, did you read these things and get inspired by that? I mean how does that kind of the respect for the market trend come about?
Keith:Well, I learned Mandelbrot, Kahneman, Tversky, Thinking Fast and Slow, which is obviously their book. I learned that after I learned all the lessons the hard way on the street - by trading my own book. I learned to have the utmost respect for the market and signals, if you could have accurate signals, by screwing up. The amount of mistakes that I made by not doing that, by starting with value. Most of the things that I make fun of, and it's pretty easy to make fun of your former self, they're born out of my former mistakes.
I've worked with a lot of different types of analysts and managers, seeing a lot of different things. And you learn a lot about what not to do. You know, like, you see people get fired all the time, get ejected from their seat at whatever hedge fund they're at. And there's a commonality to mistakes, right? There's the I'm smarter than you factor, I'm smarter than the market. That's probably number one, two and three most of the time for hedge funds. And I'm just not that smart.
I had the lowest SAT score at Yale. I'm a hockey player. So, my head's been rocked back and forth enough times to know that I'm not smarter than the market. And everything that I read thereafter. Once I started Hedgeye, and started on my own, and I knew I didn't have to really answer to anybody. I started this, I'm a routine guy, if you can't tell, and a process guy. So, I started reading a book, Alan, every 10 days. I'm like, I'm not going to read the Wall Street Journal. Who the hell reads that? I'm not going to watch CNBC or read some bullshit research reports from the Old Wall. I'm going to read books and I'm going to get smarter because I can only get smarter, in rate of change terms. And that's where I really understood the Santa Fe Institute that being a polymath is so better than being a dogmatic linear econ, for example. It's not like I hadn't read any books. But once I started reading one every 10 days, and that was part of my job, and writing about the books, then I try to find something in every book of what not to do and what potentially could be additive to my process. Then I add it to the process, and I implement that with live ammo in the market, and it doesn't work. I'm like, dum, dum, that's not smart.
That might have sounded smart in the book, but that doesn't work. So, for me, it's constantly like finding new things in books. And it doesn't have to be academic literature. In fact, it's usually practitioner type books, like books on gambling, for example, probability theory, athletes, things where people have to make decisions, the military decisions under duress and feed their emotions, things of that nature. So, the last point on this, I try to concentrate all my readings and learnings around three topics: behavioral, math, and history. So, those three things I really need always to get better, to improve my process.
Alan:Interesting. Yeah, you touch on behavioral. And I know in your book you mentioned Annie Duke and his idea of resulting, which is people kind of judging the quality of a decision based on the outcome as opposed to how the inputs were assessed.
And I mean, one thing I've been thinking about, I've been working in the alternatives industry, advocating for diversification, that type of thing. For the average investor they could have said, forget diversification, I'm just going to stay in the S&P 500.
And if you've taken that approach for the last 15 years, you've done just fine. Now that doesn't mean it was the right decision or the best decision, you know, just because the results have been good. And I know, in your book you emphasize kind of preservation of capital, etc. How do you make that case for a more active approach, a more balanced, a less concentrated approach to those people who have ridden the wave? The wave has gone up for so long and still looks positive, at the moment, if you're, if you're holding the S&P 500.
Keith:Yeah, that’s really good point on resulting. You do not want to be resulting. I mean, and by the way, you don't want to make it as simple as people need or want it to be looking backwards.
Of course, anybody could tell you what you could, should have. I mean, you could say, well, I thought a better asset allocation was to put 100% of my eggs in Bitcoin. And you would have done a lot better than the S&P 500. I have a very high level of conviction in this.
The ‘go anywhere’ diversification strategy across asset classes, it's where it's at for my hard earned capital. And it's where it's at for a lot of people who have wealth that they don't want to lose. So, rule number one, don't have drawdowns. That's rule number one. Don't lose money. That unfortunately, I mean fortunately, but unfortunately, Charlie Munger and Buffett used to start everything with that, but now it's more so, let's just talk about how stocks don't go down. Not that Buffett says that, but you get my drift.
What would be great is if people started with, okay, look, I have, I like to say, it's a P3 model: preserve and protect the pile. If you can do that and compound returns by taking components of your pile of capital and going to asset classes, factor exposures, sector styles that work all around the world, you would, because you don't have to wear those drawdowns.
So, my answer to indexing is pretty simple. Indexing has solved, for one thing, they can beat active managers because 80% of active managers can't beat the index. Okay. That's their marketing pitch. But indexing, passive indexing, or active, you cannot tell me that they don't have epic 20%, 30%, in some cases, 50% drawdowns. So, because I start with not drawing down, you can look at my history. The one thing I don't do is draw down.
ling the crash. We called the:So, to me, if we can get more people, like, that's certainly what our community believes and it sounds like you do too, to understand that go anywhere is entirely doable if you have a process like mine. All the bullshit people tell you or used to tell you about that there's too much transaction costs, not true. It doesn't cost anything to transact anymore. And three, it's again, the arguments of passive are irrelevant because we're not including a balanced argument about going into other asset classes, like something like gold. I mean, imagine that, you held that. That's not in a 60/40 portfolio, by the way.
Alan:You mentioned Kahneman and his work is all around behavioral biases and the mistakes that we make. Now, obviously your research is to help investors, but I mean, it's an argument that you can give investors all the help that you can, and they'll still probably make mistakes. We all do. It's just the nature of the challenge.
Should you not just wrap your all of your insights into a fund, and have it all systematized, and say here it is and don't ask people to do any hard work at all. Would that be a better outcome or not or what do you think?
Keith:Yeah, we're doing that. I mean we're launching ETS now and it was just time to do it. Like I said, I have enough. What I really want, wanting people to understand and be able to fish, like understand how to and be able to fish on their own, not be given a fish. Here's your return, here's your preferred return. Here’s a simple one, just one ETF from Hedgeye, which we'll never have, that summarizes everything. It's just like, you know, again, I'm not a witch doctor, I'm not an astrologer. That's not going to happen.
But what we can do is we can provide tools to risk manage a lot of different kinds of exposures. So, think of ETFs that are hedges to the S&P 500. Think of an ETF that's a hedge to gold or to TLT long term bonds. Now that's where we're going first or have already started to go and now we've started to go (which we can talk about later). There are plenty of asset management relationships that are implementing my go anywhere strategy. I basically produce now what's called, it's called Portfolio Solutions.
But I told you, I'm dumb enough to try things like this, which I show people my family office long-only account every day; every re-ranked move for any incremental sizing decision I make, any position that comes out, any position that goes in. So, now there is a go anywhere portfolio solution out there and that's only in the last two years.
So many managers are like wow. You think of just actually having that in addition to just being long beta. This can have anything in it from uranium, to gold, to obviously long QS, to long low beta equities in certain environments. It's the best expression that I can make that summarizes the process in terms of how I apply it for my family.
Alan:Okay. And I mean I don't know if you're a fan or familiar, but I mean a lot of what you talk about sounds very much like systematic trend following. Is that something you've looked at or are you an advocate or not? I guess you're doing something that's with your macro input and enhancement or how do you see what you do versus that type of approach?
Keith:Yeah, I mean systematic trend following, if you can systematically get right all the trends that are working, then you'd want to do systematic trend following. The only difference, the main difference is that I have a quantamental approach. So, yes, there is the quantitative side, the signal, but I have the quads, which is fundamental - fundamental economic reality. No systematic trend system, unless they're using my macro models, has that differentiation.
So it's not to say that trend following can't beat what I do. It's actually to say that my risk management wrapper, again on my primary goal, which is don't lose money, really has that fundamental outlook and backtest returns on all the different pivots you'd make if you see that economic quad shift coming. So, that's my version of it.
But again, if you could ride winners the whole time and get rid of your losers quick, you're going to do really well in this game.
Alan:Good stuff.
Well, conscious of time and before we wrap up, we always like to get some advice from our guests or you know, particularly for people starting off in the industry. And I mean I can direct people to the Master the Markets book which references about five or six really great books in there. But I mean in general, what would you say to people who are starting off or want to get better at managing their own money or want to get better at macro investing? Any thoughts or advice?
Keith:I'd focus primarily on your process, and I’d do it with a paper trading account at least if you're just getting started, To think that you could just slap a couple picks together and that that's a portfolio, that's a major, major issue that people have.
Take some time, like so for example, we, we make Hedgeye University free, to learn a process, apply the process, understand what in that process works or doesn't work for you.
I'd start with what is the maximum and minimum sizing that you're willing to take in each position, by asset class, and by single stock. So that you have a rules based system that will be disciplined, at least in terms of portfolio construction, that is somewhat professional but it can be your own. So, that's how we coach it if you're going to be a self-directed investor and really learn by doing.
That's why I like doing it with not live ammo to start. The luck that I had, by the way, Alan, was that I got to do it with other people's money for almost a decade. So that was really good. And then, of course, I had my own money in the hedge funds that I was managing. But I think for somebody just to start, it's a different starting point.
Alan:Okay, great. Well, Keith, thanks very much. This has been a fantastic conversation. Great to get these insights into your process and thinking.
And so, for all our listeners, please stay tuned and keep an eye on Keith's work because as you've heard from today's conversation, it's a macro driven world we're living in. So, from all of us there at Top Traders Unplugged, thanks and we'll be back soon.
Ending:Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged.
