Click the play button below to listen to a new conversation between hedge fund manager and MacroVoices podcast host Erik Townsend and Hedgeye CEO Keith McCullough. (Click here to get a special offer on Hedgeye's "Best Deal of the Year.")
* * *
Erik Townsend: You were kind enough to send us a deck of slides to accompany this interview. And I noticed the very first slide that you’ve got is a statement saying valuation is not a catalyst. And I think it plays into what you just said. It sounds like you maybe do not have a bearish view, but some growing concerns about where various indicators may be headed.
But those indicators you’re watching are not the CAPE ratio and the other things that are valuation-centric, that so many people are obsessed with. So please elaborate why is it – if you hear so many experts saying look at the CAPE (Shiller cyclically adjusted price-earnings ratio), valuations are the problem, that’s what we should focus all our attention on – why is it that you pay attention other things?
And, from what I understand, almost ignore valuations on something like a CAPE ration metric?
Keith McCullough: We, obviously, don’t entirely ignore anything that is market history. Market history has a lot of information. So a CAPE ratio, which is a cyclically-adjusted PE ratio, had information within the time series.
But don’t forget that that CAPE ratio in particular is highly levered to the cyclical. So, again, it’s a cyclically-adjusted PE. And we had a huge depression in the energy space and/or resource-oriented cyclicals. So that’s why the E is compressed or low, and the P on a CAPE basis looks very high.
Now, what happens if oil goes from 30 to 60 is that the E goes up and the market starts to look less expensive. And that’s really the point. If you look at a lot of these – valuation experts I’ll call them – and, again, I actually (and no undue respect) I really find it to be a trivial exercise to know the history of PEs, whether they be cyclically adjusted or not. That’s just history. Okay?
What you’ll also learn – and we can show you in the deck (cartoons notwithstanding) the one that we have on Slide 7 – when a lot of people answer every question on valuation, they never start with what we start with. And I’m saying “they,” not being all of “they.”
But I think that the people that have missed major moves, both in terms of expensive markets (quote, unquote) getting more expensive, and cheap markets getting cheaper – what they miss all of the time is the prevailing factors of growth and inflation either accelerating or decelerating.
So I’m much more focused, and always have been, on whether growth and/or inflation are getting better or worse, not whether they are good or bad. Whether something is good or bad is somebody’s opinion. Whether something is getting better or worse, or accelerating or decelerating, is not an opinion. That’s a fact.
So, again, I deal in the factual space. And the fact of the matter is that there’s really no history to suggest that there is a magic market multiple. If you look at Slide 9, I think, of the slide deck that we provided, the question really I should ask is – are you sure the market is expensive?
Now, you’ve looked at a lot of different things. But you tell me. Where in that piece of evidence going back to 1987, that the black line is discernably at the spot, the magic multiple, where the market absolutely has to go down?
It’s an absurd statement. Only Wall Street could live and get paid on these types of valuation statements. So I’m much more focused on what is driving the black line up and what would drive the black line down.
Don’t forget that I’m not a permabull, I’m not a permabear. I’ve been plenty short a lot of down moves in markets. And, what I’ve been focused on is when US growth in particular – in the US stock market’s case – started to roll off its cycle peak and slow. And then decisively slow. That’s when stuff can get cheaper and multiples can compress.
But, as you can see, if you started shorting the market in 1991–92 when it was right around this P multiple, or in 1996–97 for that matter, you would not be running money if you carried that position for two to three years after that point. Just by being short the market because it was expensive. It’s an absurd statement. But only – as I said – only an absurd place (which could be the old Wall) can get paid on that.
Erik Townsend: Well, certainly, the ‘90s proved to us that – as you have said so many times in your past appearance here – expensive things can get a lot more expensive. We had ridiculously high valuations in ‘97. But guess what ‘98–99 and the beginning of 2000 brought us?
I want to come back to your earlier comments. On Slide 3 you’ve got a nice graphic that kind of illustrates this point, where it says you focus on the slopes. You’re not caring about the magnitude of how high or how low we’ve been, but which direction we’re moving in with respect to growth and inflation and so forth.
When we had you last on the program, it sounded like we were kind of at max slope. You were just extremely bullish. It sounds like maybe you’re seeing a little bit of slowing of those trends since we last spoke. Am I reaching too far to say that?
Keith McCullough: No. It’s just purely time and space makes that happen. So the easiest point to call an acceleration is from the lowest point in the prior year, or at that point on the sine curve. So you always have to ask yourself – and I really think that this is ultimately – it’s taken me two decades to figure this out and I’m still banging my head against the wall to get it right.
But the reality is, if I can constantly identify within three to six months where the bottoming process is on that sine curve on Slide 3, and/or the topping process, then I’m going to do better than your average monkey. And that’s really my goal. Okay? Gotta beat the monkeys. Then I gotta beat the market. Now, if I can beat both the moneys and the market, I’m going to be happy and my clients will be happy. There’ll be more happiness than angst.
And that’s really the point. In Q2 of 2016, you were literally at the bottom of the US GDP cycle. You were absolutely at the bottom of the US profit cycle. Don’t forget that we were in a profit recession in the US. Partly why Trump got elected was in 15 states there was beyond a recession, there was a depression.
Okay. So if you need a political analogue you can have it. I don’t start and end with politics, obviously. I don’t particularly care for politics at all. Incidentally, the political winds had changed, given the profit cycle and the economic cycle had slowed into its lows of 2016.
Therefore, when we talked about – I think we talked at the end of Q2 in June – it was pretty easy to make that call. Because we were at the – we were comparing against the low of the cycle. Q3 was also a pretty easy comparison.
So, as you roll into what was a big acceleration, which was Q1 – it finally became clear to people in Q1 earnings season that GDP Cap-X earnings were all accelerating materially – that the bears had to give up. And that was the first wave.
The second wave was that the bears were offside for all of Q2 and then started whining about valuation. Have you ever heard somebody whine about valuation if they’re long of that thing? Never. Try it with your house. Does your wife whine that the house is too expensive? We need to move, we need to leave immediately, there’s too much risk living here. This is not the way that life actually works. And it is quite surprising that people think of markets that way.
So, once we get – my main concern is that it was so good this year that next year you’re going to have to compare against that. That’s the main concern. It’s just gravity. It’s not to say that you can’t comp the comps, as we like to say. Or compare strongly against a tougher basis actor, a tougher comparative basis act period. That’s up to Mr. Market and the data.
And that’s why we run a predictive tracking algorithm constantly. Every single day we get new data. Today we got retail sales. It was up 4.6% year-over-year, which is a fantastic number both in rate of change terms and on an absolute basis. CPI back up to 2 year-over-year. So you have, basically, inflation and growth rising at the same time.
So, again, when I change my mind it will be data-dependent. You are quite right, though, in identifying that we’re running out of runway in terms of how easy that call was to make in the summer of this year.