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.")
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Erik Townsend: The other thing we talked about last time you were on the program was technology stocks. And what people were saying at the time was tech was just way overdone, it’s a bubble, it’s time to get the hell out before you get burned.
You were very outspoken in saying the opposite. You actually believed technology stocks were the place to be. And so far you’ve been proven right.
So what’s going on here? Let’s talk about Slide 16. What is your counterargument to people who say technology stocks are just ridiculously expensive right now and this is not the time to be investing in them.
Keith McCullough: I appreciate that. The first thing I’ll say is, oh, so you don’t own them? Let’s go through that and they’ll know why they should have owned them.
But what I’ll do on the valuation front – because, of course, I’ll start that argument with what growth in both the top line and earnings have actually done in tech. And that’s really defined the multiple that you have today. But that multiple–
Now, there’s two parts to this slide. That multiple relative to the market is nowhere near where it has been multiple times. Now, again, it doesn’t have to be (and I say this quite often) it doesn’t have to be 1999. For God’s sake, it doesn’t even have to be 2007.
In 2007, our call at the end of ‘07 was that growth was slowing and the multiple was about to compress. Okay, now that’s a good call to make. Because you’ve got a much higher level of the market’s relative tech valuation relative to the market, and you have the causal factor of growth started to slow.
So here, you have growth is still accelerating in a multiple relative to where it’s been to the market. It isn’t even close to bubble territory. So that’s point #1.
The other part of this slide, which is super-important, is within the box we show where is tech relative to itself? Okay? So it’s much more important to define the bands. If you think of the standard deviation of risk of where something can go, I think a fair point to start is where has it been before on the top end of that? And where has it on the low end?
So, in other words, where is tech today on a P-multiple basis relative to where it’s been? And it’s in the 66th percentile. So it’s two thirds of the way to where it could be. That’s another way to look at this.
What you also note in this box is the real expensive parts of the market are in bond proxies. Consumer staples and utilities, specifically. If we had REITs, you’d see that too. That’s where people really own the most expensive parts of the market. And why were those expensive? Because they’re your former growth-slowing exposures.
I quite prefer people would approach me with a valuation call like that. Because, provided that we see inflation and growth accelerating at the same time, those sectors don’t do well relative to, certainly to tech.
Erik Townsend: I feel like I certainly appreciate you’ve got a very bullish view, and I respect that. But I kind of feel a responsibility to stop you here and say wait a minute.
Before we give everybody the impression that you’re telling people to go put all of their money into a long-only portfolio of S&P and tech stocks, I happen to know, because you’re a hedge fund guy, you wouldn’t be caught dead with a long-only portfolio.
So, our diehard listeners that have listened to my Accredited Investor Academy already know what a long/short hedge fund strategy is. But I know that what you do at Hedgeye, to a large extent, is to teach people how to be their own hedge fund, how to run a long/short equity strategy.
And that kind of explains why you can afford to be so bullish but still be hedged at the same time. So, for people who aren’t familiar with that, please explain.
What are we talking about? What is long/short equity? What is that strategy? And why do you recommend that so strongly?
Keith McCullough: I appreciate that, because that’s where I’ve grown up in this business and I believe that 100%. Because it allows you to not be wedded to a certain style of investing. In long-only you can be a growth investor. You can be a value investor. You can be a momentum investor. You can be whatever you want to be. But once you decide that that’s what you are, you’re kind of locked in.
Whereas, me, I don’t care what I’m long or short. I just want to get the causal factors, or the rates of change of growth and inflation right. And, if I get those things right, there’s always something to be long and always something to be short. So I think it’s a much more thoughtful way to be long. Like, when you’re long like I am now, long growth, I can be short on Consumer Staples.
So I’m not 100% long on the market. I’m short XLP for example, which is the ETF for consumer staples. And I’m long in the Qs, which is the Nasdaq.
So I’m long growth and I’m short growth-slowing. It’s the same bet. But it’s being smarter than what I would be if I was just naked along the market, just trying to talk up US growth until I retire. That’s no way to live. Not for me. Given that the market’s blown up three times since I started in the business. And I don’t want to go through that the wrong way.
So that’s one way you can set it up. Just at the sector level.
Now, once you get into the stocks – that’s why we have 40 people on our research team (God willing, that continues to grow) – but their job is basically to give me their top three longs and their top three shorts every three months. So I always have within my macro view, and in my sector view underneath that, I have stocks that I want to be long and short. And that’s pretty straightforward. I think most people understand that.
There are good companies, there are bad companies. Just shorting companies because they’re bad doesn’t always work. Market timing matters, being in the right sector matters. So we’ll break it down, break it down, break it down. And what you’ll find is that there are certain styles that make your longs better in certain environments. And there are certain environments that perpetuate your shorts doing better.
A good example of that this year would be something like telecom. Telecom has leverage, negative returns on equity, no pricing power, and competition out the wazoo. That looks nothing like the FANG. So if you’re just short a basket of telecom stocks, or the ETF associated with that, and long the FANG, that’s another way to express your growth-accelerating view in the US.
Erik Townsend: And I just want to make sure we get the essential point in there that you would never consider just a long-only portfolio of anything. You have a balanced number of long and short positions. So if the market does crash the way some people are saying it could, you’re shorts hopefully will outperform your longs, and you don’t lose money even in a down market.
So you can make money in either direction of market. That, of course, is the long/short equity strategy that was pioneered by Alfred Winslow Jones back in 1949, and which a lot of the hedge fund industry grew up around.
So I know a lot of what you do at Hedgeye is actually to teach people how to use that strategy and to offer them potentials for what to have. Because one of the ways that you can run a long/short equity strategy is just to choose sectors. Use sector ETFs for your longs and your shorts. Or you can do individual positions.
So tell us a little bit more about how you teach construction of portfolios. If somebody is, say, an advanced retail investor, they want to run a long/short portfolio, is it mostly with ETFs and just sector bets? Or is it a combination of sectors and individual issues?
How would you teach someone to do this?
Keith McCullough: It’s obviously not something you can teach like you would a moving monkey or a moving average. I mean, anyone can just plug that into their computer and, voilà, there’s your signal. This, of course, takes a long time. It takes an entire career to build a process that is not only beating the market, but also, to your point, protecting – during the most important times to beat the market, which is when it’s going down.
So, again, we have a variety of risk management signals that we use. What you really learn is that you have to have two big things. You have to have the fundamental research process, which we’ve spent a lot of time talking about today. Again, is it data driven? Is it getting better or worse? Is it accelerating or decelerating? These are the questions that we ask ourselves every single day. But on the quantitative risk management side, the big question that you’re always asking yourself – and we spend a lot of time teaching people – is the relationship, not on the simple moving average of price, but on how volatility is affecting that price.
So, again, there’s a tremendous amount of knowledge to be gained in measuring and mapping the volatility of price. Benoit Mandelbrot, which I thankfully learned quite a bit from him, wrote one of the best books I’ve ever read and it's kind of the bible of my process. It is called The (Mis)behavior of Markets.
And in it he talks a lot about the measuring and mapping the volatility of volatility. And that’s something that we’ve spent a lot of time teaching. It takes a lot of rinse and repeat. And we do this every morning, actually, on what we call The Macro Show (it’s at nine o’clock Eastern). So we spend a lot of time trying to educate just with live examples of what the market’s actually doing now. Because that’s readily available for people. They can see it in motion. They can apply it to what they’re doing.
And then, of course, we have products like ETF Pro and whatnot, where we’re basically, to your point, isolating what we want to be long and short, or bullish or bearish about, in sector terms or in country terms or in asset allocation terms.
And, since we’re global macro, and we do everything from stocks to bonds to currencies, we constantly have a view on all of those things.