There’s a revolution underway on Wall Street. A former Yale hockey player from (of all places) Thunder Bay, Ontario and his team of former buyside analysts are dispelling the tired notion, ‘You can’t time markets.’
The macroeconomy wiggles and waggles in predictable patterns they say. Diligently measuring and mapping these ups and downs can help you preserve, protect and grow your portfolio.
Sound crazy? There’s more.
The firm’s outspoken founder, Keith McCullough, has continued to pound the table on another ‘crazy’ idea he’s espoused since the company’s inception in the middle of the 2008 Financial Crisis: “Hedge fund quality research for all investors.”
Enter Hedgeye Risk Management
The team of 40-plus research analysts at Hedgeye spend most their day hunkered down measuring and mapping global economic data and inputting that data into the firm’s risk management tools. The goal, of course, is to identify the next big market move.
Tracking everything that ticks in financial markets around the world isn’t exciting. “It’s unglamorous work,” McCullough says after describing his daily routine of waking up at 4:30am ET and methodically recording financial market performance data into a 9.75" x 7.5" composition notebook for the last twenty years.
The work is a grind and often tedious. One of Hedgeye’s early prospective clients dismissively called it “bean counting.” “If you want to call it that, then I’m Hedgeye’s Chief Bean Counter,” McCullough says proudly. “Bean counting is our edge.”
Edge, indeed. The firm is growing quickly after a string of big victories.
- Hedgeye went bullish on risk assets from November 2016 to September 2018 – a period in which the S&P 500 and Russell 2000 went up +33% and +30% respectively
- Hedgeye went bearish on risk assets at the end of September 2018 – a period in which the firm’s favorite long ideas like Gold (GLD) and Treasuries (TLT) are up +26% and +29% respectively versus favorite short ideas like Russell 2000 is down -38%.
The firm's most recent call is quite possibly its best: The Crash of 2020.
At the end of January, CEO Keith McCullough began warning investors of the early pricing in of #Quad4 risk – a market environment of Growth and Inflation slowing. It has historically been the death knell for risk assets.
The hallmark of the Hedgeye process is following what’s actually happening in financial markets and calibrating that against the forward outlook for the U.S. economy. Core to that process is remaining humble about what the market is actually doing, and pivoting fast when the firm’s risk management signals change.
“I can tell you that there’s a lot I don’t know about everything,” Hedgeye CEO Keith McCullough wrote on January 31, 2020. “One of those things is where a large place like China stops slowing during a national virus lock-down. Markets don’t know where the #slowing will stop either.”
What McCullough did know, back in January, was that global growth data was decidedly weak and coronavirus fears had become the accelerant that was causing financial markets to price-in a deterioration of global growth. “There’s a diversified portfolio for that. It’s called Hedgeye’s #Quad4,” McCullough continued on January 31.
McCullough’s next move? Cutting small losses and refocusing subscribers on core #Quad4 asset allocations. “After selling both EM (Emerging Markets) and Energy (XLE) yesterday, I’m staying long of what I’ve already been long for 16 months: Treasuries, Gold, Utilities, REITS, etc,” McCullough wrote in January.
(Getting completely out of Emerging Markets and Energy stocks turned out to be a great risk management call in itself. Emerging Markets and Energy stocks have crashed -25% to -50% since McCullough wrote that January note. Since then, McCullough has actually been shorting Energy stocks.)
McCullough’s warnings became more dire into the February 2020 all-time high. “Looking at yesterday’s short-term spike in US Equity complacency, I guess some people believed the Chinese methodology on measuring and mapping the ROC (rate of change) of the virus,” McCullough wrote on February 13.
What was McCullough seeing?
Wall Street positioning in futures and options markets revealed complacency in the S&P 500 (SPY), Tech (XLK) and Energy (XLE). Implied volatility – a measure of the market’s forward-looking volatility expectations – had reached complacent and capitulatory levels. If the Hedgeye macro team was right, deteriorating economic fundamentals could cause a meaningful selloff.
Six days later the S&P 500 peaked and fell and fell and fell.
However you slice it the Crash of 2020 will go down in history as one of the swiftest and most violent ever. Thursday March 12 was the steepest one-day fall for the S&P 500 since the October 1987 stock market crash. The S&P’s multi-day decline was the fastest-ever to enter both correction and crash territory (declines of -10% and -20% respectively).
Most would think McCullough is enjoying financial markets coming around to his call. Far from it. “The complacency I saw in financial markets heading into this latest selloff actually really pisses me off,” says Hedgeye CEO Keith McCullough.
You may have read or heard some of these statements before the crash.
- “The U.S. consumer is in great shape.”
- “The U.S. economy is strong.”
- “XYZ Tech stock is a secular grower.”
“None of those statements were true,” McCullough wrote recently. “But Wall Street “strategists” repeated it over and over again. They sucked in a ton of unwitting investors at exactly the wrong time. The retirement accounts of a lot of hard-working Americans have completely collapsed.”
How the Hedgeye story Began
“Our story actually starts with my mother,” Hedgeye CEO Keith McCullough wrote in a recent note to subscribers. “It was November 2007. I had just been fired from the hedge fund I was working at (for being too bearish). Back then, my father was a firefighter. My mother was a teacher. So it was an extremely humbling moment when my mom asked me, ‘How do you change the world with your job?’”
The opportunity, as McCullough sees it, was in creating a firm that was everything Wall Street wasn’t. “I wanted all of our analysts to be completely transparent and accountable to every single call they make,” McCullough says. With transparency, accountability and trust as guiding principles, in 2008, Hedgeye was born.
Wasting no time, the firm made its first big call: The stock market was about to roll over.
“It was a little chillier when I got up this morning here on the East Coast,” Hedgeye CEO Keith McCullough wrote on August 20, 2008. “That physical feeling likely lines up with the mental ones that were triggered yesterday for anyone who manages risk using quantitative models. This market remains one that should be rented, not owned. Cash remains king.”
“Consensus has morphed into complacency again,” McCullough continued. “This week is the first week since May that I can review my notebook and ascertain that Wall Street is ‘Not Bearish Enough’. This of course can be quantified by a variety of tools I use to manage risk… I highly encourage you to have your analysts and brokers walk you through potential tail risks associated with a protracted downturn therein.”
The S&P 500 fell -47% from the date that note was published to the trough. Not to be outdone, McCullough followed up his August 2008 research note with another just nine months later. This time he was calling a bottom.
“As the US stock market was hitting new cycle lows intraday on Friday, I started buying US equities more aggressively,” McCullough wrote on March 9, 2009 (just three days after the S&P 500 bottomed out). “I took our Asset Allocation Model Portfolio to 24% in the USA, and took down my cash position from 70% to 58%.”
McCullough continues, “As I was doing so, my inbox was brimming with about as many notes as I received in December of 2007 when I was shorting everything from Goldman to Bill Ackman's genius levered long position in "Tar-geh"... some people didn't want to sell anything then, and those same people aren't allowed to buy anything now...”
And just like that. So began the post-Great Recession bull market. The rest, as they say, is history.
Little has changed on Wall Street since the 2008 Great Financial Crisis. “This is the third market crash I’ve risk managed in over two decades working on Wall Street,” McCullough says. “It’s sad. A lot of people are getting hurt. But the truth is—over the past 20-years since I’ve been doing this—Wall Street hasn’t evolved at all.”
Like every disruptor confronted with an entrenched incumbent, in 2008, McCullough and his fellow founders were challenged with inventing something that didn’t yet exist. Back then, McCullough looked at Wall Street’s conflicts of interest and lack of transparency and saw a big opportunity.
“I always thought what investors wanted to see was the decision-making process of a world-class hedge fund,” McCullough says. “If you could watch Stanley Druckenmiller or George Soros or Ray Dalio talk about their risk-taking process all day, wouldn’t you want to see that?”
Nothing like that existed so Hedgeye got to work. New technologies like YouTube and Twitter provided inspiration. “You could see a community of investors growing up around the democratization of information,” McCullough says.
The challenging thing for investors, and the opportunity McCullough saw, was in “curating the right sources.” In an age where information is ubiquitous and time is precious, consumers crave not just the veracity of truth. Facts matter but too many investors focus on the wrong facts.
“I call most investors Macro Tourists,” McCullough says. “They jump from headline to headline rather than from time series to time series.” Every data point must be properly filtered. Correlation is not causation. What really matters is calibration – the careful curation of signal over noise.
Noise is everywhere. Nowhere is this more evident than on CNBC, which continues its slow slide into irrelevance. (The media outlet’s ratings fell to a 22-year low recently.)
Unknowingly, perhaps, CNBC pundits cause investors to “blindly cling to Wall Street’s supposed ‘best practices’ that so obviously don’t work,” McCullough says. Technical analysts follow the 50-day Moving Average. “These investors are always disoriented at every big Macro investing turn,” McCullough says.
Others buy “cheap” stocks and short “expensive” ones, missing that the price and earnings measures used to determine whether an equity is “cheap” or “expensive” is arbitrary if you’re using the wrong numbers. “I can’t believe how often I have to remind investors that valuation is not a catalyst,” McCullough says.
Meanwhile, readers of Wall Street research are in a similar state of disillusion. According to FactSet broker ratings, over the past 20 years, less than 10% of the S&P 500 companies tracked by Wall Street each year were rated “sell,” despite the U.S. economy entering multiple bear market crashes and two full-blown recessions over that period.
It’s not just Wall Street optimism that causes this analytical failure. “Wall Street is compromised and conflicted,” says Hedgeye CEO Keith McCullough.
The results have proven devastating for investors. In the past 20 years, Wall Street and its financial media have encouraged investors to “buy the dip” in equity markets at every single cycle turn. “Over that time period, you could’ve lost half your money twice buying the all-time highs as the U.S. economy tipped into recession,” McCullough says. We could add the Crash of 2020 to this list. The Russell 2000 is down -40% from its February highs.
There’s a much better way.
This is one cartoon of over 1,000 created by Hedgeye's in-house cartoonist Bob Rich.
Most investors think “market timing” is a dirty word. “I’ve heard ‘you can’t time the market’ a thousand times. The people that say that? Believe them—they can’t,” McCullough says.
These investors aren’t using modern day risk management tools like predictive tracking algorithms and stochastically driven forecasting tools that are absent of deterministic assumptions. If that sounds complicated, it should. “That’s how you do modern Macro,” McCullough says. “The global economy isn’t linear. It’s a complex adaptive system and it certainly doesn’t respond to the assumptions of what some PhD-trained economist thinks it should do.”
One of the hallmarks of the Hedgeye risk management process is CEO Keith McCullough’s Risk Range and Trade-Trend-Tail model. McCullough developed this proprietary and quantitative process while working as a portfolio manager at Magnetar Capital in the mid-2000s.
You may recall that the Magnetar team came from Citadel in the mid-2000s. It pioneered many techniques now considered “best practices” by today’s hedge fund industry – particularly how to operate market neutral and manage factor exposure risk.
In those early days running a long-short portfolio at Magnetar, a risk management policy set by the firm would often neuter McCullough out of his positions. “I developed my Risk Range process to try to stay ahead of and front run big changes that the risk systems started to spit out, things that would run counter to my positioning,” McCullough says.
The Risk Range process uses price, volume and volatility at the index or ticker level to generate a probable range for that security over the short to intermediate-term. For example, if you’re looking at the S&P 500, the Risk Ranges suggest where you want to be buying (at the low end of the probable range) and selling (at the top end of the range).
Again, using the underlying price, volume and volatility of an asset, this proprietary signal also suggests critical thresholds, across different durations to help you identify Bullish and Bearish “phase transitions” – effectively helping an investor identify breakouts and breakdowns across specific assets.
It was McCullough’s Risk Range process combined with the #Quad4 signal from Hedgeye’s four quadrant Growth, Inflation, Policy model that guided investors through the worst selloff since 1987.
“I’d put our risk management process up against any buyside firms out there,” McCullough says. “In fact, if you aren’t measuring and mapping global economic data like we do, and interpreting it through the lens of our Risk Ranges, what are you doing to effectively manage Macro risk?”
Which gets us back to the Crash of 2020. Why were so few investors proactively prepared?
The vulnerabilities were there for everyone to see, McCullough says. All you had to do was look.
