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If you think the Federal Reserve wouldn’t dare keep interest rates high and risk throwing the U.S. economy into recession, Keith McCullough would like to have a chat with you. He’s convinced that 2023 will bring a U.S. corporate profit recession and a credit crunch as businesses struggle to obtain financing and pay down debt.
Like many market analysts, the CEO of Hedgeye Risk Management spent much of 2022 criticizing the U.S. central bank for allowing inflation to get out of hand, and then compounding its mistake by raising rates into a slowing economy. He began sending subscribers of his independent investment-research service to gold, silver and other traditionally defensive portfolio positions.
Nothing since then has altered Hedgeye’s outlook. If anything, McCullough is only more critical of the Fed’s complicity in the financial pain that many shareholders and businesses are experiencing.
This Fed-manufactured morass will deliver another blow to U.S. stocks in 2023, McCullough predicts — particularly market darlings that until last year could do no wrong. Says McCullough: “The Nasdaq
COMP,
is our favorite short.” As an example, McCullough singles out Tesla stock, which he says will disappoint and demoralize shareholders on the way down just as it rallied true believers on the way up.
In this recent interview, which has been edited for length and clarity, McCullough discusses where he thinks investors should put their money now, what would turn him more bullish on bonds, and why Tesla and CEO Elon Musk were at the epicenter of the “Mother of All Bubbles” — which the Fed created and now is attempting to crush.
“ ‘This Federal Reserve won’t go dovish.’ ”
MarketWatch: With U.S. stocks taking a dive in 2022, investors now are looking for the Fed to ease off the brakes so the bullish bandwagon can pick up speed. Do you see the Fed accommodating the markets anytime soon?
McCullough: I think all you’re going to get is a pause. This Federal Reserve won’t go dovish. There’s a belief system among investors that needs or wants to believe that the Fed is going to rescue them. They should understand that their narrative is fictional.
MarketWatch: If the Fed still won’t come to the rescue, how does that affect the climate for investors in 2023?
McCullough: Currently we’re in what I call “Quad 4.” That’s when U.S. GDP growth and inflation slow at the same time and so do profits, and stocks lose their multiples.
The inverse is “Quad 2,” when both growth and inflation accelerate at the same time. That’s why we were long both crypto and Tesla in 2021. If it’s Quad 2 we’re going to buy growth and speculation, because it’s absolutely inflationary — and in this case it was inflationary at a hysterical level. But the GDP numbers supported it. In the middle of 2021, U.S. GDP was running on a year-over-year basis at 12.2%.
This gave birth to the “Mother of All Bubbles.” The Fed is certainly complicit in both Quad 2 and Quad 4. The Fed obviously was dead wrong on inflation, calling it transitory, and dead wrong on printing money and not tightening. They are now trying to play catch up for their prior mistake and arguably making a bigger mistake, which is tightening into a Quad 4 slowdown.
[Fed Chair Jerome] Powell did this in the fourth quarter of 2018, but the difference back then is he was a rookie on the job and turned-tail dovish very quickly after Christmas 2018. This time he’s going to stay tighter for longer and he’s not going to cut interest rates. The question now is when does the Fed stop raising? Not when do they start cutting aggressively?
If you tie that to how quickly parts of the economy are slowing, that’s really the point of our market call: We’re hitting the fastest point of the Quad 4 slowdown now, due to many different factors.
In housing, for example, luxury home sales are down. We’re seeing a huge decline in mortgage demand. It doesn’t matter if the 30-year mortgage rate oscillates between 6% and 8%, it chokes demand. That’s one of the reasons why Blackstone’s BREIT is under duress. It’s the largest nonpublic REIT and therefore the most widely held. It’s clearly a game of promising “x” return and annual liquidity, and now they’ve achieved peak returns and are going to have to take their marks.
This is one of many cost of capital crises the markets are going to have. So many components of the U.S. economy are bets on lower cost of capital, ample liquidity, and the Fed put. Now we’re talking about higher cost of capital, you don’t get rate cuts, and you have no liquidity.
To me, that’s the story of Blackstone’s BREIT. Venture capital and private equity haven’t been revealed, but it doesn’t mean that a lot of them don’t have problems. A lot of bodies need to float to the surface in private equity and venture capital.
MarketWatch: Higher borrowing costs and less liquidity will squeeze companies and workers. What have investors missed about this market, and which areas should they target now?
McCullough: What happened throughout 2022 is that people got too anchored on inflation and forgot what recession risk actually is. Consensus is starting to understand that inflation is yesterday’s news; it’s peaked.
What’s problematic going forward is what happens during a recession. We see negative almost 3% GDP growth for the first quarter. I do understand that market bottoms are processes and not valuation points, but what we’re looking at is what I call “Phase 3” of the bear market, which is when corporate profits go negative on a year-to-year basis, and you have a profit recession.
A profit recession should lead to credit events. From Blackstone’s BREIT product to Tesla
TSLA,
these are all credit events — a lack of liquidity in the face of slowing profits. From the mania that was Tesla or Elon [Musk] and him using leverage upon leverage to buy Twitter, to BREIT, which is considered a pretty risk-free product, just like some crypto products were thought of. It’s wide-ranging at this point.
That’s why I’m long things that will work in this tighter environment: precious metals; gold through SPDR Gold Shares
GLD,
; iShares Silver Trust
SLV,
abrdn Physical Platinum Shares
PPLT,
We’re also long VanEck Gold Miners ETF
GDX,
silver miners, and both VanEck Junior Gold Miners ETF
GDXJ,
and ETFMG Prime Junior Silver Miners ETF
SILJ,
MarketWatch: With such a grim economic outlook, no wonder you’re bullish on gold and precious metals.
McCullough: I’m not always bullish on gold, but I am now. It’s in the top three in our asset allocation model. We bought gold, silver, and platinum last November and I’d be happy to hold for a year or five years, based on the prevailing conditions of the economy and the market. I wouldn’t have silver in your top three but it’s in my top 10. We do have some equity allocations: AGFiQ U.S. Market Neutral Anti-Beta Fund
BTAL,
the anti-beta ETF; defense-industry stocks through iShares US Aerospace & Defense
ITA,
and Health Care Select Sector SPDR
XLV,
Most importantly, gold performs in Quad 4. Gold last year was down only 1%. This year I think it’s going to be an absolute and relative winner. My top three are the U.S. dollar
DXY,
gold and the anti-beta ETF. People like to pile into the high-beta stuff and not be long the boring, low-beta stuff. In a Quad 4 market crash and recession, you do the opposite of that.
“ ‘The base case for the S&P 500 is 3200.’ ”
MarketWatch: Recession and stocks are a bad mix. How low can the S&P 500 go this year?
McCullough: We think the base case for the S&P 500
SPX,
is 3200. I update my risk ranges every day but I challenge everyone to look at a 5-year chart, take out the entirety of the bubble, go back to pre-pandemic, and the S&P 500 was at 3200. It’s not my goal to be bearish to infinity, but a pretty conservative point is to go back to the S&P 500 all-time high, pre-pandemic. That’s still a very high point.
Read McCullough’s October 2022 interview: This stock-market strategist says the coming recession could be the biggest ever: ‘I recommend prayer’
MarketWatch: You’re also recommending strategic short-selling. What are the firm’s biggest short positions right now?
McCullough: The Nasdaq is our favorite short, going back to the beginning of 2022. I think no question the Nasdaq can get to 9,000, which is where it was pre-pandemic. That’s just the start. In 2019 the Nasdaq went a lot lower. U.S. retailers are an excellent short with SPDR S&P Retail ETF
XRT,
We’re still short Consumer Discretionary Select Sector SPDR
XLY,
— Tesla
TSLA,
and Amazon.com
AMZN,
are 40% of that ETF. Those have been our top three shorts along with bitcoin
BTCUSD,
and we’re staying with those.
“ ‘High-yield and junk bonds are two of the easier ways to express our view of a profit recession and credit event.’”
We’re going to have a credit event in the first half of 2023. So we’re also short in our top five the ETFs iShares iBoxx $ High Yield Corporate Bond
HYG,
and SPDR Bloomberg High Yield Bond
JNK,
High-yield and junk bonds are two of the easier ways to express our view of a profit recession and credit event. In high-yield, the depth and reach of that market and the lack of liquidity make it probably the most underpriced risk. Investors can put on some protection buying puts or being short these ETFs.
Keith McCullough
Hedgeye
MarketWatch: Yet bonds are starting the year on a high note. What’s your outlook for Treasurys and investment-grade credit?
McCullough: I want to see the darkness of the high-yield and junk bond credit event and those will be the days when I buy investment-grade credit. At that point it’s not going to be that the yields are so attractive, but the pricing of the securities will reflect recessionary risk. The short end of the curve is going to stay pinned high because the Fed is not going to cut — they’re going to pause. But the long end of the curve is going to trade sideways to down.
I think the yield curve has had this right the whole time; my view on bonds reflects that. You had [Fed Chair Paul] Volcker then; you have Powell now. Yield curve inversion is one of the more explicit market signals of recession.
“ ‘There’s no reason, with demand slowing and the leverage metrics Tesla has, that Tesla’s market cap can’t get cut in half multiple times.’ ”
MarketWatch: The Tesla “mania” you describe reflects the cult-like market that fueled crypto and meme stocks. What’s your take on Tesla stock now?
McCullough: Tesla is in the business of selling two things: cars and stock. That’s it. That’s the crazy thing. You have a whole community pushing HODL [“hold on for dear life”] and pushing a belief system that was categorically untrue.
There’s no reason, with demand slowing and the leverage metrics Tesla has, that Tesla’s market cap can’t get cut in half multiple times.
We were bullish on Tesla for all of 2021. We went bearish at the beginning of 2022. I call Tesla and Elon himself the epicenter of the Mother of All Bubbles — crypto, real estate, stocks, bonds, the entire high-yield market, meme stocks, SPACs.
The Mother of All Bubbles is a series of concentric circles, with Elon in the middle. It wasn’t long ago that he was pitching dogecoin
DOGEUSD,
The guy was everywhere. Many of the same people who got roped in to everything from dogecoin to bitcoin, the No. 1 stock they were long was Tesla.
It’s quite an expensive education if you’ve never risk-managed a bubble before. I would have never thought — which itself is a good lesson — that we would have a much larger bubble than the “dot-bomb” bubble, but we did.
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