Hedgeye's Bear Market Investing Playbook

Summary

• What if GDP growth slows from its cycle peak? What if profits slow both absolutely and relative to expectations? What if the market is breaking down in kind?
• "With those three things potentially happening at the same time in the coming quarters, the bear is staring you in the face," says Hedgeye CEO Keith McCullough.
• In the last two weeks, the Nasdaq and S&P have joined the Shanghai Comp, the Nikkei, the DAX, the Spanish IBEX as signaling bearish trend in our Risk Range model.

The stock market is getting rocked.

Former hedge fund manager and Hedgeye CEO Keith McCullough hosted a special webcast Monday morning (before the big market selloff) reiterating the key investing risks he’s been warning our subscribers about:

As McCullough said during The Macro Show webcast:

“All of these things add up to what we’ve been saying for some time now: Sell the bounce and we’re no longer buying the damn dip.”

Watch the entire webcast free below. Below are three key important takeaways.

Keith McCullough: Going into the long weekend, you had a no volume rally to lower highs. That’s a problem. Total U.S. equity market volume was down -6% versus the prior day, and down -20% versus the 1-month average.

So volume didn’t confirm the up move.

It also wasn’t confirmed by a breakdown in stock market volatility. You’d have to get the VIX down below 13.5 to change that. The immediate-term Hedgeye Risk Range on the VIX is currently 16 to 25, so there’s plenty of upside in volatility and conversely plenty of downside in the S&P 500. The low end of the Hedgeye Risk Range for the S&P 500 is 2560. That implies -3% downside from Friday’s close.

I care about where the market is probably going to go. And that’s the point of the Hedgeye Risk Ranges. The daily Risk Range is the most probable range of outcomes that we are going to deal with today using my quantitative price, volume and volatility model.

That’s in stark contrast to journalists who have never played the game before. They like to talk about the game they’d like to see politically or emotionally or what benefits them from an advertising standpoint. We play this game like the one that Mr. Market says that we’re in.

McCullough: It was a terrible month for growth stocks and specifically the Financials (XLF). Short Financials, or just avoiding it, was one way to play our call on Reflation’s Rollover (i.e. a rollover in inflation expectations).

This also caused a rollover in bond yields. If you look at the chart of the 10-year Treasury yield and look at the -4.5% return for the Financials in March, you would say they look the same. They both went down. That’s one reason why, on this move, we didn’t want you long the bank stocks.

McCullough: So what’s going on here? We have two factors that we really care about in macro. One is growth. One is inflation. We care about the rate of change in these two things on a trending basis, so what’s going to drive the market for the next three months or more. The trend is your friend.

If you get growth and inflation accelerating at the same time, we call that Quad 2. That’s what the U.S. economy was in solidly from September through January. Now it’s subtly in Quad 2. When the U.S. economy is solidly in Quad 2, the outcomes are very obvious: Bond yields go up, Financials go up, Energy stocks go up. This outcome nailed the all-time highs. We fortunately got that right.

Quad 3, meanwhile, is very bad for stocks. That’s when U.S. growth is slowing and inflation is accelerating. We actually have a Quad 3 forecast for the third quarter of 2018. We’re currently in the second quarter so maybe Mr. Market is front-running because it’s pretty good at front-running the future.

The big risks we see:

• What happens if GDP growth slows from its cycle peak? We’re currently the low on Wall Street with our estimate for headline GDP in the first quarter of 2018.
• The other big one is profits. What happens if profits slow both absolutely and relative to expectations?
• And the third one is what happens if the market is breaking down in kind? When I look at my risk management signals, there are six markets that are currently signaling bearish trend in my Risk Ranges. What’s happened in the last two weeks is that the Nasdaq and S&P have joined the Shanghai Comp, the Nikkei, the DAX, the Spanish IBEX as signaling bearish trend.

So with those three things potentially happening at the same time in the coming quarters, the bear is staring you straight in the face.

All of these things add up to what we’ve been saying for some time now: Sell the bounce and we’re no longer buying the damn dip.

Now, I’ve been quite bearish many times in my career. We’ve never missed calling a bear market at Hedgeye. In fact, we launched Hedgeye in 2008 and were bearish right from the outset. The reason we get you properly positioned at Hedgeye is because we measure and map both secular and cyclical issues. If those things are going against you, it’s a big problem. It’s a mess when the economy is slowing.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.