ED HARRISON: Welcome to Investment Ideas. I'm your host, Ed Harrison, and today, we have Darius Dale of Hedgeye. He's a managing director there. I'm very much looking forward to this because this is a follow-up to a conversation that Hedgeye CEO, Keith McCullough had with Raoul back in January. We're going to be talking about Hedgeye's four-quadrant model and specifically what it says about how you should asset allocate going forward over the next six to nine months.
Darius Dale, it's good to talk to you and I'm looking forward to this as a follow-on to Keith McCullough's conversation with Raoul which was about four months ago. That was the first time that we had Hedgeye on. And we were talking about your four- quadrant model.
DARIUS DALE: Yeah.
ED HARRISON: And I wanted to piggyback on that. I know that Keith was talking about Q3. Both Quad 3 rather for both this quarter and next quarter. First of all, tell me what does that mean? And how have things changed since then?
DARIUS DALE: Yeah, absolutely. I appreciate being here. Thank you for having me on. So, Quad 3, Quad 3 is an economic regime that we're seeing in the US here currently and expect to continue, really persist through the beginning part of next year. And what I mean by Quad 3 is that growth is decelerating as inflation is bottoming and starting to reaccelerate. Historically, that's been characterized by late cycle, economic dynamics and as a whole host of asset allocations and portfolio construction pivots that investors need to be aware of as we dig deeper into Quad 3.
ED HARRISON: And tell me- in Quad 3, what asset allocation strategy- not just in terms of equity versus bonds, but also sector allocations, stylistic plays, etc.- do you think are appropriate at this particular juncture?
DARIUS DALE: Yeah. So, I think you can rewind the tapes a little bit and you go back into the latter part of last year, Quad 4. Q4 or Quad 4 is when both growth and inflation are slowing concurrently. Historically, that's been a really, really negative environment for risk assets. You tend to see credit spreads widening, you tend to see the more cyclical components and the more growth to components of the equity markets lead to the downside. And that's precisely what we got, obviously, heading into those December 24th lows.
When you back up the tape, okay, what happens when you transition out of Quad 4 into Quad 3, well, the two biggest pivots to make are one, energy goes from a top three short to a top three long. Crude oil and energy related equities tend to do fairly positively in Quad 3. And more importantly, tech growth and high beta style factors tend to do quite well in Quad 3 particularly large cap growth-oriented securities as market investors start to pay an increasing premium for those kinds of factors as you start to lose the more cyclically oriented companies from a performance perspective.
ED HARRISON: And what about the equity versus the bond part of the portfolio? Do you see bonds underperforming versus equities there as a result?
DARIUS DALE: I think you have to make the distinction. So, I mentioned this earlier, Quad 3 has historically been much more associated with the more late cycle dynamics. And I think it's important to parse out the different styles of Quad 3. There's two types of Quad 3, one is the Quad 3s at the end of the cycle that didn't lead in the Quad 4, i.e. recession. That 2001, that 1990, that's obviously 2008. And then there's the more "run of the mill" late cycle but not quite there yet on recession type Quad 3s, and that's 2000. That's 2011, that's '15 and '16. And that's something we currently see as today.
So, what you tend to see is the asset performance with respect to- and I'll get back to your question full circle- the performance of the market in a non-recessionary Quad 3 environment, particularly when it last multiple quarters is typically flat. If you take a look at it from an index perspective, i.e. the S&P 500. But when you break open the atom underneath the hood, and you look at the sectors, the industries and the style factors that comprise the equity market, typically, what you have then over the multi-quarter Quad 3 episodes, non-recessionary episodes is that about half the style factors are up about 10% to 15% on average and about half or down about 10%, 15% on average.
So, it's becomes this fantastic environment for fundamentally oriented investors to find themselves in the right securities and in the right sectors and the right style factors to generate alpha. So, if you think about going back to you mentioned, our GIP model, the framework starts with Quad 1- that's growth accelerating as inflation decelerating. That's really, really positive for risk, really positive environment for risk rather. Everything tends to go up a lot in the quadrant from an equity and credit perspective. Quad 2, everything tends to go up. Maybe not as much as Quad 1, but it's all going up. Quad 2 is where growth and inflation are accelerating at the same time.
I mentioned Quad 4 is really negative or growth and inflation are decelerating at the same time. That's a really negative environment. Quad 3 is this environment where half the things do well, and half the things do really poorly. And so, that creates this fantastic environment for alpha generators who kick and scream when they can't make money on the shorts because everything's going up in Quads 1 or 2, and then they get blown up on their long book when everything goes down in Quad 4. Quad 3 is this perfect, sweet spot for investors that we think more fundamental investors are really going to appreciate as the year progresses.
ED HARRISON: It's interesting, because first of all, I was thinking about timeframe, but you said something about the next two or three quarters and Quad 3? So, it sounds to me like you're basically making a call that there's going to be no recession, that we got rid of that risk in Q1. And as we head to the rest of 2019, it's not going to happen.
DARIUS DALE: Yeah. So, I think it's important to contextualize. Yeah, we do not see a recession on the horizon with respect to our forecast. Our forecasting tools have visibility up to the next 12-month time horizon. And then no part of that time horizon do we see recession occurring from an economic perspective. One thing we do see very much risk of, and this is something we can unpack the item on as well. We do think there's risk of a corporate recession in the United States. If you look at how some companies have reported or really just US corporations have reported in Q1 thus far, Q1 to date. They?re narrowly staved off dipping into annualized good traction on earnings. Obviously, sales are slowing, earnings are slowing again, but again, they're better than expected and they're more importantly, they're positive.
We don't think that's likely to be the case in Q2 and Q3 as they start the lap off against this cycle peak comparative base effects for earnings and for sales and earnings. Q2 and Q3 are the mother of all comps. You have to go back to Q2 and Q3 of 2000 to see base effects this stringent and this difficult that we do see in the current quarter. And if you go back to 2001, what happened in '01? Well, four quarters later, when you start to lap those comps, with many of the same conditions that we have today, i.e. annualized dollar appreciation of 5% to 7%, you have the rest of the world not doing so great and then obviously, a tight US labor market, which we can dovetail into after this, those three factors couple with those comps, produce earnings on the order of down 15%, 18% in a heartbeat for S&P 500 companies.
So, we would argue that that was the death knell for the equity market. And that was the death knell for credit. If you remember, credit spreads blew out statewide throughout that entire timeframe from the market peak and to the lows of 2002. And that's a risk. We don't necessarily see a multiyear bear market as a best-case scenario in absence of a recession, but we definitely think that's a risk to a lot of those companies and sectors and style factors. Those aren't going to be able to show the sales and earnings growth that they need.
ED HARRISON: So, we talked a little bit about style factors in terms of large cap. I think you were saying large cap growth. You would favor that. What do you favor in terms of sectors of the economy based upon this Q3, this Quadrant 3 multi-quarter?
DARIUS DALE: Yeah. Yeah, so just from a- I'll take it down one by one. So, from an index perspective, we definitely think large cap growth, small cap value is the best alpha generation trade out there. That's according to the MACD test. That's according to all these individual types of securities that comprise those particular indices with respect to tech. NASDAQ 100 being dominated by tech and the Russell value being dominated by financials with respect to the sectors tech, energy, utilities and retail. The longs historically in Quad 3. Whereas financials, materials and consumer staples tend to be the shorts if you think about the things that why are these shorts, right?
Well, interest rates are declining in Quad 3. And so obviously, it takes out the financials. Labor costs are rising, late cycle that obviously takes out the consumer staples. And then raw materials prices are rising for the materials companies if you think about these more industrial oriented materials companies. You got energy up 30%, 31%, 32% year to date. That's something that's obviously going to feed into their P&Ls, and you've seen the underperformance of these particular sectors thus far in the year to date. And that's something we think that likely is to continue and actually start to diverge. So, one of the things- we're not one of these Nostradamus type firms, and everything we've ever said and every trade recommendation we ever made is live on our website. Anyone can download all of our history going back to 2008 on every trade we've ever made.
And one of the things we got wrong in 2019 was that the US economy was in Quad 1, in Q1. I think a lot of investors ultimately got that wrong. If you think about the net, the max, the all-time high net short position that built up in the S&P 500 futures and options by late February. You can debate the merits of that growth number with inventories and exports accounted for over half the growth which is an 88th percentile rating in terms of those two way to contributions to growth, like the PC deflator was understated. The PC deflator understated actual consumer price inflation by 170 basis points. That understatement in terms of its contribution to the headline growth rate was also in the 88th percentile. So, we're talking very cockamamie report, but the data is what it is, right?
ED HARRISON: And how much of that was policy driven versus the internals of the market? And the flow of the economy? To the degree that we had a massive reversal in terms of monetary policy.
DARIUS DALE: It's the biggest reversal we've probably ever seen. So, with the Fed, as recently as December- mid-December- was hiking rates and saying we're tightening and we're far from neutral. As soon as January obviously, again, in January. Twice in January and then again, in March, the Federal Reserve basically opened up the door for rate cuts. We call them PE Powell short for Private Equity Powell, obviously, the guy's a history in private equity but you need to think about who's got his cell phone number down there in DC. So, this David Rubenstein, the head of the Washington Economics Club.
ED HARRISON: Carlyle.
DARIUS DALE: Okay, it's Carlyle. David Rubenstein and Carlyle, Keats' former employer, actually. So, I probably might get in trouble for saying that but anyway. The point I'm making is that the Federal Reserve is not here to promote full employment and price stability. The Federal Reserve is here to make sure credit systems blow up. So, it's consistent with our view of earnings recession that could perpetuate a widening of credit spreads, that the Federal Reserve is likely to get incrementally dovish from here if we're writing that particular faceted thesis.
ED HARRISON: Tell me a little bit about this earnings recession and how firms will deal with that going into the end of the year.
DARIUS DALE: Well, it's interesting, right? You're saying how corporations are likely to do it?
ED HARRISON: Right. I'm thinking share buybacks.
DARIUS DALE: Yeah.
ED HARRISON: Or throwing the kitchen sink.
DARIUS DALE: So, that was Q1.
ED HARRISON: Right.
DARIUS DALE: That was Q1. They threw the kitchen sink in Q1. And this is the beauty of the calendar as well. The calendar is a factor. Time is a factor in all-time series. You think about what they can do in Q1, they can throw the kitchen sink at it, make it look good. And oh, by the way, we have a whole year to basically- in terms of communicating to investors that things will get better from here. Things definitely are going to get better. My God, it's I'm going to maintain. My God, things are not, these are not so bad. As you get into Q2, obviously, report in July, and get into Q3 reporting in October, they won't have the full year as it relates to the calendar.
And the markets won't necessarily be inclined to believe the CFOs who obviously didn't see a lot of this stuff coming if you go back to Q3 of last year. Obviously, didn't see Q4 of '18 come in. If they could have all told you that growth was going to get cut in half, and then get cut in half again from the perspective of sales and earnings. They would have told you that, but obviously, they didn't. So, I think there's a lot of surprises in respect to where credit spreads are basically 250 basis points over on high yield baked into the cake. If these numbers don't come in better than expected and more importantly, positive, we definitely think that's going to be the next shoe to drop with respect to domestic asset.
ED HARRISON: Interesting. So, how far out are you willing to go in terms of your thinking about the macro? Are you going to go into 2020? Or is it a 2019 play in terms of where you have visibility?
DARIUS DALE: Yeah. So, the two quarters that we expect to see the most negative earnings growth are Q2 and Q3 of '19. Once you get past Q3, the comps really start to recede sharply, and it's unlikely that growth will get more negative from there. The one thing I'll caveat that by saying is that the labor market continues to be impressively tight. So, one of the metrics- the key metric we track to determine how tight the labor market are those few but the most important one is that the spread between the U6 underemployment rate and the U3 headline unemployment rate.
Historically, when the spread is about as tight as it is now, which is roughly there about 250 basis points is why you tend to see all of the peak rates of average hourly earnings growth in any given cycle, north of 3.5%, 4%. So, we expect 3.5%, 4% average hourly earnings growth, the hourly trending basis from now really throughout the cycle, because wage growth tends to peak during a recession actually. It's actually one of the things that causes recession. So, if you think about just running a business, your sales and earnings are slowing but your labor costs are rising.
What do you have to do to ameliorate that? You can start at the very minimum, you got to reduce hours work, reduce wages, but you really can't cut wages, right? What tends to happen as a function of that, you start to see declines in total employment. So, we're not there yet. I think it's that we've gotten too far of our skews with respect to that view. But we definitely think a lot of the sectors style factors, particularly small cap value, financials, materials, consumer staples, a lot of these companies are at hostage to that.
And they're owned, by the way, they're also hostages just historically being underperformers in Quad 3. These are the sector style factors that investors have historically shun in Quad 3. So, you have this double whammy where you can make a lot of money from a macro perspective. We can generate a lot of alpha just from a top-down perspective just