Keith McCullough on Why America Must Stop Spending

Americans can't spend their way out of a bad economy, according to financial risk manager Keith McCullough.

Keith McCullough on Why America Must Stop Spending Rebecca Jarvis: We're now joined by Keith McCullough, Chief Executive Officer of Hedgeye, an independent research firm and risk management firm. Great to have you here. Keith McCullough: Thanks for having me. Rebecca Jarvis: Right now we're at an interesting point in the economy. You say we're at a crossroads. What does that mean? Keith McCullough: We're at a crossroads from a tipping point perspective in the two big ratios that the world is watching from a U.S. economic perspective. So, those two big ratios are our deficit as a percentage of GDP and our debt as a percentage of GDP. And we're really at the tipping point or the crossroads, if you will that Europe's already gone over. And of course, they've had to implement austerity measures and our view now is that America is going to have austerity of its own. Rebecca Jarvis: And do you think that's the right path? Paul Krugman, the New York Times editorialist, says it's absolutely wrong. We need a third stimulus instead of austerity right now. Keith McCullough: Yeah, I think that the writing's on the wall from a market perspective. You can either lie about it and lie and extend and pretend that deficit building and laying debt upon these deficits is a soluble mechanism to get through it, or you can learn from the Europeans and say, okay, look, we have to stop spending, we have to reduce the exposure that we have from a balance sheet perspective and get our house in order. Now, I think Krugman's solution has been unfortunately the solution that we've had since the beginning of the Greenspan era and the Bernanke era, which is anytime you have a tough economic position, you have to cut interest rates to zero and in doing so you also cut the rate of return for anybody who has savings in America, because obviously their savings are marked to a rate of return. And at the same time you have to start goosing up this government spending. Well, that doesn't work at a point, and again, over the 10% as a deficit to GDP level ratio, or 80% from a debt to GDP ratio, you really cross the Rubicon if you will, or the crossroads of economic disaster, and that's where the U.S. is going. Rebecca Jarvis: The Krugman camp would argue, however, if you look at history, in the early 1930s, primarily what we did in this country in terms of implementing our own austerity measures for the time; that that is what created an even greater depression. Keith McCullough: Right. And this is the problem with dogma. And at the same time, Krugman and Bernanke are very close in this regard, both from a friendship and from a historical basis, because they're really living in that snapshot of economic history. Now, I don't believe that any history is the exact same. Yes, it rhymes, and we have to be cognizant of the cycles. But when people argue that 1938 raising interest rates is what took us over the cliff. I could easily argue that the three years prior to that where you didn't raise interest rates was building an expectation into the system that money was never going to get more expensive. So, there's a lot of different ways that you can spin this story. And anytime that you infuse the idea of the Great Depression, I think it's unfortunate, because you're fear-mongering people into saying, hey, look, you don't want another Great Depression. Well, that's not really a fair way to depict what we currently have. I think any American who's walking around today knows that this isn't a Great Depression, certainly not the kind that we saw in the '30s. Rebecca Jarvis: But there's still pain on the street, and people feel that pain and you see it expressed in all of the numbers, from the jobs numbers to the housing numbers to the consumer confidence numbers. How do you create confidence in society so that people feel like, I can hire, I can buy a home, I can buy consumer goods, and generate growth in the economy, without stimulus? Keith McCullough: It's a great question, and I think that when you look at it, you have to look at what hasn't worked first and you have to look at what has worked in prior cycles. Now, empowering people that are good bastions, or good kind of responsible caretakers of capital, that can earn a return on capital, that don't blow up their balance sheet, that can hire people on a repeatable basis, that's what America can build a—it's strength and confidence. Rebecca Jarvis: So you're saying you have to be selective with the stimulus, but so far we haven't necessarily seen that play out? Keith McCullough: Yeah, I'm actually not saying it's all about stimulus. I'm actually saying that we should go back to respecting the cost of capital. The cost of capital should not be zero, because all that does is it empowers a lot of bad actors, a lot of people who don't respect the cost of capital or balance sheets or cyclical hiring patterns. What you do in that regard, when you disrespect the cost of capital, like the Japanese have for the last two decades, is that you really put rules of the game in place that are letting bad players at the table survive. It's the equivalent of a bad game of Monopoly, somebody who's completely levered up, and your solution to keeping them in the game is handing them another $200.00 after you hand them the $200.00 as they pass go. Rebecca Jarvis: And socializing the losses. Keith McCullough: Right. Rebecca Jarvis: Now, what as an investor is the thing that you can do in this kind of environment to protect yourself? Keith McCullough: I mean, our solution has been, get out of the way. At the end of the day Rebecca Jarvis: Meaning go to cash. Keith McCullough: Right, so we've gone to—our peak cash position this year was 79%. Recently we've dropped that down under 60%. So what we think that you should do, and we think that—provided that we're dealing with this big Keynesian spending environment, where we're absolutely going to erode the value of our currency. Rebecca Jarvis: So you believe that is the way we will go? Keith McCullough: Oh, absolutely. We're going that way. I mean, we've been going that way for a long period of time, since 1971. Rebecca Jarvis: But we will continue to go that way? Keith McCullough: Yes, we will definitely continue to go that way, provided that Ben Bernanke is still at the head of the Federal Reserve and that Tim Geitner is overseeing the Treasury. Because these people—you can't solve the problem with the people who created the problem. So I do think that when you're looking at your portfolio, the best way to manage your way around this is to have a dynamic management style with your cash. You have to have cash on the sidelines to take advantage of both the institutional community freaking out because they feel like you should be fully invested all the time, which has obviously proven itself not a very good strategy. But at the same time you're going to get opportunities to buy things when they're on sale like we used to, and get a good deal and understand that you could earn a rate of return. By not having to chase prices higher, you're actually buying them on the way down. Rebecca Jarvis: Keith McCullough, thanks so much for being with us. Keith McCullough: Thanks for having me. Rebecca Jarvis: And thanks to all of you for joining us as well.