I found a recent episode of the Cashflow Academy podcast rather interesting and wanted to share some notes I took on the show. Host Andy Tanner interviewed Keith McCullough, professional investor and author of the book, Diary of a Hedge Fund Manager.

The crux of the interview was around Mr. McCullough’s data-driven approach to investing. Much of Mr. McCullough’s algorithms for predicting the path of financial markets is based on the second derivative of Calculus.

Everything that we do is based on the second derivative or the rate of change.

Keith McCullough

The two predominant categories McCullough factors into his second derivative calculations are growth data and inflation data. As an aside, investment guru Ray Dalio, in his book Principles, also stated that growth and inflation are the two most important challenges to solve for in investing.

I’ve learned over the years is that if we get those two very basic things right–growth and inflation and whether it’s accelerating or decelerating, getting better or worse–then we’re in a pretty good place.

Keith McCullough

GDP appears to one of his “growth data” datapoints. GDP just set a new record for accelerating for nine straight quarters in a row.

According to his calculations, though, that rate won’t maintain as he’s predicting a deceleration in Q1 2019. Consequently, he sold all his fast growth products and bought slower growing ones that do well when GDP and inflation are slowing–like long term bonds, the US dollar, and utility stocks.

Interest rates are another datapoint McCullough seems keenly interested in, given the tight relationship between interest rates and inflation. Interest rates seems to rise when both growth and inflation are accelerating at the same time.

McCullough then transitioned into discussing his Four Quad Model: Growth and Inflation, modeled on a second derivative basis, have one of four different outcomes or “quads”. Quad 2 is when both growth and inflation are accelerating at the same time. Quad 4 is the opposite: both growth and inflation are slowing at the same time. Interest rates also usually fall in a Quad 4. Interest rates have been on the rise for about the last three years. Now Mr. McCullough thinks that, in the next 3-4 quarters, inflation will start falling and interest rates will fall in kind.

Throughout the conversation, Mr. Tanner also injected some interesting thoughts. Mr. Tanner underscored four important principles in managing your finances:

  1. Gather fundamental data
  2. Gather technical data
  3. Maintain a position for cashflow
  4. and manage your risk by investing

In a brief tangent on real estate investing, Tanner mentioned two datapoints he valued highly:

  1. Net Operating Income (NOI)
  2. Capitalization Rate (aka Cap Rate)

Mr. Tanner also mentioned a few other terms I must research:

  • Factor exposures — popular quantitative strategies/predictive tracking algorithms
  • Momentum — I believe one type of “factor exposure”
  • High Beta
  • Technology Sector Factor
  • Delta Hedging