215 Systematic Investor Series ft. Cem Karsan – October 22nd, 2022

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing, and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:23] Niels

Welcome, and welcome back to this week’s edition of the Systematic Investor Series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules based investor. If you are newer to the show, I hope that today’s episode will trigger your curiosity to check out the back catalog and listen to the past episodes you may have missed. Like my conversation with Andrew Beer last week where we discussed CTA replication, the good, the bad, and the ugly, and what he sees coming for the CTA industry as a whole. Also, I would encourage you to listen to the midweek episode where Kevin spoke to Richard Duncan, economist and bestselling author, about new ways of thinking about the economic growth and prosperity and how the world has become addicted to credit.

Anyway, head over and check them out once you’re done listening to Cem and I today. Cem, it is great to have you on the Systematic Investor Series for a change. How are you doing? How are things in the Windy City? 

[00:01:17] Cem

Doing well. It’s fall here. It’s beautiful. All the leaves are changing in color. I’m excited to be on here with you.

I actually get to do some of the talking this time, so. 

[00:01:28] Niels

yes, absolutely, absolutely. 

Now we have a wonderful line up of topics that you brought along. So, we’ll be tackling them today a little bit later. Before we do that, let me briefly run through a little bit of a summary for the week. 

It was a little bit difficult in terms of what to focus on in this week’s market summary because, yet again, so many things are happening and they’re happening at a pretty fast pace on the political front.

Of course, the chaos in the UK and the resignation of the Prime Minister, after only a few weeks in the job, has created a lot of headlines. I’m not sure that her leaving Downing Street has moved the market that much today and yesterday. And both the pound and the gilt are off their lows as we record, they’re a little bit soft, heading into the weekend. 

In the US Fed Hawk Governor, Lisa Cook, warned about tackling inflation and it’ll probably mean rates going higher for longer – repeating the message from last week. The Philadelphia Fed President, Patrick Harker, said officials will probably take the benchmark rate well above 4% this year, and will most likely hold them there. 

Currently the market is pricing in a peak of 5% in the first half of 2023. Of course, what this has meant in the markets this week is the continuation of this selloff in fixed income markets. US bonds are down more than 3% this week. I can’t help worrying a little bit that we’ll see some stress in the system show up if it continues, and it may well be that it’s the pension fund system, like we’ve seen in the UK. 

Those of you who have listened to the podcast for some time know that I’ve been very skeptical about the 60/40 portfolio’s ability to work as well as people have come to expect. The weaknesses of the so-called balanced portfolio have been really exposed, in such a public manner, this year. It also raises questions about many investor’s love for the Sharpe Ratio as their go-to metric. 

On the topic of the Sharpe Ratio, one of our previous guests, David Dredge, from Convex Strategies, just published his monthly newsletter (which I definitely encourage people to subscribe to), and in it he writes, (and I quote) “In Sharpe World, historical volatilities and correlations always remain constant. Geometric compounding paths are irrelevant. Tails are never fat. Leverage is not a risk. Frequency matters more than magnitude. Ensemble averages dominate time averages.” 

Dave continues, “It doesn’t take a great mental leap to determine that a major (perhaps the major) uncapitalized tail that has built up over the last 35 years (call it the era of the Greenspan put) is the sharpe world driven universal belief and application that the fixed income component of the 60/40 portfolio and all of its variation is risk reducing. In sharpe world, the fixed income characteristics of low volatility bounded upside, low to negative correlation, is deemed to have a portfolio benefit and reduces, in effect, the amount of capital you would otherwise deem necessary to hold against potential losses on the portfolio.” And he continues, “Again, That of course, only holds as long as sharpe world assumptions of low volatility and low to negative correlation to the other portfolio components persists.

Those beneficial components have persisted for a reasonably significant number of years, but notably aided and accentuated, through active manipulation by central bank policy makers through ever greater intervention, to drive yields lower and to suppress and curtail volatility, particularly around events that necessitated the negatively correlating response. This is not currently the case.”

So, yeah, definitely something worth exploring further in the future as well. At this stage as usual, let me bring in you, Cem and just ask a little bit on what’s your, on your radar. Maybe not just this week, but maybe at the moment in general.

[00:05:38] Cem

Yeah, today is options expiration. So, that’s top of mind for me. We see all of these Vanna and charm flows, these things that I talk about. I’m not going to dive into too much detail now, but the delta buyback of options decay that happens into these expirations, once that gets removed, there’s generally a period of weakness.

We were seeing that this morning, as you might expect. Then the Fed released, through the Fed Whisperer, Nick Timiraos, an article this morning basically laying out the fact that they are thinking about thinking about pausing and taking a look and seeing what the lagging effects of their policy have been.

And that really lit a fire under markets this morning. So, interesting. That having been said, like you have noted, the 10 year yield has not come off really on that. I think that’s somewhat telling. It’s really an interesting kind of dynamic we’re seeing in markets at this point.

Outside of that we are seeing an event vol priced at significant vol, priced into the Fed meeting on November 2nd, and the midterms are November 8th. So, there’s a significant bid to vol in that area. What that ends up doing is, generally, that makes it hard for markets to rally in the short-term, but eventually that serves as potential energy and fuel for this delta buyback. We saw this during Brexit. We saw this during the Trump election in 2016, the contested election here in the US in 2020. All of those were worst case scenarios yet, we got big rallies on the back of all three of those. That really is a function of market structural dynamics which are tied to these event vols in the decay of the hedges that exist for those events.

And diving right in, there’s a lot of meaty stuff in there, but that’s what we’re looking at right now, So, there’s this potential energy sitting out there, and starting in about a week and a half, for an end of year rally. That’s the igniting of the fuel. That’s the ignition switch, and then the fuel is more poor positioning, bear sediment, and the end of year poor liquidity that could really push this thing higher in the short-term. There are big, big macro risks sitting on the other end of that (and I think we’re going to get to that probably in the back end of the show), related to kind of vol liquidation, liquidity problems in the markets, et cetera. I think we’ll leave that for the end, but that’s what’s top of mind for me. Both a little macro but also market structure. 

[00:08:18] Niels

Absolutely, it’s very interesting and it certainly will be a fourth quarter to remember, I think, in both the vol space and the trend following space. Yeah, so I have a feeling we’re going to be talking about this for quite a while, anyways. 

From a trend following perspective this week, and maybe I should say October so far, we’re three quarters of the way into it. Performance in October is somewhat broad based if I look at the attribution of our own strategy.

But of course, the main drivers continue to be fixed income, currencies, with the exception of metals and meats and maybe equities (where it looks flat-ish). All sectors are profitable so far in October. There have been some pretty big individual market moves, like natural gas, which is down about 20% this week.

And as I mentioned earlier, at least when I last looked at the screen (I don’t know if it’s changed now), but the 30 year bond is trading down meaningfully this week as well. To the upside, not a lot of action. Soybean oil has put in a brave performance of up 6% to 7% for the week, at least at the time of recording. 

My own trend barometer closed yesterday. We’re recording one day earlier, I should say. Today’s Friday, so it closed Thursday at 43. That’s at a neutral to weak level, and performance of the indices, that we normally cover, it’s the BTOP 50 Index, which is up 1.5% for the month, up 21.26% for the year.

SocGen CTA Index is up 1.6% for the month, up 28.12% for the year. The SocGen Trend Index is up 1.25%, up 37.25% now for the year. The SocGen Short Term Traders Index is flat for the month up 13% for the year. In contrast to that we have, at least as of yesterday, the MSCI World Index up 2% for the month, but down about 25% for the year. And the World Government Bond Index was down about 1.7% as of yesterday for the month alone, and obviously down quite significantly for the year.

All right, with that out of the way Cem, we’re going to dive into some of the topics and there’s quite a few to choose from and I had to organize them a little bit and it’s always hard to decide which one to come first. I’ve chosen this one which comes from an article that I received only a couple of days ago from EQD. It’s an EQD article. It is a new story that I think is pretty big in the world of volatility as it relates to perhaps one of the best known, and a really great promoter of the whole volatility space, named Chris Cole from Artemis, where it came out that he’s decided to close a couple of his funds and scale back his operation.

A lot of people will know Chris and perhaps the great papers that he has produced over the years such as how to best construct a portfolio that’s going to last you for a hundred years. Of course I know, Cem, that you also know him personally as far as I understand. Let me just start by asking you if this piece of news came as a surprise to you, so to speak?

[00:11:40] Cem

No, it’s not a surprise per se. Again, as a friend I know how hard this business can be. I want to lead off by saying that it obviously didn’t work. He’s doing kind of the right thing by reexamining and sending back capital. Not a surprise to me that there’s been… The challenges aren’t all focused on him.

It has been a very difficult environment to be long volatility. We’ve done well but that has been despite the environment. The reality is the world has been (and I’ve talked about this quite a bit), the world has been incredibly well hedged, or was near the top, in the equity vol space.

We had record skew levels and record hedging going on at the top. This happens during periods after you’ve had a big vol event, you had Fed March, 2020 during Covid. That’s very fresh in people’s minds. Entities made a lot of money being long vol along the tail. Entities that were short got blown out and will probably never get money again.

What this leads to is, again, this over hedging, a lot of money flowing into hedging platforms and vol strategies. Reflexively, when that’s the case, it pins volatility into a decline because there’s supply of vol into the decline. The ultimate pain trade ends up being, if the world is long stock, and hedged with puts, the pain trade ends up being down with vol down. And that’s, essentially, what happened. 

The world didn’t want to get rid of their high flying kind of winners. They wanted to hold onto the beta and try and spend a little bit of money to hedge on the downside. It just happens to work out that those hedges don’t really work in all market moves. And a stair step, down 25% decline, over the course of nine months is actually, exactly the worst case scenario for that. 

[00:13:45] Niels

Can I quote you? Can I quote a few things from the article that Chris said, and then maybe you have some color you can put on what this all means in your mind.

But what I picked up from the article was things where Chris was saying, that we’re seeing the VIX breakdown, comparatively. He said, there are different theories as to why that is. Cole said that he thinks that people are missing a key factor. “The big elephant in the room is the fact that in a stagflationary environment, underperforming equity stock market vol is not an anomaly. Instead, it is the new normal.” Cole said that in the current environment, he hears echoes of the 1970s where a stagflationary recession was a shadow depression clocked by money printing as inflation cut volatility and stock drawdowns in half, transmuting the variants through commodities, currencies, and rates.

He said that volatility is now being transferred into other asset classes. 

[00:15:46] Cem:

Yeah, actually it’s funny, we have our next quarterly newsletter, which is coming out in the next month there, is going to deal with exactly that topic, which is what happens to implied volatility and realized volatility in inflationary markets when you’re dealing with nominal products.

That’s essentially what he’s referring to. There is no implied volatility data because options didn’t exist the last time we had structural inflation. It’s an interesting topic. I agree with Chris on this. I’ve talked to him about this on a panel before. I think structurally, you look at ‘68 to ‘82 nominally, equity markets went nowhere for 14 years. What does that tell you about volatility – Long term volatility? Whereas markets are, on average, going up 15% a year, the last 20 years with significant kinds of volatility on the way that makes for higher realized and higher implied.

So he’s onto something there. That is not the story of what has happened, in my opinion. The inflation supporting equities is not the story of the short-term, in my opinion. Again, if you look at the sixties and seventies, there was a lot of realized volatility on short-term vol.

So, those are different things. If you look at a 10 year period and say, “Oh, the market didn’t go anywhere.” So, with vol you could have gotten a major problem. We went through the Vietnam War, the OPEC crisis, the Savings and Loan. It was an incredibly volatile geopolitical time on a lot of different fronts.

The market had multiple drawdowns of more than 25%, had a 50%, 47% drawdown early in the cycle, and had several 25% to 35% drawdowns. It was a very volatile time. It had 75% to 80% rallies. They all happen relatively quickly when they happen. 

It’s important to note that is not necessarily true for realized vol on a daily, weekly, monthly basis. But it does change the broad dynamic, and I do think that long-term vol is broadly more of a sale than people have expected. If you look at the last 40 years of data, you’re going to be playing the wrong game. Again, short-term risk to this market, in a world where we have more geopolitical strife (I’ve talked about this with you and other platforms), we’re in a competition game. 

We’re no longer in a collaboration game, and that means more war, that means more resource scarcity. So, entities battling over that in other ways. Again the OPEC+ cuts is a great example. Bombing the Nord Stream pipeline, things like that, or are things that happen during a time of resource scarcity and a time of competition. That’s not something that’s going away next year. That’s something that’s here to stay for probably a decade plus, in my opinion. That’s what we’ve seen historically. 

It’s a complicated topic in the sense that there is more risk. We’re sitting in front of the risk of tactical nukes, China invading Taiwan. You can go on and on about the geopolitical risks. People may have thought they were small black swans but they’re rhinos right now. They’re gray rhinos. These are things that are known, that are likely to, at some point, happen, honestly. 

So, real potential tail risks exist more than maybe during past periods. Long-term vol is likely (which is what he is referring to), is likely to come down. Again, not the reason. The reason when things have come down, when it hasn’t performed in the last two years, is more practical. It’s more a function of supply and demand. I think that’s the truth. 

[00:18:50] Niels

But let me pick up on one of the things you said, and this is where you said we’ve never had volatility strategies through an inflationary environment because the VIX wasn’t invented until 2004. So, we’ve never really been through this. obviously. 

What I remember, from a trend follower’s perspective, is how popular the volatility strategies became after Volmageddon, after Covid, even though trend following didn’t do well through Volmageddon, but at least it held its value (I should say) through Covid. But there was a lot of interest and there was a big push to get people to go in that direction for their portfolio protection. 

My question to you, in a long-winded way, is to say if these strategies have never really existed in an inflationary environment, we now have that. How on earth are investors to have any way of knowing how those strategies will behave now that we are here?

[00:20:01] Cem

What’s worked in the last 30, 40 years, which, seems like forever? It’s all that anybody thinks about is following a trend in a way. It’s really looking at what works and has worked and modeling it based on price performance. 

The reality is when the market starts to turn, and the world changes, it takes bigger thinking. It takes creativity. It takes a kind of understanding of what the bigger picture is doing, (honestly) still looking at trends. You have to look at data but bigger trends; longer historic trends, and that’s what happens on the turn.

Anytime something’s really turning, and things are changing, it’s one thing to model things in different regimes, but how do you understand when a regime is changing? How do you understand (And we’re talking about a 40 year regime)? So, it takes thought leadership. It takes being right and really understanding what the knock-on effects may be.

[00:21:07] Niels

But my point, Cem, was a little bit, maybe a little bit different because I’m just talking from my own personal experience, that every time we talk to investors about including trend following in their portfolio, they’re going to want to look at our 40 year track record to get a sense of how we behave, how the models behave, et cetera, et cetera.

But over 40 years, we’re lucky enough to say at least we’ve had a few different environments in terms of inflation and so forth. When you have a volatility strategy where most people don’t have a long track record I’m actually just curious how you, if you were the investor (let’s put it that way, maybe that’s a better question), if you were the investor, how would you look at a manager’s track record given the fact that most of them, if not all of them, have never gone beyond 2004? 

[00:22:03] Cem

Yeah, first and foremost to Chris’s point, you need to look at realized vol. You need to look at historical performance and then adjust for the effects of inflation. That’s what he’s saying. He’s saying yes, ‘68 to ‘82, the market went nowhere in nominal terms. That seems incredibly nonvolatile, but it lost 70% of its value over that time in real terms.

So, you can adjust nominal volatility versus what real might be. In those scenarios you really have to build a different model. You can’t just look at nominal assets and model them directly. That’s one.

 Two, while writing this paper we were struggling with the same issue.  How do you model what you think should be, and convince people that’s what is most likely? The answer is where you have to go dive into the realized volatility that you’re seeing and then make some assumptions about what implied volatility would do in those environments, et cetera. Again, there’s a reason there’s an opportunity in this, if it was easy, and everybody knew what was going to happen, there wouldn’t be an opportunity there. This is a unique time. We have history to look at and have a sense of what’s possible and likely.

But yeah, unfortunately there’s no way to say for sure, as you know, how things are going to turn out. You do the best you can with the data that you have and you have to think big picture and think about the risks and the distributions of outcomes. 

[00:23:53] Niels

Sure, that’s fair. Let’s move on.

You brought up a question, which I thought was very interesting, and obviously you look at it maybe slightly differently than I would. I think most people, or a lot of people who listen to the podcast, will be aware that liquidity actually became a little bit of an issue very recently in the UK due to pension funds being really called for margin and forced to sell government bonds, et cetera, et cetera.

So you said, let’s talk a little bit about liquidity conditions, how they’re changing, why this matters. I’m all ears, Cem. I want to hear your thoughts on this. 

[00:24:35] Cem

There is no more important topic than this, in my opinion, right now. For me, the center of the world is US equities. It’s where all the liquidity is, broadly, for hedging in particular. As I had mentioned at the top of the show, that is a major cause (and it’s part of why Chris Cole’s strategy hasn’t worked). It’s been the primary driver of the pinning of this market, that there have been hedges, that there has been liquidity. 

This is where the world comes to get liquidity when they need it to hedge, to get out of certain positions and take off beta. At the end of the day, remember the whole world’s equity exposure is about $100 trillion dollars, and if you talk about all commodities it’s at about $400 trillion – all long assets, $400 trillion. There’s not enough liquidity in this world. The places where there is are incredibly important to the stability of the machine. Those hedges have broadly pinballed and controlled what could have otherwise (if you think about the macro risks and what’s happened out there), could have been incredibly more volatile.

Nevertheless, we’ve seen incredible volatilities and illiquidity start to happen on the exterior, around this pin. We’ve seen it in gilts, we’ve seen it in JDBs, we’ve seen it in treasuries, we’ve seen it commodities. There are so many spaces that we’ve seen real volatility and real tail events, but it continues to be tethered to this big 10,000 pound gorilla in the middle.

What we’ve seen recently, and why this is so important, is we’re starting to see that pin, that liquidity in the place where the liquidity matters most, thin and do so significantly. Top of book liquidity in the ES Minis futures is at a record low. If you look at options liquidity in the SPX, again, it’s thinning out dramatically. There’s some of the lowest liquidity we’ve seen in terms of depth of the market. 

[00:26:55] Niels

May I ask you how you define liquidity? Just because we may think about…

[00:26:58] Cem

Yeah, each one’s different. With the ES I was saying top of book liquidity – just the how much, on average, the bid ask is. 

[00:27:08] Niels

Okay. 

[00:27:09] Cem

At any given moment, in the SPX, it’s actually depth, it’s pure depth to get a certain amount of size, a notional value done on the books. So, it’s the actual depth of the bid/ask spread. There’s no perfect way to measure liquidity, but I can tell you anecdotally, this is very representative of what we’re seeing too. If you want to get things done, it’s just not as easy as it may have been several months ago, never mind a year ago.

That obviously happens in distressful declines. But, when things are relatively calm, which they are, yes, things are crazy, but that doesn’t tend to happen. Ultimately dealers at banks, market makers, have an incentive to stay in the market and take their money.

So why is that happening is the question. It’s not just because things are happening on the exterior. But there’s actually, now, more and more… Option volumes actually hit a record recently in the SPX. It’s centered around zero days to expiration options.

So, it’s things that are hard to hedge for dealers, broadly. It’s, generally, buying on speculation like we saw on calls and tech names. It forces dealers into very short gamma positions when it happens, and it’s very hard to hedge, broadly. And we’re getting big trappy moves in all directions and risk over. Some dealers are, broadly, saying, “Hey, look, I need more edge to be compensated for what seems to be increasing risk.”  If this is the place of liquidity, and it’s thinning out, and there are so many risks on the exterior, that’s really a bad sign. I think you add to that the point you made about long vol managers capitulating. That’s what’s happening.

They’re being forced to capitulate. There’s a general timeline (I’ve talked about this before in other platforms) of slow vol moves, followed by people abandoning those hedges, and then big vol moves, then everybody crowding back into vol hedges. Where are we on that timeline?

We went from the hundredth percentile on skew in vol, at the top, and everybody being hedged. Now, the zero percentile, we’re literally in the zero percentile for skew in the S&P, downside versus upside hedges because it hasn’t worked and because people, who were long those puts, absolutely got decimated.

Chris Cole’s not the only one. Absolutely, they had to liquidate, and people who have been selling puts and selling stock against it looked like geniuses. This is the new, “Oh, you can hedge your portfolio by just selling puts apparently.” So, the pendulum has swung and things are getting less liquid at the same time that long vol managers are getting liquidated.

People aren’t hedging as much because they’ve gotten destroyed doing it. Once you get that kind of capitulation in the place which is the source of liquidity, and the pin that has controlled this decline, things start to get a little bit scary. Especially when you have the macro risks and the potential tail that we’ve seen across, in other corners of the market.

[00:30:30] Niels

Is it fair to say… So, I had two questions that prompted me when I heard you talk. One, is it fair to say that the actual liquidity issue has happened before, but it’s just never really happened at a time where the potential catalysts for something big to happen, that there are so many of them.

[00:30:57] Cem

Yeah. 

[00:30:58] Niels

Is that how to think about it, in a sense? 

[00:30:59] Cem

Yeah, yes, that’s true. I think particularly noting how we’ve never really seen this much hedging into an event that has pinned. It’s basically been a massive tug of war between macro and real geopolitical risks – real money flow risk against reflexive effects of hedging in the market. That’s been the tug of war. Now, markets decline, people are abandoning those hedges. The thinning of that matters in the context of what else is happening, like you said, what those risks are and what we’ve seen as a result.

Yeah, I think without that pin, I think it’s fair to say we would’ve had a much more volatile move, if people were less prepared for it, given the things that have happened. Now that people are less prepared for the next leg, there’s more risk to that tail.

[00:32:05] Niels

I don’t want to scare people listening to us today. I don’t know if you follow Elliot Wave Theory, but I happen to come across it from time to time. I know that the people who say that they were, or I wouldn’t say they say, but they were certainly the early ones, and I don’t want to name any names in terms of the Elliot Wave theory. And they were wrong. 

Their timing had been horrible because they were expecting this massive turn years ago. Now, it may have happened last year in 2021, which is probably my own base case, that is it. If they’re right this time, it’s interesting what you say because in their way of counting what’s going on in the markets, we are just about to hit into the first of the really major, nasty down moves, in their way of looking at markets.

So, it’s like what you’re saying. People tend to abandon stuff just before they need it. We see it in trend following so often that people redeem just before the trends come back. It wouldn’t be a surprise, in my view. 

[00:33:13] Cem

Yeah, reflexively it drives that. That’s why. It’s not a coincidence that happens.

That’s what it takes to get the unpinning that we need. We’re seeing the signs. This is supply and demand at the end of the day. It’s what the top of book liquidity, the hedging that is happening in the market, these are things that drive direct demand or supply in the markets. It’s important to understand what they’re saying, and that changes your distribution of outcomes, and that distribution is becoming increasingly fat tailed to the left tail.

[00:33:48] Niels

So, when you see something like this, Cem, I’m just curious. Obviously we have to be careful about talking specifically about strategies, et cetera, et cetera. When you see something like this happening, what happens in your thinking? What’s happening in the way you approach the whole space? 

[00:34:05] Cem

Yeah, I’m fortunate to be in the vol space, so I don’t have to bet on up or down. I can bet on the distribution. That sounds complicated, but it’s not, really. Every option represents that spot on the distribution in moneyness and time. And there are different options and different assets to bet in different ways along their distributions.

So everybody thinks vol is an asset class. Vol is not an asset class. Vol is the underlying distribution of every asset class. If you take that perspective, there are ways to, with very low cost, bet on certain specific parts of that distribution being different than are being priced. That’s essentially what we do.

We go find places that we feel are very mispriced, based on our analysis on the distribution and we make very targeted bets on those parts of the distribution. The obvious thing here is a fat tail would mean that the market is not pricing correctly that tail. That doesn’t mean you just go buy a gazillion puts necessarily, because that can be expensive over time. But you can go find ways to go buy those puts, and sell something else to to offset that, and take advantage of what you think the distribution is relative to what the market is pricing.

[00:35:25] Niels

Okay, cool. 

Now, I don’t know if you want to talk more about the vol space. I have one follow up question, but I know we also had some sort of non-vol type topics we wanted to talk about. Feel free to go back and talk more about some of the topics that are more specific to the volatility space.

But of course I can’t have you on and not ask you about when it comes to portfolio protection or crisis alpha (as a lot of people love to, to put it, and that’s fine), how do you, (I obviously don’t know how well versed you are in my world of trend following), how do you think of volatility strategies versus trend following when it comes to portfolio protection, and maybe how should investors decide what to prioritize in terms of their allocation? If that’s what they’re looking for.

I think a lot of money flows into these strategies with that objective: I need something to protect my portfolio. What are your thoughts on  those two? I can’t think of any other strategies, per se, that people would say, “I have to look at this for portfolio protection,” but I do think volatility and trend following are two that they would always look to. 

[00:36:47] Cem

Yeah, I think so obviously trend following has worked very well. We’ve been in very much a trending market. Part of that, I would argue, is because of the vol compression. There are macro structural flows that are pushing us in a direction, but there’s a clear dynamic happening here, with a push and pull, that leads to a somewhat orderly trend flow.

I think when that becomes more unpinned, it becomes more dangerous. It becomes more trappy. Trend may not work as well in those environments, but it’s very useful and has been incredibly useful for these types of environments. It should definitely be a part of an allocation for this approach.

I think it’s important. The way I think about the world, again, is through that volatility lens. Most people think about beta. I think beta’s an awful measure because what a 1% down move is, over a month, is very different than an up 5%, than down 6% move over a month.

They’re very different types of moves, and understanding the different outcomes and speed of which they happen is important. Vol is not a monolith. People look at the VIX, “Oh, you either buy vol or you sell vol.” It doesn’t really work that way. You buy different parts of the distribution.

I could be long a one delta put, en masse, a week out, or I can be long a 10 delta call and short stock against it a year out. Those are completely different things. They both will have convexity to the downside – different levels of it and different amounts of it. They’ll have different convexity to the upside.

They’re both long volatility if hedged. Ultimately, it’s a very, very different distribution that you’re betting on. I think of the beta that you get from something like trend following, or a long tail strategy, are all just different forms of betting on that side of the distribution.

The right approach is to find people with edge, whether it’s trend following, whether it’s different vol strategies, that ultimately represent part of that downside distribution. Put together a portfolio that has multiple orthogonal performance that has edge. Each one has its own little piece of edge and that diversifies your outcomes to the downside. It’s very hard, even if you have a relative probabilistic edge in your strategy for one part of the distribution, it doesn’t mean that’s going to happen. There are lots of other idiosyncratic things that drive outcomes. So, best to cover yourself. 

As we’ve seen with Chris Cole, they were long downside, they were long protection. They weren’t misrepresenting what they did. It just didn’t work because the way that downside unfolded wasn’t supportive for that performance.

Again, he performed incredibly well Fed March, 2020, because that was a convex move. That was a tail move. Talking about beta in that context is almost irrelevant. It really is a function of what kind of a down move are you getting? What kind of distribution is happening?

So, the point is you have to diversify your hedges and not just diversify them with different kinds of puts or different strategies that do well, and [that do well in] different types of environments over time and distance and multidimensionally – how do the assets they’re managing, within that time and distance, perform throughout those periods?

[00:40:35] Niels

Yeah, I think that’s well said. I don’t know, I can’t speak for anything about volatility, of course. Just like we’ve seen this year where bonds, as a protection part of your portfolio, have clearly shown that you can’t rely on that anymore. Sometimes you can, but not as consistently as we’ve seen in the last 20 years.

I wonder, and this will be my last question on vol, I promise, I wonder if you think that long vol, as an isolated strategy (as we talked about earlier), which was promoted a lot after those events in ‘18 and 2020, but something (and I don’t want to make it sound like it’s simple), but something that is focusing more on the just long vol side of things. Do you think people will shy away from that in terms of looking for protection after what we’ve experienced now? A little bit like what we’ve seen with bonds, where people are most likely not going to say, “Yeah, I’m just going to buy bonds as my protection.” Then look for, as you say, other types of strategies that attack the problem from a different side. 

[00:41:55] Cem

That’s what’s happening. That’s what the closing of Artemis is showing you. People aren’t willing to take that pain anymore. They’re liquidating. That is what capitulation is. People are capitulating. Why are they capitulating? Because it’s a function of time.

They can only take so much pain over so much time. It’s a function of distance. This was meant to be short beta. As the market’s down 25% and this is down 25%, people just don’t fully get it and they don’t care. They’re out. The answer is yes, people chase performance.

That’s part of why trend works. People chase what’s working and there’s a momentum factor that makes trend work. The problem with that is after they capitulate the trend changes, and when the trend changes is when you want to have more of the thing that was not working, and really changed. That’s the change in trend. There’s a connection here between these assets. We’re definitely reaching my point as a change in trend moment in my opinion. I think it’s coming in the next three to six months.

[00:43:13] Niels

Let’s leave it there. Let’s move to another thing that is, how should I say, putting the world maybe at breaking point. That is our friend the US dollar. It is something that is debated heavily in terms of how strong it is, how strong it can get. We know of course that, in the last couple of years, there have been so many people predicting that it would just collapse, disappear.

But it’s still here. This was one of the topics you wanted to talk about. I will be quiet and listen to your thoughts. 

[00:43:49] Cem

I don’t want to spend too much time. I think it is so important, so, I just wanted to make sure we get into the effects that this can drive.

When I started in the market, ‘97, ‘98 was the last time we saw this kind of dollar strength. That led to some very predictable things. We’ve seen this throughout history. Dollar denominated debt becomes a problem abroad. What the Fed is essentially doing is they want the dollar higher.

Because they get to export inflation in a time of inflation that’s helping internal inflation be controlled. That means we are, as a country, the US is exporting that inflation abroad. It also, as I had mentioned, becomes a dollar denominated debt that can cause tail events on the sovereign level.

That can then come back, it always comes back to sink the whole world in the sense that there’s always financialization around these things that ultimately that implodes. That’s why we saw the long term Capital Management implode in ‘97, ‘98. We saw a lot of other entities have similar problems throughout that period.

Even though we are, in some ways, managing volatility by markets rebalancing with these things. We are creating tail risks within that context. I think we’re going to a type of market that is much more like ‘97, ‘98, where things are not necessarily going to implode in a straight line.

I think we’re building more and more pressure for some tail events that are going to come from unknown locations but throughout the emerging markets and world, in that regard. I think, again, the dollar, to be clear my view is that this inflation’s secular. We haven’t talked about that much on the show and that could be a whole other podcast. You know that from other conversations and that view means we’re likely to see a stronger and stronger dollar.

We’ve been calling for that for a while, and it has definitely been playing out. We think there’s a much even longer leg up to this dollar strength. It’s already getting a lot of countries and a lot of entities really uncomfortable. 

Again, you’re likely to see that through currency issues. We’ve seen that with gilts already. We’re likely to see something with JGBs, we’ve seen a little bit there, but that could get worse. There’s so many little pegs, and little things that can really blow out as a function of that.

That’s the most important cross national thing to be aware of and thoughtful of as we’re looking at real flows and geopolitical risks. That would be the first thing I’d look at. Obviously, outside of the dollar kind of wrecking ball, I think there’s a lot of other things sitting out there. 

The commodity story here is a big one. Again, you and I have recently interviewed Adam Rozencwajg a couple of times. He really dug into that topic on your Macro series. I think, again, we’re in this competition game and resource scarcity is a real thing.

That’s the leverage that countries are going to use versus one another, not just commodities. It’s true for labor, it’s true for capital. That’s what the US is doing with a strong dollar. It’s a leverage point and a resource that they’re able to yield as a weapon, or however you want to think about it, against others.

I think commodities are the other kind of pain point. That’s a leverage point and a resource that is really going to continue to cause tails, as we’ve seen out there. Particularly with the SPR being down to where it is, getting to the end of the midterms, and having the US government’s announced, Biden announced that he’s going to buy back, very publicly, oil at $72 a barrel, which is very interesting.

You have the US government put on commodities now, and you have an inelastic supply, which could really make it go a lot higher. I don’t know how they put a roof on it. There’s a put and there’s massive upside. Commodities are definitely a problem out there for obvious reasons.

So those are just the first two, and then obviously, China. I think that’s the biggest tail risk of all. People have just whistled by the US semiconductor policy change and what that means as if that’s nothing. That is basically telling you that we are bifurcating.

It’s been happening, but that is the nail in the coffin. To be clear, you don’t do that, if you’re the US, unless you’re worried about something bigger happening. They’re trying to proactively lean on a form of deterrent, I think more than anything about what might be happening.

I’m not going to name any names, but I was with an executive from Palantir just yesterday, had a nice dinner, and the topic of China, Taiwan came up. I’ll just say his views, based on what he’s seeing, are very much aligned with what I’ve been saying for some time, which is it’s going to happen much sooner than people expect.

That’s the other big tail event happening. 

[00:50:09] Niels

Yeah, I think there actually was some news out that I saw within the last week where one of the US officials, or maybe not. No, maybe it was actually… 

[00:50:20] Cem

It was a US general, I’m forgetting his name actually. He recently came out and said we can’t say that it’s not going to happen before 2024. Basically insinuating that it’s likely to happen before 2024. That earlier expectations of it being years away have dramatically changed in the US intelligence community. 

Every action we’ve seen, not just from China and what they’ve said insinuates that. We don’t have to get into all those details. Every action now that we’re seeing from the US response also verifies that’s broadly what the US intelligence is also thinking. People laughed me out of the room six months ago when I said it’s a 30% to 50% probability of happening in the next two years. Now, it seems like that’s more the expected outcome, or we’re moving that way. I think everything I’ve seen since only confirms that. 

[00:51:25] Niels

Yeah, it’s quite interesting. In my world, in the trend following world, one of the themes that has happened in the last few years. It’s almost like when pension funds get into trouble because in their search for yield, they do silly things like lever up or go into more illiquid stuff. Maybe they even add leverage to that as well. Then they’re surprised when they realize that suddenly they’re sitting at massive losses and so on and so forth.

In the trend following space, we see this very interesting evolution where many managers have moved into “alternative markets.” Where maybe some people believe that they are more trending, et cetera, et cetera. If they are, it may be because of less liquidity in those markets. They’re harder to get access to for managers. 

There’s certainly been a big push for that. My own view is that I don’t think they are more trending, but they may trend at different times. If what you’re suggesting comes to pass and we do see this sudden massive conflict breakout in the East, again, what I worry about is that we are going to see these markets suddenly dry up completely in terms of liquidity. That these alternative markets really are alternative and you can’t get neither in or out, either because of regulation or exchanges closing down, or just no bids, no offers.

It is a concern for sure on many, many levels, not just the actual human life level, which of course would be disastrous as well. 

[00:53:14] Cem

Yeah, look, it’s not just about war and life and all the struggle there. Quite simply, 40 years of deflationary pressures from globalization is coming to an end.

That sounds bombastic. That’s fact. That’s what we’re seeing. What does that mean for input costs, for labor, in the Western world? You think the inflationary pressures we’ve seen so far are bad. What happens with true bifurcation?

You have to make up for 40 years of just in time logistics across Chinese labor. That doesn’t happen overnight. That’s going to take some time and investment. It’s not the end of the world. We will get through this too.

It does mean dramatic shifts and change in the way the economy works and the way global trade works. These things, you can’t put Humpty Dumpty back together that quickly. It takes time. 

[00:54:26] Niels

I don’t want to steal his thunder. I will say that you and I have, in a couple of weeks or so(maybe it’s 10 days or so), we have a recording coming up with someone who’s spent most of his life traveling in China, Russia, Middle East, and I’ve heard him on other platforms talk about what he’s expecting in terms of inflation, and yields, et cetera, et cetera.

I think that people will be surprised to hear how high he’s expecting them to go. Maybe like yourself, people will initially laugh when you say that. I also remember conversations with people, only a year and a half ago, when I was saying actually I think inflation was going to be a much bigger problem than anyone can think about right now.

People were laughing at that. Then suddenly we have double digit inflation in Europe. By the way, I can’t remember who told me, but I think someone recently just put together like a basket of goods in Germany that you would normally buy in a supermarket. Not the official inflation number, but a basket of goods that you would normally buy in Germany. The price was, this year, 39% higher than last year. That is scary. 

[00:55:51] Cem

Yeah. I have family in Turkey. I go out there once a year and talk to them, very much in touch with what’s happening there. They’ve had 80% inflation. That’s what the headline says. It’s probably higher. 

People get used to it. That’s the thing. It’s being in a car, if you’re going a 100 kilometers an hour, it feels fine. If you accelerate to 200 kilometers an hour, very quickly it’s painful. Then again, you’re at 200 kilometers and just everything’s just coasting along on a train or whatever.

I think it’s the move from one regime to another that’s going to be painful and scary. I think we will adapt to that new environment as we get there. 

[00:56:33] Niels

So let me ask you a question, Cem, because that’s interesting. Of course I knew your background, but now that you say it, it prompts me to ask.

What do investors then do when they’re faced with that level of inflation? What do pension funds do when they sit with bonds in their portfolio? Inflation is 80%, I imagine their bonds are probably not worth a lot. What actually happens? I don’t know if you know the answers?

[00:57:02] Cem

Yeah. It’s interesting. I can speak about it a little bit because I, again, I’ve recently spoken to my cousin who’s like a brother to me. He’s my age. He works up there and we dove into this topic a bit, so I got a little bit of boots on the ground to understand what it’s like. Inflation’s not a monolith. Not everybody experiences inflation in the same way. I think that’s important to note. It’s really uneven, dramatically so.

In Turkey 55%, or so, of the workers have their pay tied to some minimum wage. It’s either minimum wage or tied to it. What the government has done is raise pay twice, a total of 80%. Workers are getting paid 80% more. There are rent controls nationally, so you can’t raise rent more than 25% per annum.

Food is broadly well supplied in the country. They’re a self producer of most of the food that they eat. That hasn’t been a major pain point. Inflation for food has not been bad there. Really the only major input that they don’t have is energy. This is why you see Erdoğan buying energy from Russia at a discount.

For your average worker, they’re actually doing better. 80% inflation sounds like you’d have riots in the street. There are no riots in the street because most of the working class are doing better. It’s still psychologically bad. People don’t like inflation. It’s scary, but they’re doing fine.

Also, healthcare is nationalized there, they’re provided healthcare nationally, and so that hasn’t been an issue either. On your other side of the question, you have the landlord who is battling the rent controls. The corporation that is having to pay all these people that much more.

This is where the dollar wrecking ball and these things come into play. Sovereigns have to backstop some of these things and provide, and they can do that for a while. It comes down to their own power. Luckily, Erdoğan in Turkey, sits in a very pivotal place in a time where countries that need him are willing to do things that they need to do.

He, much like India and other countries, are wielding that power, much like the US, and other countries wield their power, to make sure that they can borrow more. Make due with the reserves, and get lines of credit, and do whatever they need to do to keep everything together.

This is a complicated topic. That doesn’t mean if a country doesn’t have that power and can’t keep global investment, and has outflows, things start to break. That is where the dollar wrecking ball starts wrecking things.

The question is, where is that likely to happen? Where is that power not strong enough to hold things together in a world where you could get major outflows for corporations? I didn’t answer your question directly, but that’s my broad answer.

[01:00:21] Niels

That’s a fair view. It’s funny you mentioned this thing about rent control, actually Denmark, a country that you would think is pretty well run in terms of the economy. They’ve announced they’re going to introduce rent control of 4% whilst the inflation is more than twice of that.

It’s definitely something that’s happening. The other thing I was curious about is, think about Germany. From my travels to Germany and meeting with institutional investors, I seem to have walked away thinking they have 70%, 80% of their money invested in fixed income.

It’s the complete reverse of the US. In a world like that, what the hell? (Sorry, I shouldn’t swear.) What happens when inflation suddenly takes off like that? Bond prices so far in Germany, obviously the yields are still modest on a historic scale, but what if 10 year bunds goes to 20% yield because inflation is 20% in real terms? 

Anyways, these are just big questions, but we’re not going to tackle them today, unfortunately. There’s so much to dive into. It’ll be next time. It’s only going to be a few weeks, no worries about that. I think, Cem, we’re going to say this is it for now.

We hope the people have enjoyed it. If you did, head over to iTunes, head over to Spotify, Amazon, wherever you listen to the podcast. Go there, hit follow, leave a rating and review. We’d so much appreciate that, and we certainly appreciate the support. 

Next week, I’m joined by Alan. This will be your chance to tackle some of your questions with him on allocation, trend following, whatever you want. You can email them of course to info@toptradersunplugged.com. 

From Cem and me, thanks ever so much for listening. We look forward to being back with you next week. Until next time, take care of yourself, and take care of each other.  

[01:02:29] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review, and be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show. And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance.

Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us, and we’ll see you on the next episode of the Systematic Investor.