223 Systematic Investor Series ft. Cem Karsan – November 19th, 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’re new to the show, I hope that today’s episode will trigger your curiosity enough to check out the back catalog and listen to the past episodes you may have missed, like my conversation with Rob last week where we had a wide-ranging conversation on lots of topics that relates to both people considering trend following as part of their portfolio for the first time, as well as for the trend following nerds like ourselves.

Also, I would really encourage you to listen to the midweek episode where we had the pleasure of speaking with the author of The Financial Times Best Business Book Award for this year, namely Chris Miller, who recently published his book Chip War, which is just a fascinating book on so many fronts. So head over and check them out as soon as you’re done listening to Cem and I today.

Cem, it is great to be back with you this week. How are you doing? How are things in the Windy City?

[00:01:24] Cem

Good. Holiday season is upon us. We just had our holiday party here at Kai Volatility last night and I think it’s going to be an interesting end of the year, beginning of the year. I think we’ll dive into that a little bit, but seasonality is a little different this year and things feel a little different this holiday season.

[00:01:44] Niels

Yeah, absolutely. Absolutely. So that explains the more than usual Barry White voice, I think, this Christmas party.

[00:01:51] Cem

A little huskier this morning for sure.

[00:01:54] Niels

A little huskier. Good. Good for you.

All right. Well, there obviously were a lot of headlines this week. Quite an eventful week, really. A lot of it was driven by all of the Fed action and maybe to celebrate this but in a different way, maybe we can try something a little bit different, namely, talking about some of the myths surrounding the Fed instead of the usual market summary, which I’m sure most people have already seen.

This comes from some of the reading I’ve done this week, in particular, something that I saw Bob Prechter wrote. He talks a little bit about these Fed myths and he’s got like three of them lined up. I wanted to read them out to you, how I remember what he wrote, then I’d love to just hear your thoughts about it.

The first one is that the Fed is proactive in setting interest rates, and he contends it’s not. It’s 100% reactive, always has been. What I mean by this is that if you look at the chart of the Fed funds rate, it continues to lag. The rate changes and the T bills are set by the market.

Now the second myth is that the Fed is using interest rate policy to produce some kind of outcome. For example, we had lots of talk about the Fed lowering rates to step on the accelerator or raising rates to step on the brakes of the economy. But can you really say that the Fed’s policy produced outcomes that wouldn’t have happened naturally?

The third myth that’s mentioned is that the Fed is doing either a good job or a bad job in producing these outcomes. But again, is it really true? Because what may look like a good job, in say slowing the economy, often ends up in an economy heading into a recession, like the current moment where officials are saying that despite rates rising more aggressively than ever before, we’re still going to have a soft landing and that the tech tumble will not end up in a dot com bust, and that the housing sector is just cooling down, it’s not melting down.

The Fed is obviously something you’ve studied. We’ve talked about the Fed in different ways before, so I’d love to hear your thoughts on these kinds of myths that Bob puts out there in his writing.

[00:04:14] Cem

Look, the Fed is absolutely not proactive, they are 100% reactive. I couldn’t agree more with that. The reality is they are constantly chasing the new thing and I think that was never better seen than this year. This year, inflation was transitory. They weren’t out in front of the data. In the last 10, 20 years, for the most part unless it was easy, they were constantly chasing whatever the next thing was.

For the most part, other than the self-fulfilling prophecy part of the Fed, their narrative and their ability to control through their speech what they want (except for that piece), they’ve really been playing from behind almost always. So, their narrative tools are powerful and they’re able to use those to their advantage to get a bit of what they want. But other than that, they’re really chasing a lot of wrong outcomes and trying to get back onside most of the time.

To be clear, it’s been an easy 40 years for the Fed. We’ve talked about this before, but we’ve been in a situation where the Fed has been able to take interest rates from a very high level down and constantly go back to the well. They had this big pile of liquidity that they could draw upon, and they went to the lower bound. Along that way, they went below the lower bound in a lot of places; and along the way, they created massive inequality, which we’ve talked about. We won’t dive back down that rabbit hole.

But the reality is, it just went too far and now they’re stuck. They’re in a box. This isn’t the same Fed. It doesn’t have the same liquidity to draw upon that it normally would, and to the extent it does, the forces, the popular and populist forces that it’s up against have put it in a box. We talked about that starting last year and it’s really become more true now.

There’s this vicious cycle which we’ve talked about, which the more politicians respond to populism, the more fiscal policy they do and measures they do to help fix inequality, the more we ultimately drive to an inflationary place which is ultimately a flat tax which hurts the populace, which drives more populism. So it’s a big loop, and the Fed is stuck in it, and there’s not much they can do now.

The second and third points, ultimately, the Fed, not only are they stuck, but they are in a situation where it’s hard for them to do a good job because ultimately, it’s a problem that they can’t solve with the tools they have. But ultimately, are they stepping on brakes? Are they accelerating? Yes, they’re doing it on a cyclical level. I do believe they can slow down the economy. We’re seeing that now. I think they can accelerate the economy. But these are short-term cyclical things. They can provide liquidity to the market. They can push liquidity in and that can drive speculation and investment and all kinds of things. But that’s very much in the short-term and that is a supply-side response. Over secular outcomes, they really can’t control that.

Actually, ironically (I’ve talked about this in the past), the more they do the cyclical things to slow down inflation, which they’re trying to do now, the more they’re exacerbating structural inflation. We can kind of get into the details of what the drivers are there. But ultimately, we’re in a secular inflationary period and the Fed cyclical responses are very short-sighted. They’re not trying to solve the problem or the causes of the problem. They’re actually exacerbating those at the cost of lowering CPI in the short term. That’s really, again, a political action.

To your first point, it’s not the Fed getting out in front of things and being proactive. They’re being reactive. That reactive policy is actually ironically maybe the worst thing they can do to the structural inflationary picture.

[00:08:29] Niels

Yeah. When I think about some of these points, I think almost where the Fed has ended up is in a situation where they can, for the most part, influence behavior of speculators, if I can almost call it that, not even the broader investment community, but certainly the speculation part of the financial world. They do seem to, at least in recent years, be able to influence that. Of course, some of the things that drive markets for sure would (Bob wrote about this), are they doing a good job or bad job?

Of course, this is something that may look like they’re doing a good job in the beginning but then turns out to be a bad job. I don’t think we can even say vice versa. But one thing that’s really stuck in my mind, when I think back over the last few years is, for example, something that seems very obvious, even for people who may not have studied economics for a long time, and certainly institutions, even those who don’t have 400 or 4000 PhDs or however many they have. But I’ve always wondered why it was, when interest rates were historically low, the lowest level we saw in 4000 years or people who have gone back and looked at that, which is only a couple of years ago really. Why was it really that the Fed didn’t finance themselves for more than just a few years? Why didn’t they go out and issue 20 or 30-year bonds? It would certainly have saved a lot of money for taxpayers in the coming years.

Of course, we don’t know if interest rates will go back down again, but it doesn’t look that way. Let’s put it that way. So that’s one of those policy errors that I think are glaring for all of us to see, and it has real consequences if they’re going to go out and spend billions of dollars on finance costs which they could have saved.

[00:10:39] Cem

Well, they didn’t want the long end of the curve to go higher. I think they were stuck. They needed to save the market in the way they could without going and creating a bigger and bigger speculative bubble. Yes, they could have done more. I hear you. As a trade, it makes sense.

[00:11:05] Niels

Yeah. I just think they had all the optimism, all the wind was in their back at the time; there was so much optimism and equities had gone up for a decade with very few wobbles and all of that. But anyway, that’s a moot point but it’s just something where I think that that is an easy policy error that I would think maybe will come back to haunt the US taxpayer at some point.

I want to jump to something much closer to your heart. Because it’s a little bit of a micro kind of interesting conundrum, I think, and has to do with the market action in stocks since you were last on. You came on in mid-November, and it’s been quite an interesting period in equities since then. I just wanted to hear your observation. I’m referring to two specific trading days, November 30th and the recent December 13th.

On November 30th, we had the S&P futures soaring 150 points and the NASDAQ went up by 580 points in just a couple of hours. The Dow Jones hit something like 34,000, just shy of 600, which was a top tick, and the next day it actually gapped lower on the open. This week on the 13th, we had the S&P raising up 160 points, the NASDAQ up almost as much, 524, so almost as much as November 30th. It had a rise between 08:29 and 08:31 in the morning (I guess this is Chicago Time, maybe New York time), which was one of the biggest moves that I can remember. Shortly after midday, we had markets rollover and the Dow actually was down after midday and it closed the day down as well.

So, we have two instances. In the first, we had the Fed Chairman say nothing new, really. In the second instance, we saw a tiny change in CPI. Now, clearly, investors are dying to buy the markets and really want the bull market, that we’ve seen in the past decade, to continue. But as a volatility expert, two very different reactions or market behaviors on some pretty big days, really. What does that tell you that’s really going on here?

[00:13:44] Cem

The first and most important thing to note here is illiquidity. We’ve been talking about the trend last month, we’ve talked about the trend towards increasing illiquidity, top of book depth in the futures, total depth in the options markets has been fitting dramatically, and then you add to that (which is seasonally) a very illiquid time and you get a market that’s just not prepared; not liquid enough for the types of flows that can come off of some of these bigger news events.

Seasonally, I think it’s important to note what’s happening in November and December generally. I’ve talked about this a couple of places, but I think it’s important to drill this home. People don’t understand what seasonality is at this end of the year. There are several components. I hate calling it seasonality. Why are there positive flows or negative flows in this period of the year and what are the things that happen?

You have this move into the longest-standing expiration which is December OpEx, which is three years old. It’s leaps, a lot of open interest, a lot of structured product side to this OpEx, a lot of dealer positioning, that short-put long-call, and a lot more higher vol and those expirations exacerbated again because of CPI and the Fed and everything in front of it here.

Then you have on top of that holidays. You have this much more days-off in the market, and the days surrounding those days-off happen to be holidays that aren’t just days on the calendar, but here in the US, Thanksgiving (which is a big family holiday), and then obviously Christmas at the end of the year (which again, in most of the western world is a very important, quiet time). If you take all of that and you look at volume-weighted time, which is how we look at it, it’s not a perfect way, and the time actually, on them is almost 50% of other time periods.

So you really have this decay of time that happens much more quickly during this period, a decay of vol that happens. On top of that, you have this skew in the market. So structurally, as that December OpEx comes down, as the risk premia across the market comes down into the end of the year, there are every day major structural flows that come in the market, and they’re bigger than normal in the context of less liquidity to absorb it.

Then you add short interest and chase into the end of the year, all the things that everybody else knows about. That tends to be very structurally positive. Now this year, it’s even more positive than usual, I would say, or was, up until this point, up until really Wednesday. The reason it’s more positive than usual is because the vol is higher and there’s more potential energy because of that.

Now, that’s not all seasonality. At the end of the year, there’s some other effects which are very important, that are actually maybe even more important than this kind of Santa Claus January effect period. Usually, you get that positive vol that I was talking about with the other things. In addition to that, you get another very important thing that usually markets go up every year, or companies make money and there’s more money coming into the market.

On average, let’s say the markets up 10% per year, 10% of $100 trillion which is the amount of equity equity exposure, $450 trillion in global assets, so it will include private equity, real estate, venture capital, all these other assets, they’re all tied to equities as well. As markets and things appreciate by 10% per year, guess what? That’s $45 trillion that needs to go to work each year. That doesn’t all happen on Jan 1, but a pretty decent amount of it does. Let’s say only 10% of it goes on Jan 1, $4.5 trillion dollars in a world where liquidity that moves the market is $75 billion per day.

So it’s a massive thing that comes in at the beginning of the year, a lot of mandates that are specific to that so you get this front running of it into the end of the year. Then again, the ‘sell the news’ that happens by the first/second week of Jan when all that money gets committed, you put that together with all these other structural effects and you get a very positive flow generally.

Now this year, that second part is flowing in reverse. The market is down, we’re having a lot of things early in the year that people aren’t talking about. Private equity, venture capital, a lot of these things lag and are going to be slow to reset but they’re going to have to at the beginning of the year, real estate as well. So, that drop in collateral, that deleveraging that’s going to happen during the year is very important and people aren’t looking at that. People are used to thinking about it in reverse, and I think that’s an incredibly important thing. I think that part of what this flow we’ve been seeing; the market has been rallying on these positive flows, but then it’s forward-looking and people are saying, “Look, this is the time to sell into.”

Again, not surprisingly, we were fortunate enough to get this right as well in the last couple of days. We’ve been really bid under this market. We were pretty pumped last month about how you want to buy it into this period. But the Santa Claus period of January, we’re actually not bullish. We’re actually quite the opposite now. With that, I think it’s important to note there’s a vol picture. We’re talking up-down really first.

The vol picture is very well supplied vol because behind the December expiration, you have these 30th and January and all these other expirations which were very well supplied under something that people are very short. So as that first expiration, which is high, goes away, everybody gets laden with more and more volatility at cheaper and cheaper prices. That leads to more vol compression.

So as you would expect here, the last couple days, and I would expect this going forward too as we go into the holidays, vol compression should still be very much in play. With more of this environment, you’re going to get a sideways to down market with the negative flow, plus also tax laws. Selling this year will add to that in the context of vol compression. That’s probably what we’ve expected. We’re kind of seeing now that we’re getting to this back half of the year.

Now, that’ll kind of play out the opposite way it usually does probably and then let’s say Jan 10th is what we’re targeting as a place where you really want to start stepping in and start nibbling a little bit. But we’ll see. That’s the broad context on the way we think about the world and these flows and some of the things that are happening in response to, more specifically, those moves. A lot of that up and down has been these forces pushing against each other.

One, the positive structural flows that are at the end of this period that people knew about and are getting out in front of, and then again, that ‘sell the news’, when you get that opportunity to sell in the context of a very illiquid market. So you put those things together, and you get a big pinball with massive range. But yeah, crazy to think, in particular, that most recent one on CPI on the 13th of December, that was a 4% rally in the S&P followed by a 4% decline in a matter of hours. To put that in context, the S&P caught $40 trillion.

We created $1.6 trillion of wealth and took it away a couple of hours later, and that all probably was based on $100 billion to a $150 billion dollars in net flow. So it’s this leverage in the market, the amount of liquidity. People really don’t understand. Most players don’t understand what is actually moving the market and how little that is relative to the actual value of the markets.

The overwhelming majority of markets is passive and is not net moving the market. The whole market is like a venture capital deal where there’s like 5% float and they’re pricing it at x because of that float, but it’s less than 5%. You’re talking about less than 1%. So it’s crazy for people to think that’s scary once you kind of really start to understand the realities of it. But that liquidity is the biggest theme and will, in my opinion, be the biggest theme of the first half of next year.

[00:21:37] Niels

Yeah, absolutely. I seem to remember in my last week’s episode with Rob, I seem to remember in the summary, there was some news out, that I referred to, where we saw the first net outflows of US equity funds since April of 2020 or something like that. So, that’s also kind of interesting if sentiment among those types of investors is starting to change.

Of course, if volatility really is compressing and coming down, then our friend out in Singapore, Dave Dredge, whom we spoke to recently and the episode is coming out very soon, he will have lots of phone calls, maybe, when there’s value in volatility again.

[00:22:27] Cem

That was a wonderful conversation. I look forward to it.

[00:22:30] Niels

Yeah, it was a fantastic conversation. I can’t wait to publish it. Anyways. From a trend following perspective, we are recording Friday, so I don’t really know what’s happening today. But I think this week actually is a little bit of a recovery week. I think most managers will have made back some of the losses they had early on in December.

Of course, this is to some extent, to a large extent really, coming from the market action yesterday where some of the price moves we saw across the markets came back towards the longer-term trends and kind of waned on these correction moves we’ve seen the last few weeks. So, we’ll see how that all plays out. I will say though that I did notice a little bit of dispersion returns yesterday.

It could be also that timeframe plays a bigger role this week, meaning if you had certain shorter-term timeframes, you may have turned on some of these corrections and then you might get caught now where markets are coming back to the longer-term trends, and so on and so forth. So we’ll see. My trend barometer yesterday was at 34 so actually confirming the slightly down numbers that we see so far this month.

Speaking about those, as of Wednesday, probably these numbers are a little bit lower than what they are as of Thursday, but as of Wednesday, down 1.44% for the BTOP50, up 12.5% for the year; SocGen CTA Index down 1.7%, up 18.19% for the year; Trend Index is down 1.8% for December, up 25.3% for the year; and the Short-Term Traders Index down 0.66%, up 10.77%. Putting that into context the MSCI World Index, as of yesterday, was down 3% for the month, down 18.5% for the year, and the S&P also down 3% I think and maybe down a little bit less on the year. Bonds, government bonds are actually still up for the month.

All right, Cem, let’s jump into some of your topics. We’ll see how many of them we get to. Obviously, I never quite know where we’re going with this so it’s always exciting. But you wrote to me why the debate between recession and no recession doesn’t really matter the way people think it does. So tell us what’s going on here.

[00:25:02] Cem

Yeah. We’ve referred to this a little bit already. But I think it’s important to note that most of the talking heads you hear out there are talking in two dimensions. Are we going to get a recession? Is the economy going to fall apart? The insinuation with all that is that ultimately will determine the direction of the market. This is the way most people think about markets. They think the economy is the market. We’ve mentioned this before, but I want to keep hammering on this. It’s so important. The economy is not the market.

Again, ’68 to ’82, we’ve talked about this before where, over 14 years, the market went nowhere, but the economy grew above trend; much more above trend in the last 20 years in real terms, and inflation was high. So growth was very strong, was a demand-push economy. What people don’t realize is that broadly, we have a demand-push economy and a very strong economy here in the US. Globally actually, demand-push is actually pushing decent growth.

Now, obviously, in the context of that, we had four recessions during that ’68 to ’82 period. But overall, even taking those recessions in, we grew above trend. Much more frequent recessions, much more the Fed trying to, as we talked about, chase inflation and control. You ultimately are in a time, and this is much more akin to a longer-term history, in a period where the Fed can’t have absolute control, the Fed can’t just reduce volatility, the Fed put is softer and less existent.

In those periods, despite the inflation and despite the above trend growth, you’re going to get a lot of negative net-net or secular effects, which is again, contraction in liquidity broadly, most importantly, for all assets, the reverse TINA effect, which is the money flowing to bonds. There’s a huge whooshing sound that nobody’s talking about. If you can now make 5% in bonds, given what’s going on in valuations in the S&P, it’s very different from when interest rates are zero. You have an alternative.

All that money that rushed out of bonds into equity and risk assets is now flowing aggressively the other way. That’s not a small thing. I don’t think people are talking about that enough. You heard so much about the TINA effect on the way up, you don’t hear much about the opposite now. Importantly, it’s not just less demand, less assets, less liquidity. We talked about earlier in the year that collateral is going to drop even more, which has reflexive effects.

That’s basically the lagging effects of Fed liquidity coming off the table and reducing demand for assets. But not only do you have those two things, but in terms of risk assets, the risk premia is going up. Less liquidity in the market doesn’t just mean less money chasing assets. It also means there’s just less money to absorb liquidity in the market, the risk premia has been compressed by the Fed taking rates to zero.

This is what led to the absolute speculation because not only is money flowing in, and not only is there this TINA effect forcing the risk assets, but the risk premia has been compressed, because you always know the Fed is there (on some level) to come and save the market. Even if it takes a decent decline before it happens, you’ll get that v bottom; you’ll get that stretch back. So risk premia during periods like this dramatically increases. So spreads should continue to widen.

The point here, I guess, all in all, is we’re likely going to get a recession. In the short term, sure, people can point to that and say that’s what’s wrong. The economy will recover out of that if the Fed pauses and pivots and does whatever it does. But at the end of the day, if we have a strong economy or a shallow recession, it’s probably the worst thing for the market.

The worst outcome for the market right now would be a very, very shallow recession, something that doesn’t ultimately do enough for the Fed to pause or pivot in a meaningful way. It doesn’t slow inflation enough, and ultimately, secular inflation keeps building and then the Fed has to come back in and remove more liquidity. It’s actually the worst thing that can possibly happen. The stronger the economy is, ironically (this is not just in the short term), longer term we’re going to have more and more problems for the market.

Ultimately, the Fed and the liquidity that the Fed is providing is what is important here. That is what is driving all these effects. I strongly believe the economy is going to continue to be a demand-push economy and the more pulldown we have, the more there’ll be a populist fiscal response (in some form or another), and the more problems we’re going to have for the market. So, the economy is not the market. We’ve said that before but keep that top of mind. The worse the recession, ironically, that might be the better thing for the market here. We actually don’t think we’re going to get that deep of a recession.

[00:30:14] Niels

No. It’s kind of interesting that a lot of people are cheering for this pivot. But actually, you could sit down and just rationally think and say, “Well, if they’re really forced to pivot, then something must be really wrong and that’s not a good sign.” So in a sense, I’m thinking either way, it’s not a really clear sign whether it’s good or bad for the markets.

It leads me to another thing that actually I’ve been thinking about especially because (and this is an upcoming episode that’s going to come out soon so I’m not going to steal his thunder), we are having Dylan Grice on who’s a really, really interesting person to listen to about investments, and building portfolios.

He made a point that actually goes to your point about whether recession or not, where in a sense, I think he’s saying that, “Well, why don’t we just focus on building portfolios where we don’t have to worry about inflation, where we don’t have to worry about the next CPI number or the next nonfarm payroll number?” This can be done. Using vol strategies like yourself, using trend following, using traditional investments, but essentially, blending together these non-correlated return streams like Ray Dalio calls it, obviously the Holy Grail.

So I’m not saying it’s easy, but I think it can be done. I’m fascinated by all of this focus you see every single day in the news headlines about, “Is it going to be 7.3% or 7.4%,” like it really matters.

By the way, last time we spoke, you said the reverse TINA effect, and I said, “Well, that’s an ANIT.” Now, that didn’t fly well in Google trends. Now I’m thinking about YHAA, YHAA, YHAA, You Have An Alternative. Maybe we should trademark YHAA, you have an alternative? I don’t know.

[00:32:22] Cem

We need a person’s name. We need to work it into a person’s name, but maybe we’ll figure out a way to call it the Niels effect. We’ll figure out the acronym.

[00:32:31] Niels

No, I don’t think that’s going to fly either. But maybe there is someone out there listening to us that’s actually called YHAA and then we have our solution. Anyways, enough of that silliness.

[00:32:41] Cem

We definitely need a new name.

[00:32:43] Niels

We need a new name.

All right. You have another point?

I think some of the points we kind of already talked about. We talked a little bit about the Santa Claus, we talked a little bit about CPI, but maybe one of the things you also brought along that you might want to expand a little bit upon is how and when to get short this market if that is your expectation.

[00:33:04] Cem

Yeah, so we’ve talked about this a little bit but I think it’s becoming clearer and clearer. We have gotten that reverse-the-counter trend move recently. We’re getting this kind of weakness here, end of the year, but with low volatility. I would expect that sometime… Again, we get a bit more in early January, call it Jan 10th on forward, a kind of rekindling of a next leg up, nothing crazy but from a lower level, and get a pretty powerful rally in Jan to Feb.

I kind of think of it as during that COVID crash, we’ve mentioned this, that drop happened. We knew about COVID in early January, but the market continued to reach new highs until Feb OpEx and it rolled over the day after Feb OpEx, that’s not a coincidence. It ended the day after March OpEx. Again, not a coincidence. That is the interplay of dealer positioning on display and we have a lot of those effects, which are similar this year in the sense that, from a vol perspective, February vol is quite well supplied, even more so than January, behind December and January which, generally, are the highest. So people are decaying longer and longer vol into a period where the market is going down but not down aggressively.

So, I broadly expect that we’ll continue to have a lot of what we’ve had the last few years into February which is this vol compression into a broadly sideways to down market. That said, you come into this January period and I expect that to cause some type of positive flow, on the back half of this year; what I think this year is going to be about seasonality and some positive flow.

I do think that’s going to lead to some type of market up, vol up, a situation which we haven’t seen that much of; something that’s not just one day or two days, but something that really over the course of a week or week and a half, you really start to see some stretching, some squeezing. Maybe there’ll be a narrative about CPI being weak again or the final pause coming, because that makes sense in terms of timeline, the Fed is going to do another 50 basis points probably next time, and then maybe they drop it to a quarter or nothing.

So that’s kind of that ‘sell the news’ moment, which again, is this: the macro was lining up with the flows just right where we would expect that in that Feb OpEx period. I think it’s Feb 14, that CPI, where you start to get a period that, if the market can rally like we think it is, if we get what I think we’re going to get in that period (which is counter-trend strong rally), that could be finally the last rug pull. So we’re really targeting out this period in February. We’ve been talking and insinuating it for a while.

We’ll see how it goes between now and then. I don’t want to talk too much about it, get everybody playing for it. But the reality is that, and it sounds very specific, but I want to be clear, a year and a half ago, back in September of 2021, we called January almost to the day the top in the market. So these are things that matter. These are these counter-effects. It sounds crazy.

But look for a February, particularly that Wednesday of Feb OpEx to be a general period that we’re targeting for if this market does continue to hang in there, vol continues to be compressed, and then we get some rally, that you get some broad optimism that that might be the period to really look for what is a continuation finally of what has otherwise been a pretty stable return to liquidity and optimism coming back in the market.

[00:36:42] Niels

I was just going to ask you. Clearly, everybody who listens to this conversation knows that I’m not a vol expert. But something that came across my radar is that say VIX hasn’t really reacted the way it has done in the past this year. So when you look at these things, I imagine you look back at history for some of this. I was just going to ask, in a year like this year where things have been (as far as I can tell) so different in your world, can you still rely on some of these indicators if I can call it that?

[00:37:27] Cem

Yeah. People misunderstand what we do. We’re not looking at technical trends. I’m not looking at history on a calendar and saying, “Okay, be bullish here. Don’t be bullish here.” I’m looking at dealer positioning and understanding if that changes, that changes the way we approach things. So it’s a dynamic process that’s a function of the actual drivers of supply and demand in the market. That’s a qualitative understanding, which is very important.

Yes, we’re quantitative in our approach, but the quantitative piece comes on the back of a qualitative understanding of how things work. I think that’s very different than, let’s say, Renaissance or Jim Simons who will themselves tell you they’re ambivalent to why they do it just because of the data. There’s a lot of trend following, things that are the same way, which works, I want to be clear.

[00:38:20] Niels

Sometimes, Cem. Sometimes it works.

[00:38:22] Cem

Well, the same is true for all of our strategies. But the reality is our approach is to really understand the “why” and start there and then measure the “what” and then kind of optimize to that. So we are very dynamic. We’re not sitting here saying, “Oh, seasonality says that I want to be long XYZ, or this is where in the OpEx cycle you want to be long.”

There are some trends, because of some historical trends and the tendency of those things to work, and that’s what a lot of people that are punters are kind of doing and they can benefit off it. That works until it doesn’t, but like you said, when things start to go upside down a bit, which they are now, that can really confuse people, and it does. The “why” is the hard part and measuring the “what” is the hard part, and that’s what we try and do.

[00:39:08] Niels

That’s what you do. All right, cool.

Well, let’s stay in the put world, so to speak, because as you and I discovered, I think actually it was Adam Rozencwajg who informed us on our last recording with him, where the US had just imposed a new put which was the oil put, so to speak. I don’t know if that’s where you’re going but you wrote to me the oil put sale versus S&P is short. So tell me a little bit more.

[00:39:44] Cem

From a vol perspective, if I look across the vol market (we touched on this a little bit last time), but when you really look at the vol market across different areas, Treasury vol has become fairly priced in our opinion based on the inflationary environment. The removal importantly of the Fed put; again, I say removal. Obviously, the Fed can still stimulate, but it just has much less ability to do that. It’s in a box (as we mentioned). It has another mandate, which is price stability, that it must hold true to and that is now giving it less ability to do what it wants, or whatever it wants, whenever it wants.

So that means Treasury vol should come up because there’s less control from the dominant entity. FX vol is tied to that as well. FX vol is tied to the Fed’s strength and ability to control that volatility. So we’ve seen the adjustment in FX vol as well. But ironically, we’ve actually seen commodity vol increase in step with those others and what we see historically, and what makes sense to us broadly, the “why” is oil vol; commodity vol actually. There’s a new put, because we’re in a time of resource scarcity.

During times of inflation, historically, you have less two-sided vol to commodities. There’s more of a trend, an uptrend, with more vol compression to the downside, and there’s essentially an OPEC Plus put, or whoever the controlling entities of energy have a bit more ability to underpin in this environment. That’s especially true with the Fed less dominant now that the balance of power has shifted with resources.

So there is a Fed put, and we’re seeing that almost explicitly with the US government having to spend all their resources into the election and drain the SPR and now explicitly come out and say, “Hey, we’re buying oil for $70 to $72 a barrel.” Not surprising. When we got this risk, recent liquidation, there was a lot of support down at $70 and we got a nice little bounce there. Because of all this, the cyclical recession fears, whatever, we’re getting this liquidation back down into the $70s. But the point is, there’s a put underneath that. That doesn’t mean it can’t go lower.

Again, during these periods, even during a period of Fed dominance secularly, we have some volatility over short periods. But on a secular basis, vol was more compressed, risk premia was more compressed, and we expect that to actually translate over longer time periods. I’m not talking about the next quarter, the next year here in oil. I’m talking about the next 5 years, 10 years. Broadly, one of the bets we think on a long-term basis is vol compression in the commodity space, that vol has broadly overreacted in the oil space, and then particularly on the downside.

Upside long-term vol in oil, you should get trend there, which we’ve talked about. We’ve seen good commodity trend this year. I think that’s a great thing. That’s just the tip of the iceberg there. We think there’s a lot of opportunity there as a function of that put supply. So the more put supply, the more vol supply ultimately, which is coming from market.

On the other end, the one asset that hasn’t, on a vol basis, responded and directionally as well, that’s part of the reason, is gold. Historically, during inflationary periods, gold actually is more volatile than oil. You actually have a lot more swinging similar to FX. Because it’s more of a currency in many ways, you have more volatility, but there’s a nice uptrend. So you see a much more volatile uptrend to gold and a much more stable kind of uptrend to oil.

Ironically, the vol in them has done the opposite so far this year. So there’s an interesting opportunity to really express your directionality as an inflationary hedge in gold with calls because they’re cheap. Again, we’re talking longer dated, not in the next six months. We’re talking about a longer secular inflationary hedge kind of thesis. But on the oil side, you actually can offset that vol exposure with selling puts which are higher in the commodity space. Again, we’re talking longer-term. Feel free to buy shorter-term protection against those and get gamma protection.

So this is not an actionable thing today, per se, as much as hey, we’re trying to set it and forget it for a long-term investment thesis. So, you can offset your vol exposure, get a really nice credit to your vol across those two things and then really have a nice inflationary hedge which is I think a really kind of unique thing that other people aren’t talking about in terms of a macro. It’s hard to hedge vol right now because vol has gone a lot higher across the board.

Equity vol and gold vol are the two I think that are that are now cheap relative to everything else and relative to the opportunity set, and we’ve already kind of talked about how bad equity vol performed this year and that a second move phenomena will likely take correlations more to one and give us a bit more equity vol, finally, probably in Q1 or Q2 of this year. So that’s what we’re looking for from a vol perspective and also from a macro perspective and kind of tying them together.

[00:45:08] Niels

Now, since you bring up gold, I don’t know if you feel you already answered it. Maybe I didn’t pick it up. But of course, gold has been mentioned by so many people as the best hedge against inflation. It’s also a hedge against other things, governments and all sorts of things. But I think a lot of people have talked about it in terms of hedging inflation and actually uncertainty in general, geopolitical uncertainty and stuff like that. But of course, again this year, it hasn’t really reacted the way you would expect.

[00:45:47] Cem

I was going to say, but it’s interesting, right? Because I wasn’t out here talking about gold early in the year. I was talking about commodities and the commodity piece worked. Now people have gone a bit too far on that end and now’s the time that nobody’s talking about gold. I’m not a gold bug. I haven’t had a secular view.

[00:46:05] Niels

My question is just if you have any explanation as to why gold hasn’t really done what a lot of people expected. Do you have a view on that?

[00:46:15] Cem

Yeah, there’s a couple of reasons. First and foremost, positioning. Everybody has been waiting for this event for gold to work and it didn’t work. Same reason puts didn’t work in the S&P into a decline. If its space gets too crowded, that doesn’t change the secular realities of the situation. But in the short term, that can lead to considerable liquidation and underperformance of things that otherwise you would think would happen.

That doesn’t change the longer-term personality but you have to get that market more balanced before you can start to get the underlying moves to work. So there’s things that operate, which is do you have positioning over shorter time frames, and then there are more structural macro flows that matter over the long-term. So our view is that it was just a crowded trade.

The other argument is, and this is kind of like a Rorschach inkblot test, but there’s always the argument that also gold, when interest rates are going higher, doesn’t pay a yield. So it’s kind of something that you can sink your money in and you’re not going to get what you can get in theory on a treasury side or something like that. So it now competes away from gold. There’s a lot of that kind of that…

[00:47:26] Niels

Bitcoin as being another explanation. People were saying that they were buying the Bitcoin and not gold.

[00:47:33] Cem

Yeah, I think you know how I feel about that. We won’t go down that rabbit hole. Bitcoin is a speculative asset first and foremost.

[00:47:45] Niels

Sure.

Now, the last point that I just picked up from your newsletter recently, I don’t know. It looks interesting to me because it’s a surprisingly big number. But I think there’s something to do with almost half of the options volume is in super short-dated one-day options, or something like that if I understood it correctly.

[00:48:11] Cem

Forty-four percent of the volume in the S&P options has been zero DTE, zero days to expiration options this whole quarter.

[00:48:21] Niels

What does that mean and why is it so big? What the hell is going on?

[00:48:25] Cem

Yeah. Why? Because vol itself, implied volatility, hasn’t performed this year. So people are really hesitant to go buy options and buy implied vol because it just hasn’t worked. People are more keen to bet on the realized volatility itself, which is really that one day, the zero day-to-expiration options, much more gamma intensive and less exposed to implied vol itself. That’s worked this year so people have chased into it. That’s one.

Two, there’s still a lot of speculative activity in markets broadly and it’s moved out of chasing meme names and whatever. But there’s this reality that the gamma effects are so big that you’re forcing dealers, for somebody who’s big on looking for liquidity, you’re forcing dealers into a short gamma position and on a realized basis, we’re getting a lot of short-term (we referred to the 13th). I mean, you got a 4% drop in the S&P 500. On a straddle, I think that was like $55, $60. It was not that big. So it’s an incredible opportunity today.

Now, if you went and bought a three-month option, by the end of the day, the market hadn’t moved. What good did that do you? So it’s reflexive. Much like we talked about, options are so reflexive. The more people play in those, the more volatility it causes, the more illiquidity it causes. So it’s causing a lot of knock on effects in the market, which is a much more kind of schizophrenic market that’s moving very quickly, that’s very illiquid, and that’s dangerous.

Just like a market can rally 4% in a couple of hours and then drop 4%, we could very easily see the opposite also begin to happen. We’ve talked about that. The more illiquid these markets are getting, the more speculation you’re getting. A lot of the buying is on the call side. On these numbers, speculation is on the call side so that’s forced a little bit more upside moves but there’s nothing that says that the opposite is not going to start happening more too.

I think in particular, there’s a lot of volume there that’s put selling, like unit put selling. That’s another thing to note. So when we look at that volume, you have a ton of people that come in at zero DTE and sell nickels and dimes and 15-cent options, in mass, and it makes for, this year, a track record. If you see any track record out there that’s showing you 3 to 4 Sharpe, trading S&P, zero DTE options, run.

The reality is they’re just selling tails and it’s worked incredibly, down or up, because the moves haven’t been big enough. The reason they sell zero DTE, and not one or two or three day expirations is because the zero DTE doesn’t show up on margin. These clearing houses look at your margin at the end of the day, and guess what? If you sell them zero DTA and they’re not looking at your margin during the day, you can do whatever you want.

The clearing house probably doesn’t say anything. It’s a very dangerous game in reality, but again, at the end of the day it expires. If it expires above your number, you’re not worried about the implied vol or the margin squeeze. Margin squeezes are a real thing and you can see massive dislocation between zero and 1 day to expiration.

Actually, we saw just this yesterday because there’s a massive short interest on the AM print because everybody’s short the AM print OpEx options, but they’re available. They’re able to get the zero DTE at 5 PM. So you see a strike, out one day, that’s priced at $5 and the other one trading a nickel. It’s just a margin chase. So my point is that you see a lot of selling because of those lack of margin constraints. That said, that’s kindling. That’s that gasoline on the floor we’ve talked about. At some point, you get a liquidation.

Margin doesn’t matter but P&L does, and if your P&L starts imploding, there’s just not enough liquidity in that stuff and it can cause major gamma effects. So a wide-ranging kind of conversation about that stuff, but it’s really changing the distribution of outcomes, as we talked about. The more and more trading there is in those things, it’s making for less liquidity, it’s causing more gamma effects. So watching that dealer positioning is also critically important to your day-to-day trading and what’s going on out there.

[00:52:59] Niels

Before we wrap up, this is the last conversation you and I are having before the end of the year, because over the next two weeks we will be releasing our group conversation, in two parts, on the 24th and the 31st, which has of course already been recorded. But just while I have you here, Cem, looking back at 2022, and it doesn’t have to be restricted to vol, it could be anything. What are you going to take away from 2022 that might be maybe your biggest surprise or something unexpected that you thought, “Wow, I didn’t see that coming?” I mean, other than Denmark going out of the World Cup, of course, early on.

[00:53:53] Cem

Oh, yeah. Look, we were actually fortunate enough to be on the right side of this. Remember, at the beginning of the year, inflation was transitory. We broadly called for ‘expect the unexpected’, expect more geopolitical strife because of rising inflation. All this has been part of our thesis for a year and a half. That said, Russia invading Ukraine was not on our card. We didn’t see that level of acceleration of geopolitical issues coming.

The bifurcation between China and the US and the acceleration of what seems to be going there, China pairing up with Russia as part of a block. Those changes are structurally so important to the next 5, 10 years. Everybody’s not talking about that anymore, but that reality is still the most important thing.

If you think about the last 24 years, it’s not just the Fed’s ability to stimulate and pushing money in the market, but it’s the globalization that happened; the growth of bringing in 1.2 billion Chinese, 1.2 billion, and it’s into the market and integrating it. That’s been the biggest deflationary force which has allowed the Fed to control what it needed; to keep printing more money and pushing liquidity into the market.

So these structurally deflationary forces are really, in our opinion, coming to or slowing and coming to actually a more abrupt halt, in our opinion, than we would have even expected. So it doesn’t go in a straight line. But the realities are until we see a pivot from China, things are going to get worse before they get better. Maybe everybody’s looking for that pivot from China, a reopening, a pulling away from their backing of Russia.

But there are no signs that that’s going to happen. There’s no sign that the West is also going to allow it to happen, in our view. So that’s the biggest thing to keep in mind. People have stopped talking about it because it was February and market memory is pretty, pretty short. I think, again, the Russia-Ukraine piece is important and has played a role in inflation this year.

I think the bigger piece is the continued relationship between China and the US and the resource scarcity that’s caused from a labor perspective, from a resource – a commodity perspective, from a currency perspective, a funding perspective, all of those things are accelerating faster, we think.

If we truly begin to bifurcate in some way; if the Taiwan thing does come to pass in the next couple years, which we still believe it will, we think things will actually get worse. So I think that’s the biggest thing that surprised me and that I think has accelerated a lot of the forces that we thought were coming anyway, it’s just happened a lot faster and a lot more powerfully than we expected.

[00:57:14] Niels

A couple of thoughts just when you were talking. You talked about China. If I’m not mistaken, within the last 24, 36 hours, I think China has come out and said they’re not going to report COVID numbers anymore. That to me is a worrying sign. Because either way you look at it, it doesn’t bode well. So that’s one thing that’s interesting in that regard.

The other thing, when you talk about this bifurcation, another way of looking at it is of course that often I don’t think people realize how the world has changed. What I mean by that is go back 20 or 30 years, the biggest trade partner for many European countries and in many parts of the world was the US. Today, it’s China. That changes things, it changes allegiances, and so on, and so forth.

So of course, you and I, I think we started doing the Global Macro series really intensely in around February-March time, and had Peter Zeihan on pretty early on and, and so that obviously was a big theme. But I think sometimes just stepping back and looking at the whole situation from 30,000 feet and what it really means having a very different world today compared to 20 or 30 years ago when you have to deal with big issues, that is frightening, frankly.

[00:58:54] Cem

Yeah, it touches everything we do. We are going to have to change in the West, our economies. This is truly becoming an adversarial relationship if we are truly going into a new Cold War (for lack of a better term), or even a Hot War with China. At the end of the day, our economy is not built to work that way. Yeah, we can move stuff to other countries, try and go to Mexico and Vietnam and Philippines or wherever, but at the end of the day, that capacity is reducing dramatically and all the lines that have been created there are changing.

We’re going to have to onboard a tremendous amount of things here in the West that we haven’t been doing for decades. That takes us back to a different type of economy and has structurally really inflationary effects and the inflationary effects are just first order. The second-order effects that come from that have even bigger effects. So, I think deglobalization is the biggest thing that we need to be thinking about and that’s an incredibly important thing that has accelerated quicker than I would expect.

[01:00:16] Niels

Yeah, absolutely.

On that concerned note, let’s put it that way, we’re going to wrap up this conversation. If you want to support us, if you want to help us grow and allow more people to listen to our episodes, please go and leave a rating/review on Apple, on Spotify, on Amazon, wherever you listen to your podcast (iTunes is what I was thinking of). Please do so and make sure you follow the podcast. That will be fantastic.

As I said, we’ll be back in a two-part special episode the next couple of weeks with a whole group. Unfortunately, Rich was not able to join us but the rest of the guys are here.

From Cem and me, thanks ever so much for listening. We look forward to being back with you soon. On a personal note, I wish all of you a warm and happy holiday season. Until next time, take care of yourself and take care of each other.

[01:01:20] Ending

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