236 Systematic Investor Series ft. Cem Karsan – March 25th, 2023

[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 this 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 catalogue and listen to the past episodes that you may have missed like my conversation with Mark last week where we naturally discussed the fallout on CTAs from the Silicon Valley Bank issue and a few other bank emergencies. We also discussed how we are in a period of, as Mark calls it, the great bond reprising and what that means for the economy more broadly, a topic that I’m sure we’ll revert to later on today.

Also, I very much would encourage you to listen to our midweek episode which was highly interesting. It’s a conversation for those who want to hear an alternative view in terms of the world’s largest country. McKinsey said that we are living in the Indian century. Morgan Stanley believes that 20% of global growth in the next decade will come from India. But our guest, Princeton economist, Ashoka Mody has a different view, which he details in his new book called India is Broken. This turned into a fascinating conversation with Kevin on the podcast. So head over and check that out after you’ve been listening to Cem and I today. Cem, it is wonderful to be back with you this week. How are things where you are?

[00:01:48] Cem

Doing good. I’m actually at the Grand Canyon with my kids, believe it or not, looking out over the canyon. So hopefully, inspiration today. No, it’s been a while. It’s wonderful to be back on.

[00:02:01] Niels

Fantastic. Good stuff. Now, even though it’s been a few weeks since we last spoke, within the last couple of weeks, I would say it has been quite eventful. We’ve had a few bank failures. We’ve had central banks continuing to hike. The last one came yesterday where the Swiss National Bank went to 1.5%, Bank of England now is up to 4.25%, ECB 3.5%, and the Fed, of course, somewhere between 4.75% and 5%. Now, we are recording on a Friday so of course we don’t know if there’s going to be more bank rescues over the weekend.

But I would love perhaps maybe to start off to hear your reaction to some of these things that have taken place in terms of what’s gone wrong for some of these institutions, how the authorities have reacted to avoid perhaps even bigger crises at least for now. But maybe also, the speed of how these collapses are happening and maybe even how (you have a big social media; you’ve got a massive following) social media may be playing a role in how quickly this happens.

I’m fully aware I just gave you four questions in one so I will remind you if you forget some of it, but I’m just curious to get your take on current events if we put it like that.

[00:03:19] Cem

Yeah, I think it’s been a particularly interesting moment. I know this rhymes with a lot of other times we’ve seen in the past but it’s different, as you mentioned, because we live in a different time. This was always the point we were heading to when interest rates started ratcheting higher. By definition, increasing interest rates and doing QT means you’re taking liquidity out of the system, and when you do it at a historic rate, which the Fed has, eventually, something is going to break somewhere.

Michael Kao actually mentioned, just a couple days ago (I thought it was a good analogy), it’s like playing Jenga and there’s a piece at the bottom you’re trying to get out. The Fed has been jiggling it. That Fed funds rate is that little piece at the bottom. There are lots of examples of (and I’ve talked about leptokurtic markets) why we live in this much more dangerous kind of world. It doesn’t mean things are going to be volatile all the time. It doesn’t mean things break all at once. It does mean that there’s much more fragility in the system and it’s kind of like a sand mound where we’ve been removing sand.

At some point, you have that kind of Kaminski moment when things kind of break and can be pretty ugly. That’s kind of the world we live in, So this isn’t a surprise, I would say. If anything, it has been very controlled. The Fed has been ready and waiting for it. They acted quickly. We’ve prepared also over a decade, two decades, for another banking run to some extent. It’s still an imperfect system and there are still flaws. It doesn’t mean things can’t get out of control. Almost by definition, banks are leveraged entities with a massive tail. But I’ve argued this, and I’ll stop here, we can kind of dive into other topics.

But I’ve mentioned this in other places that ultimately, the Fed kind of wanted the air out of this market a bit and they got that to some extent, briefly, unfortunately, and they’ve managed the tail as well. Their job is to try and control this volatility, to manage this and they’ve been writing calls in a sense, and now they’re trying to manage the tail. So we’ll get into that, I’m sure later. But it’s been a bit of an interesting moment. I think there have been a lot of extreme moves in the market that I think are overreactions and that are going to lead to extreme reactions back. We’ll take it from there.

[00:06:04] Niels

Yeah, absolutely. Absolutely. We will for sure go back and discuss some of this in more detail. There are a couple of more things I wanted to talk to you about here in the beginning of our episode. I saw this description. I should have written down which publication it was. It could have been from Bloomberg, it could have been from one of the other digital platforms, but it basically said history remembers the Federal Reserve chairs, Paul Volcker is the slayer of inflation, and Ben Bernanke and as the crisis firefighter, but it seems like Jerome Powell is in danger of having to play both roles at once, or what may be worse, to choose between them.

Well, in your opinion, because I know it touches a lot of the things that you’ve been talking about for a while, which one do you think he should focus on if he had to choose?

[00:06:56] Cem

Yeah. The Fed is in an impossible situation. They have a mandate to control inflation when they only have a cyclical tool that actually, ironically, works across the grain; the opposite way for secular trends. We’ve talked about this here on the show, but they’re trying to control cyclically the economy against a secular inflationary problem.

Volker succeeded by being very, very forceful in his response but it worked because we were already at the end of that secular trend, not because he was the only person to try that approach, because the two Fed chairs before him tried almost as hard. You could argue McChesney Martin too, before him, did just as much if not more in some ways. Bernanke was at a moment where Federal Reserve dominance was at its strongest, and we’d yet to hit our tipping point of populism, and the Fed still had complete control of markets and wasn’t battling the populace or the government with fiscal policy. This is a very different situation. Neither one of those solutions is going to solve the problem. The problem is structural and just takes time.

If he pulls a Volcker, we will have a massive recession and the second that we have a massive recession, ultimately, they will have to pivot. The political force will be such they’ll have to pivot, while at the same time, the populace will pass more fiscal policy and the response will not be monetary, and that will lead to another at once stimulus, but again, fiscal inflationary push. That’s what we saw in the ’60s and ’70s, that’s what we will see now. So that’s not a winning solution. You kind of get the worst of both worlds. You get a recession and then you get worse inflation.

So I would argue definitely not that being the solution. But more monetary policy at this point ultimately is politically unpopular and against their mandate. They can’t do it because then inflation is not going away, and we’ve seen that. We’ve been talking about that for years before transitory happened, after transitory happened, and now here we are again after them talking about pausing and that things seem to be resolving themselves. Guess what? Sticky CPI and unemployment numbers continue to come in.

[00:09:37] Niels

Yeah, absolutely. Another thing that I’d love to just hear your thoughts about, of course, on the other theories we do together, the Global Macro Series, we often debate not just US issues, we look at the whole world. We look at many different things, not just economic things, but what’s basically going on from a geopolitical point of view. In the last few months since we last spoke, what are you taking away or what has caught your attention the most when you look at it from a geopolitical point of view and not so much a central bank type point of view?

[00:10:17] Cem

Yeah. So they’re all related. The reality is that populism is not a US-centric thing. I was just in Iceland and Amsterdam. When we got to Iceland, there was a tourist workers strike while we were traveling, and then we got to Amsterdam, and there was a sanitation workers strike and there was trash all over the streets. I venture to say if I moved on to the next country, there’d be another strike. so that is the zeitgeist and it’s a function.

Is that some weird coincidence that we all are going through this at the same time? Nobody seems to talk about why is populism here, why is this dominant. It’s because inequality got too far because of monetary policy and now we’re addressing it. That’s partially generational because, again, inequality is not just rich versus poor. It’s labor versus capital and labor of the younger generation.

There’s a reason these cycles happen again and again. These are structural ways that things are tied. So the point is, it’s a global phenomenon. When this happens, it actually exacerbates global issues. It’s not a domestic thing because protectionism is also part of populism. Labor is domestic. By definition, it’s the people of a country. Corporations are international for the most part. They trade across. So globalization happens during times of monetary expansion historically, and during fiscal times of populism, the opposite happens. Guess what?

When you’re more protectionist and the world is more protectionist, we’re no longer cooperating, we’re competing a lot more, resource scarcity becomes a thing, global War becomes a thing, and guess what? Here we are. So the way I see it is it’s all interconnected. This is not a US versus Europe versus Asia thing. This is a global trend and it’s not going away tomorrow. Unfortunately, these things were built over 40 years and they’ll be unwound over probably 20.

[00:12:36] Niels

Sure. I agree. Final thing I wanted to bring up with you before we talk a little bit about trend and then we go into the topics was I remember last time we spoke, and people should just be reminded, this is back in December where you essentially, very accurately I might add, said, well, keep an eye around mid-February OpEx and expect some kind of pullback.

I don’t think you put any percentage numbers on but you thought there could be some weakness after that, and of course, we’ve seen a 5% pullback or so since that. Now we’re getting closer to March OpEx. I think the buyback window is closing in as earning season will be with us soon. Is there anything that kind of surprised you or panned out slightly differently from those things you were seeing already back in December to where we are today?

[00:13:35] Cem

Yeah, I don’t want to toot our horn or do whatever but I do want to point out to over a year and a half ago, I think it was in September, we called the January market top at 4800 within two days as well. People were like, “How’s that possible? The news, it’s all about news.” The narrative follows price. The reason this happened is to a great extent because the market decline was happening and there was stress which drove some of the knock-on effects. Flows are dominant in these markets.

We live in a time of broad illiquidity. It doesn’t take much to support markets or also the removal of much liquidity to allow a vacuum for things to occur. Again, we’re not going to call within days every turn. That’s nearly impossible. There is more to it than just the flows. A nuclear bomb goes off in New York City or London, that changes the picture. The reality though is those things matter incredibly, generally, but particularly in a time of illiquidity which is the world we live in currently. So narratives follow price.

I think the Fed and we were very vocal about this as we approached that Jan-Feb period. The Fed for a month, mind you, a month and a half, was coming out and very vocally trying to talk the market down and the market continued to rally. That’s, again, the power of flows. The market wasn’t ready to listen yet. But the Fed was out there and we kept saying they’re selling calls. What does that mean? They’re out here trying to put a cap on the market and take out the speculation. The market had rallied 20% off the bottom since late October and that was helping to drive a stronger economy, that wealth effect, helping to drive hotter CPI numbers in a lot of ways.

So the Fed was trying to push against that, the market was listening, and then all of a sudden, flows were removed and people started talking about it. Now there’s this tail though from the bank run or whatever you want to refer to it as. Because of positioning now, in other products particularly on the yield curve, you’ve seen a historic move in one-year, two-year Treasury rates. We had a 1.75% move in a matter of a week, two weeks. So that’s not what the Fed wants either. The Fed wants the longer end of the yield curve up so they don’t stimulate the economy.

We’ve had a relatively resilient property, a construction economy, and now you’re massively lowering mortgage rates. That’s not what the Fed wants. Again, there’s this cyclical reaction that people have and algos have because it’s been 40 years of the same thing. It’s all been a cyclical game within the context of a secular story that’s been the same for 40 years. So algos right away, there are potential market liquidation risks, crank down yields when there’s a much bigger secular story that the Fed is battling against here. The Fed still has to battle that. That’s why going into this Fed meeting just a couple days ago, we were very vocal.

If you expect the Fed to be really, really stimulative and come in here, markets are going to be disappointed. Sure enough, they came in and sold more calls. That’s what they have to do. If we can keep getting hot CPIs, they’ll have to do more and that is the problem at the end of the day. This cyclical removal of credit that we’re so used to remedying this inflationary impulse is no longer working and it’s not going to work, not the way they want it to. To the extent they blow up the economy and at some point, they can do drastic things which they haven’t quite gotten to yet, at that point, there’ll be other things that will bring inflation back as we referred to.

[00:18:04] Niels

Yeah, sure. We’ll definitely dive into some of these topics I think maybe in even more detail in a few minutes. But this was great, Cem. Good way of kicking things off. Just a quick, quick word on trend just as a little bit of an update. Oddly enough, it has been a pretty volatile week. But I think to a large extent, trend followers obviously were hit quite hard, I would say, relatively speaking last week.

I think this week has been more, yeah, there might be a little bit of weakness overall when everything is counted at the end of today, but for the most part, I think a lot of positions actually were being offset or performance were being offset between positions, and of course, there has been a massive reduction in exposure by CTAs. So in terms of performance, I’m not expecting nearly as big a move as we saw last week. But still, it’s going to be a fairly big down month for March if everything closes where we are.

But putting things into proportion, people should just be aware that whatever the losses are this month, there were probably similar gains last year and of course the year as a whole was a very strong year. My own trend barometer right now is at 41 as of last night, so that’s neutral but in the weaker end of neutral. I am expecting today, Friday, that CTAs probably are having a down day. Despite that, numbers that I have seen last, as of Wednesday (since we’re recording a day earlier), I don’t think they posted Thursday numbers.

The BTOP 50 is down about 5% for the month, down about 4% for the year. SocGen CTA Index down about 6.25% for the month, down 5% for the year. SocGen Trend down 7.6%, down 7.2% for the year, and the Short-Term Traders Index down 1.8% for the month and down 0.2%. But as I said, there will be further weakness in the numbers once we finish the week as a whole. Equities still doing fine for the year, up 3.6 in MSCI World and about 3% for the S&P excluding today, and of course, bonds are having a good month of nearly 3% for the World Government Bonds.

Now, you sent me a list or Chris sent me a list of topics that we should talk about. I heard you touch on some of the things, but I will still put things to you and then you can decide how much more you want to dive into it. But one of the things you and I don’t speak so much about really, I mean, because volatility is obviously equity related. But it seems like most of the volatility we’ve seen lately has been in the yield curve. It’s been in the fixed income markets.

So I was kind of wondering if you want it to expand your strategy a bit to include some of that because it’s a pretty interesting opportunity set. Not sure you’re going to do that, but as you rightly pointed out, there are some historic moves happening right now. Dive into this a little bit more maybe from a perspective of how that might change your view on your own strategy, your own field, in terms of equities as well when these things happen, or whatever direction you want to go.

But I think it’s an important area to talk about because a lot of people let alone have never experienced yields going up like we saw last year. Most investors today have never seen this. So that was pretty historic last year. Now we’re getting into short one, two, three-day moves where we have to go back to the early ’80s to see something similar. So we can’t just say, oh, this is business as usual. It’s really business unusual at the moment, even in the vol space I imagine because perhaps there wasn’t much data to analyze back from the ’80s. So how do you make sense of all of these (and I hate to use the words) “unprecedented moves” that’s taking place?

[00:22:15] Cem

Yeah. We’ve done some analysis. You and I have talked about it a bit about different asset classes other than equities and vol and how they performed during different environments. One of the things we highlighted is that last year, at first, some vol really exploded and then implied vol exploded a little bit, and others did not. The question was at that point, and we were looking several months ago, if we believe this inflationary environment to be the case, which ones should remain elevated and which one shouldn’t?

One of the ones that had exploded last year already but that had kind of pulled back was interest rate vol. We were very clear that that will remain the case. That is not an anomaly, and don’t expect that to come back to where it was. Same with FX vol, and those two things are obviously very connected. How are they connected? Because interest rates are cross national; they affect flows from country to country. The Federal Reserve is ultimately battling money supply here and abroad to deal with inflation.

So FX and interest rates vol both went quite a bit higher, were fairly priced in our view. It kind of came down from that after a period of flaccidity. That was an environment, an opportunity to buy in the last couple of months. Not a surprise, we’ve seen another spike. It’s going to come in waves. Again, not a surprise. The last time we saw these types of moves were early ‘80s. That was the end of the last inflationary cycle.

Throughout the ’68 to ’82 period, that kind of inflationary period (just go look at a chart) interest rate volatility tied to inflation and the Fed and three recessions over that period. So a very, very volatile time. The one that hadn’t, until more recently, participated was gold. We were very vocal when we talked, you probably remember, that gold, in terms of vol and in terms of upside potential, was significantly undervalued. Soon after that, we saw a massive run in gold and gold vol has also began to participate a bit more. So that was an opportunity.

It’s still cheap, in my opinion, but again, that ties in to this FX and interest rate kind of world. That part is going to continue to be a point of focus for the markets and volatility.

[00:25:03] Niels

Am I remembering correctly that you, back then, said in particular long-dated gold vol, was that it?

[00:25:10] Cem

Yeah, long-dated gold calls, which again, were pretty much the perfect trade at that moment right before gold took off because vol also increased into that rally, which is not necessarily what normally happens. But the equity vol, as you mentioned, has been very weak recently. We broadly think that that is a broader trend in these periods because nominally, markets (if you think about ’68 to ’82) went nowhere so they had a decent amount of declines and rallies. But particularly long dated vol went nowhere for 14 years. That’s a pretty big opportunity. Whereas there’s usually a trend in equity markets that’s particularly strong to the upside and that long term can make for bigger upside volatility in markets.

The last thing I’ll say, the one thing we highlighted as the opposite of gold which was the vol was overdub was oil. Sure enough, oil has kind of been dead. There hasn’t been nearly as much especially on the downside. I mean, yes, we got some declines, but they’re very controlled and that speaks to this resource scarcity reality that we live in, where that resource is ultimately something that has an underpinning demand that’s going to continue to be in a demand push economy where fiscal is feeding demand, and now that China’s come back online, there’s a natural underpinning there as well.

So longer term, vol there is likely to be more subdued than the jump in vol that we saw early in the cycle, and that was also an opportunity. So we do look at that across not just equity vol. We’re very cognizant of these other complexes and opportunities and we’re actually launching a macro vol product this next quarter.

[00:27:06] Niels

Okay, yeah, because just when I hear you talk, there’s so many things actually that are kind of going a little bit off script in terms of the topics that we had. First of all, just as a comment on the oil thing, I think that a lot of people probably maybe including myself are a little bit surprised where the oil price is today compared with all the forecasts people were coming with last year, of course, but also in recent months and all of that. That’s one thing. But I had a couple of questions and maybe you know, maybe you don’t, that’s okay.

One is vol became very popular a few years ago in my world. People were looking at vol kind of almost in competition with trend following as a crisis strategy. I don’t want to use alpha, but just as a place to have some exposure should we get a crisis, etc. The thing is, I’m not so sure that the crisis that people imagined is turning up the way they imagined it would turn up. For example, we were obviously talking just now about the interest rates.

So I’m curious about is vol in the fixed income space (of course, we have the move index), but is vol in the fixed income space actually something where there are a lot of strategies that people can invest in at all? I’m not personally familiar with any but I know, of course, there are a number of different vol strategies in the equity space. What does it look like if you wanted to have exposure to yield vol and stuff like that?

[00:28:43] Cem

It’s a very liquid market. It is actively traded. There’s a lot of hedging that goes on, as you might imagine, in interest rate space, a lot of institutional money. It tends to be much more heavy; it sticks to a certain place because there’s big institutional flows and then breaks all at once. It’s kind of disjointed as a function of that. It was a wasteland, when interest rates were pinned to zero, for a long time.

But I highlighted in the derivatives several years ago that the biggest opportunity, going into inflation cycle, was interest rate vol. So it is a place where more and more people are trying to play. It is a fairly liquid world that you can play in but with big, big institutional players where you’re sometimes getting pushed around a bit. But for secular trades, it’s an immense opportunity and there are plenty of strategies. Eurodollar options are very liquid in particular, but yes, treasury, I could go on and on and obviously you can play that.

[00:29:58] Niels

Yeah, but not so many hedge funds are doing it, right?

[00:30:03] Cem

More and more.

[00:30:04] Niels

Okay, more and more. Fair enough.

[00:30:07] Cem

Because it’s a very positioning heavy market, there are a lot of people who got stuck on the wrong side of the trade that had some problems. We heard about that like six months, nine months ago. There are a bunch of desks and entities that got completely wiped out on some of those first moves. People have readjusted and vol has readjusted, to an extent, and those things happen. But there’s great opportunities there, again, something that that I think is a place that particularly in the next decade is a secular opportunity.

[00:30:39] Niels

Yeah. The other thing, and I’m sure you’ve been asked this question before, but I think if anyone can, it’s you, and that is make a little bit of sense of (and I don’t know how to explain it well), I think a lot of investors, as I said before, came to vol a few years ago expecting that this would be a good place to hide out in a situation where we were people felt that we were probably moving more towards crisis periods, not knowing necessarily we would have a pandemic, not knowing that it would be followed up by other challenges, etc.

Again, this is probably more you talking about the landscape of vol funds, not necessarily what you’re doing. I think you’ve probably done much better than most other people. But just generally speaking, and I know also that you have funds that have been long vol but there other relative value farms, etc., so maybe you need to distinguish a little bit. But I think a lot of people are sitting back with this difficult situation of explaining, how can it be that we in a situation where we have historically changes in interest rates? We have a war, we have deglobalization, we have one crisis after the other and yet, my volatility fund is losing money. Can you help them make sense of that?

[00:32:11] Cem

Yeah, it’s all about positioning. One of our three funds is called Dealer Flow. It’s about watching dealer positioning and trading accordingly. It is the biggest component. Everybody wants to paint a broader narrative about some macro thing and why it pushed a day to day move or week to week move or month to month move. For the most part, macro affects things over the longer run, much like fundamentals. The day to day, week to week, month to month, even annual moves are a function of positioning.

You and I have talked about this as it relates to a first move versus second move phenomenon, the reality that often people are prepared for the first move, especially with the Fed which telegraphed that they were going to have to raise rates. There was a record amount of hedging going on, particularly in the S&P 500 at the top and the market skews at record levels. We’ve talked about this at length, but when the market liquidated, that meant all those hedges had to be monetized, and if you were levered long equities and long vol as your tail protection against it, you not only lost on your equities, but you lost on your vol.

Once the losses started coming in on the vol, there’s a liquidation because you’re losing on both sides of the trade. Funds are getting liquidated that were doing both. There’s a forced selling component, and skew flattened to essentially a historically flat skew. That’s a function of just people having to liquidate. But a lot of that liquidation has happened, and it takes time for it to happen. That pain essentially forces positioning out and pain and gain the other way.

If people are making money doing something, they do more of it, and if they’re losing money, they stop doing it. It’s that simple. People crowd into trades and crowd out of trades. People ask me, “When does a dealer positioning fund do well? When does a strategy like that do well?” Well, a strategy like that does well once you’ve been in a trend of some kind. It doesn’t mean trend up or trend down, some type of environment that’s been sticky because that means people are making money doing something and they’re losing money doing that exact opposite thing and people crowd into trades.

That makes dealer positioning bigger and that means, at some point, the effects of that become bigger and bigger on supply and demand imbalances. So you said oil, a lot of people were surprised that oil didn’t work. Guess what? Everybody’s been talking about the secular opportunity in oil. Well, that’s going to make it difficult in the short term. It doesn’t mean the macro trend is not going to play out. It means it’s going to be hard, and it’s always hard. If it looks like an easy trade, and everybody’s doing it, it’s not going to work. As a trader, if you don’t know that, you’re not in business anymore.

Everybody forgets about the number one most important thing about an asset. It’s supply and demand. Everybody talks about the narrative and how it might be affecting supply and demand or how it should affect supply and demand, but very few people go look at actual supply and demand. Positioning is literally like a direct effect to supply and demand, and very few people pay enough attention to that. It’s critical. So why did it play out this way? Because we’re hedged.

Why will we eventually get a tail of that much like we have in all of the other major tail events I’ve been through? It will be because people are no longer hedged because they gave up on vol, which is happening. It’s a function of time and losses and vol, it’s a function of price and price frustrating vol traders, which all are happening. It’s a function people saying, “Hey, I bought this. Vol never works in a volatile time. I bought this for volatile time. Guess what? It didn’t work. I’m done with it.” That’s what happened and that’s what’s happening.

[00:36:12] Niels

That sounds very familiar to a strategy I know well, I have to say, but let me put it in my own simplistic, non-vol expert terms. Is it fair to say that in the last say, whatever period, 18, 24 months (I don’t know exactly how long), we could observe that, and again, for simplicity, say the VIX didn’t quite react the way it normally would react. So if equities were down, the VIX wouldn’t really go up as much, and so on and so forth. But is it fair to say that you feel, now, that maybe a lot of this has been flushed out of the system, that we may expect that some of these reaction patterns that we’ve seen before may come back?

[00:37:03] Cem

Let’s stick with may. It’s a function of time. It always takes longer than you expect. I’ve said this before, knowledge is vol dampening. If people are aware of things, they are broadly hedged for it and that means it’s less likely to happen. That’s why we were talking about the housing market crisis in the US in 2005 and 2006 and it didn’t happen until 2008. On a smaller timescale, we knew about COVID in late December, early January. The decline didn’t happen until mid-February. We kept getting new highs for like two months. People forget that.

People think we learned about COVID and the market declined 30%. No, we learned about COVID and the market rallied 7%, and then it dropped 30%. Positioning is critical. If I sit out here and tell everybody, much like I did about February 15th, to be prepared, this is a bad flows window. You don’t get a 15% decline; you get a 5% decline.

[00:38:08] Niels

Right. So let me rephrase my question a little here. Sorry to interrupt here but let me rephrase my question a little bit because I’m really trying to make this easy to understand. Now, we know from COVID, March 2020, a lot of vol funds back then, obviously, with a long bias made a killing that month and they’re sort of spending most of the time since then giving that back or more. You could say that well, okay, maybe some people were a little bit quicker to realize that this could be a major problem.

But you could generally say that going into 2020, everything was fine, there was no signs of deglobalization, interest rates were under control, central banks were forceful, and then this came out of the blue, a pandemic. So in that sense, you could say you had this massive reaction. It was the unexpected. But now, let me put it this way. I think the narrative in media, certainly including our little podcast here, we’ve been talking about that the world is changing, we have a regime change, everything is much more uncertain. We have deglobalization, we have all of these risks out there.

So in an odd way, does that mean that it kind of makes it harder for these vol strategies (certainly from a long vol point of view) to actually work because everyone is on alert. Everybody’s uncertain so they’re trying to kind of be prepared and hedged and all of that. Can that simple analogy be used for anything?

[00:39:39] Cem

Yeah. I think broadly, if people are prepared, it’s less likely to happen. The question is, are people still prepared or are people becoming a bit more complacent or not willing to hedge with vol? What we’ve seen is markets at the top, in Feb, 2022 (the local recent top), were largely overleveraged to beta and hedging it with vol, and that was because everybody had experienced Feb-March 2020 (not that long ago), very front and center in people’s minds and said, well, this is the answer; you don’t want to get rid of your beta, and that was a losing proposition.

Now, instead of being, I don’t know, 120%, 1.2 beta equities and negative 0.4 beta vol hoping to get taken out of the tail, that’s a very different distribution. Now, people have 0.8 beta equities. It’s the same beta, in their minds, but a very, very different distribution of outcomes. The 0.8 beta means you lose 0.8 all the way down. Whereas the other scenario, after maybe a 5%, 10% decline, you get taken out of your equity exposure. So just a very different distribution of outcomes and that’s where we are now.

We are not at late 2017 type vol positioning where the whole world is short and there’s a massive tail. We’re not there yet. There’s a lot of short vol funds that are out there and marketing their returns of the last year and a half into a declining market as a diversifier non-correlated strategy. They did very well into a market decline. Short vol was the trade, and it did well if you look back in recent history obviously as well because the markets haven’t had a decline. It looked pretty appealing when you only look back 10 years or this couple of years, I guess. So, people crowd into these trades and it’s more hazardous.

The more you make money in those, the more assets there are, the more people chase them, and the opposite is true for long vol. So that’s where we are despite the macro realities of the world and so people begin to, at some point, say, well, maybe the macro environments not as bad as I thought and there’s a reflexive effect to the realized vol. Markets have been very low vol realized as well.

In my opinion, I’m seeing underneath the hood, that positioning has changed and it is changing. It doesn’t change from one to zero, it’s a gradient and it’s relative. Just like some of these other things, where’s that breaking point? You know it’s going to come eventually, but does it take six months, does it take a year, does it take two years? Generally, it’s on the longer end of these things because in the more especially top of mind that vol is, people are willing to kind of wait out the pain and they are more patient. So there has been a big move and people haven’t wanted to abandon this. It’s a little bit more nuanced.

People don’t want to abandon all their hedges but the vega hasn’t been working, the implied vol has been awful. So people have crowded into a new type of vol trade because they don’t want to abandon at all their hedges, which is zero DTE kind of gamma, because realized vol has been okay. There are problems to that positioning. People broadly think that in 15 years, we haven’t really had, other than a week or two, an implied vol move without a realized move. So the realized move is a much smarter way to go.

Well, I’m here to tell you that happens as well, and just like oil will go to negative 30 because a positioning, strange things can happen and that’s a very unbalanced positioning and is having structural effects which is important to the oncoming prediction. So I would point people to that, to look at that and think, well, how are things going to evolve differently than they have in the past?

We’ve been seeing a much more interesting implied vol response lately. Even with the macro dealing with this by the Fed and whatnot, we’ve seen that response continue to happen. That’s interesting. I’ll just highlight that as one of a couple of major positionings that have changed, particularly in the vol market, that maybe give us a clue about how this will evolve in the coming months.

[00:44:16] Niels

In terms of other clues, Cem, I’m curious about this. We talked before or I talked before about the pandemic as being kind of a black swan, people didn’t expect that. I think there’s another thing that could turn out to be a black swan and maybe we’ve just seen a little tiny introduction to what that looks like, and that’s loss of confidence. I think one of the things that we have enjoyed and investors have enjoyed is an incredible amount of confidence in what central banks have been doing on the control, etc.

A number of years ago, I started talking about that one of the things that I worry about the most is the time when we get to a point where people lose confidence in what we’ve been doing. We’ve been dealing with massive amount of debt by adding a further amount of debt, and so on and so forth. I think what happened in these banks, and with the speed up of what had happened or how it happened, is an indication of how things can change dramatically when markets lose confidence.

So I don’t know if you agree with this, that this could be an issue. But if you do, I’d love for you to talk about it. But also, is there a way to detect loss of confidence in the markets that you follow a little bit ahead of time maybe compared to the markets most people follow?

[00:45:50] Cem

Yeah, I think in particular, confidence in the Fed is…

[00:45:56] Niels

Or central banks in general.

[00:45:59] Cem

Central banks in general. Correct. There’s a broad belief because of last 40 years, the Fed can control the system and the economy. As we mentioned, there’s a secular component, but they’re likely not to be able to. The Fed at some point, in my opinion, is going to lose control of the long end of the curve. I think that’s going to be increasingly tied to… higher vol in interest rate is part of the mechanism that gets us there.

As positioning becomes shorter and shorter, vol in those products because it’s just too expensive, that opens up the window for more extreme outcomes. Just like we saw 1.75% move in the one-year vol, you can see that happen in the opposite. Now imagine if instead of dropping from 5.4 to 3.65 or whatever it was, now that the opposite had happened, that is a terrifying thing for the Fed to not be able, especially in the face of maybe them trying to control that.

So, yes, I agree with you that the second let down I think will be accompanied by a loss of confidence that the Fed can resolve a stagflationary environment, and that’s the truth, that they can’t. If that becomes embedded, and importantly, it’s not just that, I want to be clear. We should talk about the narratives of why things don’t happen. But if positioning gets to a place where, broadly, there’s less liquidity and more risk to that side, in particular, is when you need to be watchful for that. I think that’s coming.

I think it’s going to happen sometime in the next year or so and I think that is the major risk. It’s likely ironically after a recession or into a recession that it’s likely to happen because that’s when positioning is likely to turn and the potential energy of that happening is higher.

[00:46:01] Niels

Is the clue for something like that… Obviously, it would be major. It would be nothing that I think anyone (there may be a few people who are old enough who have actually gone through a period like that, but I can’t really think of a period, maybe in the ’60s and ’70s, people felt that the central banks had lost control, maybe so early ’80s, before Volcker), but very few investors will have gone through a period like that and is, in your opinion, the way to spot something like that beginning to happen just more vol in long dated bonds?

[00:48:45] Cem

Yeah, two things. One, it’s a function of vol being loosened. So there’s this greater risk of this happening. We’re seeing that. Two, positioning directionally. A lot of people are trying to hedge for an inflationary response and being frustrated as part of why you get these moves. I think when we start hearing a narrative (and positioning will reflect that narrative) of, hey, maybe this isn’t inflation. Have we entered an deflationary environment?

When that becomes central into a coming recession and the pain, that’s when I would begin to be very aggressive at the long end of the curve. Again, if you believe in that secular narrative, there were three recessions, ’68 to ’82, and they each were accompanied by (especially early on before it took hold) a belief that, okay, we’re done with inflation, and yields came down. It took a while for the long-term inflation expectations to break out, and that really took some time and a couple of recessions where hey, it kept going higher, despite the cyclical responses, and I think that’s what’s going to happen.

I think particularly into an oncoming recession, when everybody’s like, look, see deflation, see, we’ve healed inflation and (as it’s a function of a cyclical response and not that secular trend), I think that’s going to be when positioning gets off sides and ultimately allows for a move there that’s going to be very counterintuitive. I think the key is it’s got to be counterintuitive. The moves that work in vol almost always, in some way, come at a counterintuitive moment or when people have given up hope. That’s, by definition, what volatility is. When people are prepared for it, it’s not generally a volatile event.

[00:50:57] Niels

You know, today, you and I are allowing ourselves to really speculate and come with all sorts of ideas of what could happen. One thing that is pretty sure to happen in the next 18 months, I imagine, is we’re going to have a US election. In your world, how does a period leading up to an election, how does that play out if at all? Do you think about that already?

[00:51:22] Cem

I absolutely do. Actually, it’s top of mind for us because other people aren’t talking about it. I’m so glad you brought it up. It’s the thing that is going to be the next narrative and the next important narrative but in reality. So the critical piece of that is that fiscal policy is front and center. So to the extent that it’s taken a pause, the absolute worst thing that could happen for inflation, in my opinion, is a big recession here before the election, and then you’re just going to get a fiscal wave.

Ironically, that story and narrative that we’re talking about here, that would also be the moment when people like talking about deflation and that CPI has been fixed. So it’s very front and center to how I’m thinking about this. We’ll see. Timing is important. I think regardless of whether we get that big enough recession to serve as the crisis excuse for the greater fiscal, we’re going to get some either way. So I feel pretty good about the broad trend there, the secular trend. You generate that from the millennial generation down. If you look at Biden’s numbers, nobody would have thought he’d be where he is now a year ago, especially into a market that’s probably down.

It’s not about the market as much as it’s been last 40 years. It’s about payments and that people on the bottom are actually more and more able to afford things and relative to others feel like they can. It’s about policy, whether it’s forgiveness or attempts to forgive loans or housing payments, or you go on and on, the fiscal response. So expect price controls if we have inflation, which is fiscal. If inflation is coming down, just expect outright support for the economy but heading to the bottom of the distribution. I think that that’s going to be a very important component of where you’re heading.

Whether it’s Biden that gets elected or Trump or DeSantis or whoever you’re looking at, it’s all populist at this point and you better believe there’s more protectionism, more onshoring, more fiscal response, whether it’s healthcare, education, defense, like all of its going to be increasing here going forward, in my view, and again, the worse the economy does, the more that we’re going to get in the short term, so buckle up.

[00:54:13] Niels

There’s one thing, and I don’t know if you have thought about this, but it’s something I overheard in another conversation. I actually thought I haven’t really thought about that myself and it’s a topic we haven’t touched upon, even though I think actually it is pretty important, and that’s the US debt ceiling. Someone was just reminding everyone that actually, what happens is that as long as there is no agreement, they can operate with this emergency policy, which means that Janet Yellen doesn’t have to fill up the coffers of the Treasury. But as soon as they agree, they have to issue a bucket load of bonds to fill up the Treasury account or whatever it’s called.

Is this deadline, even though it’s a few months away, but are these negotiations (I don’t follow it closely, I have no idea where it is, but it usually gets resolved like in the one minute before deadline), but is this something you also pay attention to?

[00:55:09] Cem

Yeah, very much. I’m glad you brought that up. This is likely to become, again, a period people wring their hands over, because, again, election season is coming and posturing and everybody grandstanding is part of that. People are going to try and have their mountain to build their brand on and so there’s going to be a real battle here over it. That said, nobody, it’s not politically good for anybody who’s an incumbent to have this. It’s all about incentives. It’s always about incentives. It’s not in their best interest to not figure it out so they will figure it out, they will have to again, otherwise, the fingers start getting pointed and none of them win.

So that’s what will happen. So expect, as it tends to happen, some bullets will be going into that and for it to kind of be the last second and there to be a resolution. That said, to your point, the TRG or the Treasury’s funding of things; the emergency funding has actually been stimulative underneath the hood. It’s been kind of reversing a lot of the effects of QT to the market because there’s just not a supply of treasuries on the market.

To your point, when that happens, supply and demand, which is the ultimate most important effect, does get out of whack and that will be appear. In my opinion, we’re also likely to start seeing some more interesting potential supply demand imbalances on the yield side. So yes, something to watch, something that there’s a lot of talk about. The more talk you hear about it, you’ve got to be careful.

But to your point, it’s about supply and demand and at the end of day, where these things are getting priced, and to the extent there hasn’t been enough upside pressure in yields, some of that is just we’ve had secret QE behind that curtain that’s been helping out and that’s likely, again, to dissipate and be one of the components that could really lead to a greater imbalance and push things the other way.

[00:57:29] Niels

If I was going to sum up what you’re saying with the very big chance of me getting it wrong, it sounds like you actually think if we just stick with equities that, yeah, we may get some counter trend rallies along the way, but overall, the trend is probably, in the bigger picture, heading south. Would that be fair?

[00:57:50] Cem

Don’t fight the Fed. When markets were going up, the Fed was selling puts. The Fed put was in place. That was the answer on a secular basis. Yes, you had counter trend drops and opportunities to buy etc., but now the opposite is true to a large extent. Just don’t ignore when the tide is going out. Even if cyclically, we get out a little blip the other way, we’re not in the same cyclical world.

We’re not still playing the same up and down within a very controlled Fed-dominant environment. There’s a different entity in town which changes everything, which is the government and fiscal policy.

[00:58:38] Niels

Cem, anything as we wrap up? Anything that we forgot to talk about? Anything you want to bring up before we wrap up? This has been super fun and useful and extremely insightful, so I really appreciate your time today.

[00:58:53] Cem

Yeah. I’ve missed our conversations. These are always fun. So two major things going on in positioning. I already referenced one of them in passing which was gamma versus vega. People ,broadly, aren’t exposed to implied vol anymore. They are trying to hedge it with more realized vol. 45% of options volume is now zero days to expiration. Again, it’s everywhere. People are talking about it. I don’t want to spend a ton of time on it, but I think that component is likely to mean, in my opinion, that gamma stops working as well, which is kind of what we’re seeing. We’re getting a lot of just back and forth, but that the vega starts creeping higher, and I do think that’s something we’re broadly seeing. I think there’s a greater opportunity in skew, skew has gone significantly higher, and tail.

Again, I think by the time the event happens, costs will have gone up where you need it and a broader, longer, call it a one year plus, think of in ’08 or 2000, 2001, long term vol can make some crazy moves that are not necessarily rational. In early 09, 10-year vol traded 60, 10-year variant swap traded 60. The long-term average is 17.5. That makes no sense, it’s irrational, but it happened because people were short it and it went higher and they had to buy it back. Equally, as insane as in 2007, it was trading 15.

It’s a lot about positioning at the end of the day, and that lack of positioning in vega I think is particularly important into what’s a broadly secularly dangerous period. It won’t happen right away, but the opportunity set is growing there. Gamma is likely because that’s where people are positioned, a little likely to frustrate hedgers that are doing just realized vol. That’s one.

Two, the other one we didn’t talk about yet which I think is very important, this move in duration, like growth versus value, Russell versus NASDAQ. We’ve seen some really incredible moves in the last couple of weeks. We’ve broadly called it. Why? Because especially going into March up OpEx is when it started to accelerate because there was a massive amount of put hedging both in retail and speculative hedges in the NASDAQ because that’s what’s worked. People crowded into that because it was working, short call one put there. Whereas nowhere else has had the hedges and people have started to abandon it. Guess what? Into that decline, you’ve actually have seen massive NASDAQ strength, which is counterintuitive to a lot of people. You also have seen value really had problems, particularly small cap value. That’s a function of positioning, that positioning is still strong. People are still caught in that trade, and until that resolves itself, that could continue. Those two things are also connected in the sense that when volatility does tend to increase, you tend to get correlation going to one across assets or more and some of the assets that were underhedged, despite maybe safety or lower beta, can sometimes be much more dangerous.

I think into the next decline if and when occurs here, if it is a volatile decline with vega going, a more implied vol focused declined I think is likely to continue to see, again, maybe not the NASDAQ as much as some of these other oil names and these places where people have been hiding counterintuitively be just as painful, if not more. So I think that’s something to watch. I’ve been talking about that for a couple of months and we’re starting to see that happening. That’s a function positioning that’s taken a year to reverse to these positions, and now, you’re going to be forcing people out of those positions so far.

[01:03:00] Niels

Cool. Well, I’m glad you brought that up. This has been amazing. Luckily, you and I are recording another Global Macro episode next week, so that’s going to be fun. It won’t be long before people can listen to you. But of course, if you do enjoy these episodes, then why don’t you head over and leave a rating and review. It only takes five minutes and it’s easy to do. If you don’t know how to leave a rating and review, then you can go to toptradersunplugged.com/review and you have all the instructions. I hope that’s not too much to ask.

Questions, of course, next week, you can send them in because we’re going to have Andrew Beer back so I’m sure we’re going to be tackling some trend following and CTA replication topics with him and I’m sure some other things. But if you have a burning question, send it to info@toptradersunplugged.com. That’s it for today.

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

[01:04:05] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed 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.

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