243 Systematic Investor Series ft. Cem Karsan – May 13th, 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.

[00:00:22] 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 catalogue and listen to the past episodes that you may have missed, like my conversation with Mark last week where we discussed the topic of how to detect changes in trends and whether you should use economic data in addition to just looking at price in your investment strategy.

Also, I would really encourage you to listen to the midweek episode which admittedly will not be for everyone as it is somewhat politically charged. But the topic is nevertheless incredibly important as it deals with the dangers to democracy that the Financial Times chief economics commentator Martin Wolf lays out in his new book The Crisis of Democratic Capitalism, which explains why, in his view, the marriage between democracy and capitalism is breaking down.

Lastly, I’m excited to let you know that in our CTA mini-series where Alan and I have been privileged to speak with some of the decision-makers of the most successful CTAs in the world, we have another episode planned which will come out within the next couple of weeks. In the meantime, if you haven’t listened to the previous episodes, I certainly encourage you to go and check out that series.

So anyway, head over and check it all out after you’re done listening to Cem and me today. Cem, it is always great to be back with you. How are things? What’s going on in the Windy City today?

[00:01:56] Cem

It’s raining, a little spring, May showers. Hopefully, we get some flowers here. I’m not sure that the market will get flowers here but that’s a whole other conversation.

[00:02:09] Niels

I think that’s a little teaser. Well, over here, actually where I am today, the sun is shining and we have a whole weekend of the Eurovision Song Contest lined up for us which is one of those things where the more extreme you are as an artist, the better the chance is of winning, or at least that’s how it seems. So I’m not sure which one is best, Cem.

But anyway, we do have a good lineup of topics and we will dive into all of those. But maybe just to kick it off, your headline big views that you’re focusing on and then we’ll dive into all the details plus some other important topics.

[00:02:52] Cem

Kind of how I tease it. This is an interesting crossroads in the market. We have gone through the relatively well-telegraphed, to my view, springtime market, especially given some of the dynamics that we had been witnessing the last four or five months. There’s a lag to monetary policy that is continuing to work through the economy.

As we get to this debt ceiling debate, I think we’re getting to an interesting moment here as we head into a more illiquid summer. Generally speaking, the months before quarterly OpEx, whether it’s February or May or August mid-month tend to be very interesting structurally and have more risk. So that’s something that we’re looking at as we head into OpEx here into an illiquid summer after a particularly steady complacent rally.

[00:03:56] Niels

So perhaps the old saying “sell in May and go away” might turn out to be a good myth this year. Now, I completely forgot that I did want to actually just mention that there are a few interesting things, I think, worth paying attention to this week. Of course, many believe that with the Fed action we saw last week, that the Fed will be on pause. But I did notice that today, Friday, Fed Governor Michelle Bowman expressed concerns about high inflation and a tight labor market suggesting a need for continued interest rate hikes.

In fact, she was speaking at a symposium at the ECB in Frankfurt today and she said that she’s seeking signs of and I quote, “consistent evidence that inflation is on a downward path when considering future rate increase and at what point we will have achieved a sufficiently restrictive stance for the policy rate”, which of course, is an interesting comment given the fact that interest rates are at a 16-year high. You would probably argue that it is at a restrictive level even at that point, but it does suggest that there might be a little bit of disagreement in the rate-setting committee, and it does raise the question about future or potential pauses at the future meetings.

I also saw that the initial claims ticked up to a fresh high of 264,000 yesterday and that the four-week moving average also hit a high or recent high of 245,000.

Anything you want to add to that before I dive into my little trend following update before we go into the global macro topics?

[00:05:41] Cem

We’ve talked about this a bit but I think it’s important to continue to set the stage that we are not in a typical cyclical kind of economy. Is the economy slowing or is it speeding up and what does that mean for the Fed action? There are structural secular inflationary headwinds that are likely to remain sticky even in the face of cyclical pressures. So I really think that we’re no longer really playing in two dimensions with the Federal Reserve, which we’ve really done primarily for the last 40 years.

There is an increasing probability (and we’ve been talking about this for years) of stagflation, and that is a very difficult situation for the Fed particularly at the beginning of a secularly stagflationary environment. So I really think there will be continued debate, and again, I think we’ll dive into that a bit more later. But the crux of it is we have a situation where the Fed may not be able to fix the cyclical downturn this time around.

[00:06:46] Niels

I can’t remember what movie it’s coming from but I think there’s like a movie where the quote line is something like “it’s complicated”, and I actually think it is pretty complicated at the moment, I have to say. Anyway, what’s not complicated is that in the last few weeks, and probably most of this year really from a trend following perspective, it’s been kind of a non-trending environment lately.

But we did see some recovery in the last week after a soft start to the month of May. So there’s been a little bit of improvement. But frankly, it’s been driven by just a few markets really. It’s not very broad-based, pretty much like the stock markets where a handful of stocks is responsible for the gains this year.

Interestingly enough, I noticed, Cem, that my own trend barometer which tracks the trendiness of a broad-based diversified portfolio is actually at the exact same level, namely 41, as it was last time we spoke on the Systematic Investor Series, which means it’s completely neutral, no conviction up or down.

Anyways, a quick run through as we normally do. The BTOP50 Index is down 88 basis points for the month, down 3% for the year. SocGen CTA Index down 72 basis points for May, down about 4% for the year. The Trend Index down about 45 basis points, down about 5% for the year. The Short-Term Traders Index actually struggling a bit, down 1.15% for the month, down 3.3% for the year. Given its much lower volatility, it is relatively underperforming, I would say.

Anyways, stocks are down as well this month. Down 74 basis points for the MSCI World and 93 basis points for the S&P Index, but they’re still up 7.5% and 8% for the year so far, and bonds are just marginally up so far in May.

All right, Cem, as we already alluded to, you’re talking about an interesting inflection point that we’re at right now. I’ve heard you talk about that it reminds you of a recent topping process because let’s not be too cagey about it, you do think that markets will head lower later on. But talk to me a little bit about what you’re seeing in more detail and maybe some of the underlying reasons why you take the view of the coming market actions as you do.

[00:09:13] Cem

Yeah. So there’s (as I mentioned to set the stage) a lag, as we all know, to the monetary policy, interest rates specifically, and that’s working through the economy. It usually has about a 12 to 18 month lag. We’re getting to a point where we’re about, call it 13, 14, 15. We’re beginning to see those effects. We can walk through all of them, but whether it’s in housing, in buybacks for stocks, private equity, venture capital, rerating, all of these things are starting to begin to work through and those have significant effects to collateral in the market and broad liquidity for asset support.

At the same time, and I think this is important, the QT, the drag on liquidity that the Fed is supposed to have been doing, which has a much more direct effect to markets in terms of liquidity, has really been counteracted by several things, not just the deposit insurance that we have recently given to banks, but also the Treasury general account stimulus that has been coming as a function of sending money during these emergency measures for the debt ceiling debate.

So if you look at a chart of liquidity, really, in that regard, it really hasn’t come down much given the $90 billion of draw that we’re supposed to be seeing in terms of quantitative tightening. Our estimation is that as we move forward here, we’ll begin to see a lot of unwinding of not only the deposit insurance effects but also, importantly, the refilling of the Treasury general account once we get past this debt ceiling.

[00:11:14] Niels

If we get a debt ceiling?

[00:11:17] Cem

I think the great irony of all this is the resolution of the debt ceiling ultimately will sell the event, we think. So as we move towards that, those pressures are all increasing in terms of removal of liquidity, all while we’re moving along a path of generally worse margins, margin compression and other issues that are hitting equities broadly. At the same time, positioning is actually quite short. So people know all of this. I’m not telling anybody here things that aren’t publicly understood or known.

The question is, the market is forward-looking, why hasn’t the market taken this to heart yet? The answer is positioning. This is what the answer always is, by the way. If everybody expects something, it doesn’t happen exactly as one might expect, and that’s because of the reflexive effects of dealer positioning. We talk about this all the time, not just in the options markets. But broadly, if there’s a lot of short interest in the market or there’s a lot of put buying, these things ultimately lead to reflexive support for the market. It’s that proverbial wall of worry that people talk about.

So we’ve really had this macro versus positioning push and pull. The way that usually ends is one of two ways. It ends either with time. Why does time matter? Because risk increases with time. People are willing to take more risk if things don’t happen for some time and they’re willing to whether it’s sell vol or other forms of risk premia. They’re willing to come in and sell risk over time. That’s greed at work. It’s also the diminishing of fear. People who are buying protection or are risk averse eventually give up on that because it’s expensive.

By the way, market structure works, not just the vol, but broadly. That generally leads to the unwinding eventually. Think about the selling of vol that in 2017 that eventually led to the 2018 vol apocalypse as an example. But there’s a million examples of this along the way. Generally, that starts to get unpinned before a decline. We saw that in ’07. We saw it in ’99 and 2000. We’ve seen it even in other circumstances and that’s part of why things always take longer, not always, but generally take longer than we think, because of those reflexive effects. But they do eventually come.

People were talking about the housing crisis in ’05, ’06. It took till ’08 to really unwind. But macro realities eventually do come home to roost. It’s just a matter of things building to a point often beyond what you think is possible.

So time is always one possibility. The other is this price. You can shake short positioning simply by a big enough rally, a stretching of markets. You can squeeze shorts, force people, institutions back in from underperformance, as well as naturally take vol higher into a rally because markets slide naturally to a lower implied volatility just at baseline.

Eventually, that becomes low enough where participants are willing to come in and buy it and then remove that liquidity from dealers and vol naturally becomes more unpinned. This is a natural process of why we often get also blow-off tops and an increasing vol into those final rallies that we see.

So these are two ways that this story ends and that we shake positioning. That’s really what needs to happen at this point. All these structural liquidity factors, the macro elements are in place. But you have to shake the conviction of shorts and long vol and the short vol has to build in the market. So this is generally the process.

We saw this as recently as the recent November, end of February 2022. All the things were in place. People were positioned for a decline. There was a lot of talk about the Fed increasing interest rates. Everybody knew it was coming. They started and then it took several months and it also happened to line up with a seasonally positive period. That’s not a coincidence. End of year, beginning of year, all those flows, and that pushed us into a very big blow-off top, not very big but a big blow-off top that ultimately then unwound last year.

So we believe, after a seasonally positive period here, for a lot of the reasons we’ve talked about and the lags we’ve talked about, that everybody knows what’s coming here. Now we’re in this topping-type process and it really is a function of time and distance for what comes next.

[00:16:28] Niels

There are actually two questions that come from your thoughts there. One is one thing that I’ve actually always, as a trend follower, have been wondering because what we notice in our models is that we make a lot more money on our long-sided trades than our short-sided trades. Some of it can be explained by say bonds haven’t gone up in price for so many years up until a couple of years ago and so on and so forth.

But I’ve always myself had a little philosophy, and you will probably know this much better than I do, that tops take a lot longer to form compared to a bottom. You often see like a one-day like March 23 2020. Now, it was artificially induced by the Fed. Sure. But that’s kind of just what I’ve been noticing. How do you think about it because you mentioned time, and I completely agree time is important. But how do you see or have you ever thought about whether timing of tops or the duration of forming a top versus a bottom is structurally different?

[00:17:44] Cem

Unquestionably, and for one simple reason. The world is long, right? If you eat, sleep, breathe, you’re long. You own a home, you work a job, you own any asset whatsoever, you’re long. So panic is akin to death. They are fearful, scary things for everybody. So that simple positioning, again, it’s all about positioning, necessitates some type of panic and expediates panic into a decline and makes them more volatile. Ultimately, it is that panic and that stress selling that is beyond some rational level, that ultimately will turn a market quickly into a decline.

Ultimately, we all still breathe, we produce, we create earnings, etc., and so there is a natural bias up in markets now. That bias, to be clear, is long term (again, we’ve talked about the ’68 to ’82 period at nauseam), the reality is you can go decades without that upside trend if you bring that forward in other ways, which we did before that period and we’ve done now for 40 years. But there is a natural upside bias for lots of reasons. That’s why there’s skew in markets as well, which also structurally has a reflexive effect here too. That’s all still positioning.

At the end the day, the gamma is to the downside broadly in markets, not just structurally but also for dealers because insurance gets bought and that also exacerbates faster the elevator down escalator up reality. It’s structural to markets and how they work. It is not a coincidence that that’s the way it works. Because of that though, it’s also hard. It takes time, as I mentioned, for markets to go down at first because there’s steady stream. A great example here just structurally is (one of the many things that feeds into this) as market of vol declines, it’s easier to hedge.

Structurally (this is kind of some inside baseball) what happens is put skew actually historically increases because people will still pay some price for insurance to the downside. When you have a structure where the vol comes down and skew is high, it’s easier to buy insurance but there’s also this buyback of delta that happens because skew is higher in the market every day. So it’s a naturally stickier… and the more buying that happens in that scenario, the more that supports markets in the short term. So there’s a structural buying and stabilization that happens during these periods.

Again, reflexively, the more worry there is, the more of that there is in markets, it won’t stop it from happening. The macro realities eventually do play out. Often, this creates bigger problems that eventually are bigger crises because they take longer and they build in the system. But structurally, yes, it is, by definition, a vol event or a structural decline can’t happen if people are expecting it and preparing for it.

[00:21:27] Niels

That actually brings me to another thing that you mentioned. I’m sure that some people listening to us today will probably sit there wondering when you say it kind of reminds you of that period, November 21 leading into February 22. You talk about both periods where investors are short. So I’m thinking, okay, last time, rates were at zero and everybody was expecting rightly so that Fed was going to put up rates not necessarily by 500 basis points in a year, but certainly.

So you could kind of logically say, yeah, okay, I’m going to take some risk off, I’m going to protect myself, go short, whatever. Now, we’re talking about the complete opposite. We’re talking about the Fed pausing. So why do you think people are short today as well in that sense? I think people might want to hear your insights on that.

[00:22:24] Cem

Yeah, absolutely. So my likening those two is more in terms of structurally how the market is positioning and broadly how markets top. I could have given many examples throughout history of that. That’s the most recent and vivid in people’s minds. The macro realities are actually not as much a function, in my view, of again, given the lag in interest rates, is not as much a function of the Fed raising rates, it’s a function that we’re heading along the same secular path that we’re on and we’re just further down that path and the realities are becoming more and more evident based on how sticky inflation was.

We were in camp transitory still at that point. There’s a lot of information that we now have that (we’ve been talking about it since back then) a lot of these things have been affirmed, at least to this point. So my view is the secular realities of the more stagflationary environment that we’re in, the geopolitical tensions haven’t gone away. If anything, they’ve continued to ratchet up.

The resource scarcity we’ve been talking about, OPEC and the battle across borders in that regard, the economic warfare, all of that has continued. Meanwhile, we’ve raised interest rates 0 to 5, and guess what? Unemployment is at a new record. The realities of the situation are if anything more dangerous at this point. So yeah, I think it’s more the secular realities and we’re bumping along this top, this trend that’s coming that we’re seeing and I think that’s becoming more and more evident.

[00:24:24] Niels

In many, many ways, Cem, if I take off my systematic hat, I kind of see it the same way as you do. I’m kind of thinking, yeah, there should be some downside, maybe even a lot of downside in equity markets. I hear a lot of people, that I have huge respect for, with that view. The only thing that concerns me is I hear more and more people expecting that and that reminds me of the rally after the global financial crisis in 2009. People were saying, it’s just a bear market. Clearly, we’re going to go down to new lows and all that.

The market just kept going and going and going I think it really was one of the most hated bull markets we’ve seen because too few people participated in that bull market, I think, with as much exposure as they would have liked. Be that as it may, I’ve also actually heard people, one of them on the podcast, and he is Simon Hunt. Although he did expect the markets to go down first, which hasn’t really happened, he was saying, well, and I’ve heard that from other people, as you say, you could have that blow-off top but actually lasting a lot longer than a few months, maybe even into ’24, ’25.

Druckenmiller, and I’ll come to him later, but he sees this and has for a long time seen 2025 to 2035 as a really troubling period. But I’m going to leave Druckenmiller for a second because I’m going to ask you another question.

You talk about stagflation. Again, I don’t disagree necessarily with that view. We do see unemployment, at least from the official numbers, at record lows. This is a little bit of a curveball but since you’re from Chicago, I’m sure you can handle that. That is, AI, even since you were last on this particular series like 5, 6, 7 weeks ago, so much has happened in the AI space, meaning it has become so much more accessible to all of us.

I’m thinking it’s going to have an impact. People already talk about all the things it can do. But what’s interesting about AI, it’s different from the technology revolution where a lot of the “blue collar” workers were suddenly obsolete because we could have machines do the work. With AI, it’s kind of the well-educated people that become potentially obsolete because it can do things and maybe do things better than you and I can do, write a blog post or whatever it might be, a memo.

Again, I don’t want to scare people too much on a weekend, but I’m thinking you and I have these big-picture talks about where we think things are moving in a much bigger timeframe. I’m curious about what you think that the real risk is if suddenly AI does create, you could say, an unusual pickup in unemployment, not from the usual places where you would see it coming, but actually from the middle class, the well-educated. How, from a societal point of view do you think that can impact all of the things we’re talking about here?

[00:27:55] Cem

Yeah. Great question, and I get this question, mind you, a lot. This is the new question everybody’s asking is like AI, as if AI just came out of nowhere. I want to be clear. You were around in 1999. Did you hear anything similar about the internet in 1999? It was going to change the world, and guess what? It did? But just because that was true did not mean that the realities of financial markets didn’t play out. Yes, unequivocally, technological advancement is deflationary. There’s no question about that. We have been advancing for 100,000 years. This is not new.

Again, when you’re sitting on the trajectory looking up, everybody always thinks we’re going to keep going at this pace. The problem is that the reason that AI is happening here right now and that we’re at this moment of exuberance and the world is going to change tomorrow is because we took rates to zero over the course of 40 years, and essentially invested in technology and advancement and globalization, and at the same time, that advancement. So everybody has been growth at all costs.

The reality is that this is what happens at the end of those cycles. But now, if you’re pulling that money away, and this takes time, it took 40 years, it’s not going to happen overnight, you are now taking the means of investment into more future technological advancement away. That happens not overnight. Talk about lags. That’s a much bigger lag. But the bigger structural question isn’t, well, look, now that we’ve done this for 40 years, look at where we are technologically, what does that mean? It’s what is happening underneath the hood and what does that mean for the coming cycle?

So in my view, yes, secular technological advancement will continue. This is part of that never-ending trend. Again, we all live, we all create, we all grow, we all create advancement. But you better believe when the wheel was created, people thought the world would never be the same. Nobody will ever have to walk again. When the internet was created, we’ll never have to talk again. We’ll just plug our brains into another.

All of these things are essentially true but they don’t change the simple realities of supply and demand and the ability to supercharge that advancement versus deplete it over the course of decades.

[00:30:58] Niels

Now, that is perfectly fine and I appreciate your comments there. I was actually expecting a different answer, Cem, because I was thinking about potential civil unrest. This is to the extreme, meaning you’re suddenly getting unemployment in a group of people that are not usually unemployed or at least not as badly hit during recessions, etc.

I was more thinking about the social impact because I think both you and I also share the view that although we might think that markets are going to change and that we are in a different regime, we’re in a different regime geopolitically and so on and so forth, but I also think you and I believe that the “cycles” for civil unrest and war and all of those things are changing at the same time, and they are obviously interlinked. But I was just curious on that aspect as well.

[00:32:10] Cem

Yeah, very astute points. I couldn’t agree more. We’ve been on a three-legged deflationary stool for 40 years and all three of them are tied to monetary policy. One of them is just quite simply the first base effects that cheap money makes it cheaper to do things. But the knock-on effects of cheap money is that corporations, who are the ones that borrow the overwhelming amount, have a profit-seeking mandate and they go find the cheapest means of production, which leads to globalization.

If you spend enough money that way, it’s a competitive evolutionary force that just creates more technological advancement. Technological advancement, globalization, cheap capital, those things are massively deflationary things. They also lead to cooperation because corporations are global. Broadly, the unwinding, the knocking out of that most important leg of that stool, which is interest rates, eventually leads to protectionism, etc. Populism comes out of that period.

The distribution of wealth, which we’ve talked so much about, has gotten too far as a function of that technological advancement, globalization raw in tooth-and-claw, natural selection, capital market priority. Now we have a generation, and this is the key, that drives cycles. We wouldn’t necessarily have cycles if the younger generation wasn’t by definition labor. When you come into the world, you don’t have assets. You work and then you earn and so baby boomers are the top of the stratification broadly and millennials on down are the bottom of that stratification of that period.

So Millennials on down have gotten the bad… They’ve been at the wrong part of the cycle over this period and that drives populism. It’s pretty straightforward in that regard. Go talk to any millennial on down. This rings true. Forty percent of the household formation and wealth creation are the baby boomers at this point in the generation, we’ve talked about this. So that ultimately leads to a lot of frustration and anger.

If you’re living in mommy’s basement at the age of 35, you’re not happy. Now, this has driven crypto and all the other things that we’ve talked about, but at the end of the day, that’s where we are in the cycle. Now, add to that what you’ve said, that all this technological advancement is essentially making things worse for them and likely, at this point of the trajectory, to continue to make because these are the lagging effects of that 40 years. It made government’s efforts to fix that for the populace harder. That’s basically what this is.

That technological advancement will continue, and as a result, will continue to take money from the rich and move it to the poor. If people become more and more unemployed in the middle, we’ll have to fix that with other governmental means as well. We vacillate between trusting capital markets implicitly as the best allocator of capital to saying, well, wait a second, that raw to the claw isn’t fair and we need somebody to come set rules to make things more fair and trust in government.

Nobody broadly trusts government ever. But sometimes, particularly after crises, think about 1929, think about ’69 and some of the things that came after in the ’70s, we broadly begin to trust government to fix that for us. That’s where we are in the cycle. That, at the end of the day, everything is tied into these political realities of how the voters or the people who are determining the leadership feel and I think that’s the critical backdrop to be thinking about.

[00:36:12] Niels

Yeah, absolutely. Before we move on to maybe some other topics, you obviously expect, at some point, that markets will keel over and start heading south. But I’ve heard you talk about that one of the reasons why you also expect that or one of the factors in this view is your outlook for earnings. Can you talk about this for a little bit?

[00:36:39] Cem

Yeah. Again, I always hate to refer to that most recent period but ’68 to ’82 is the last time we had inflation. So if you’re looking at a data set, that’s a pretty important one to look at right now. GDP growth during that period was above trend. Not just above trend in nominal terms with inflation, but in real terms. I think that’s pretty mind-blowing when you think about how markets did relatively.

When you really start to put your mind around the fact that the economy grew above trend from where we have been in the last 20 years. We lost 70% in real terms while real growth was higher in the last call it 20, 30 years. We’ve been growing at 15% in the market in real terms or 13, while GDP growth has been much weaker. So a complete disconnect between the economy and the market. Why?

Well, one of the big things that happened was not just multiple contraction. It’s not just that we were having to pay less for stocks and more for stocks recently. It’s that margins got crushed during that ’68 to ’82 period. Why? The same reason why they’re at records now after 40 years of monetary policy. It’s that three-legged stool. Sending cheap money to corporations, those corporations are lowering their cost of capital by globalization and technological advancement. So all three of those things help margins dramatically.

If you start to unwind all those things, not surprisingly, if you have to onshore all the means of production in the developed world, if the rate of technological advancement slows, if the cost of capital goes through the roof, guess what? Margins collapse. Power, as we’re seeing, also makes things harder. All of these trends which we’ve been seeing for 40 years now go the other way. Nobody looks at price to sales anymore. It’s always just price to earnings, price to earnings, price to earnings, but price to sales is through the roof and has been for years now. It is off the charts.

The reality is a normalization, not just of price to earnings, and not just normalization but a multiple contraction there, sure, that’s part of the story. But the margin compression that’s ultimately going to drive a dramatic reduction in price to sales and a normalization in price to sales is going to play a major role in the next decade of stock market going nowhere as not only I believe, but a lot of other big names as you mentioned believe.

[00:39:26] Niels

Now, another curveball for you which I’m sure you can handle here, Cem, and that is, there’s one thing that’s different, I guess, between previous periods and now, and that is the huge amount that we have in passive managed funds versus actively managed funds. I can’t work my head around how I think that might impact the next, I hate to use the word crisis because it’s almost like we’re always in a crisis, but let’s just call it the next downturn in markets.

Now, last year, we did see a downturn in markets. In fact, we saw a downturn in both bonds and stocks at the same time. I don’t know that passive versus active made a huge difference frankly, I don’t know. Is that on your radar or is that one of the factors that you do pay a little bit of attention to?

[00:40:21] Cem

Absolutely. If you talked to most people, especially up until maybe a year ago, about the advancement of passive investment, most people would consider the advent of passive investment a technological advancement or a natural move along progress to making things easier, lower cost to deploy. I think that up until the 1980s, we just weren’t there yet in terms of that technological advancement. The reality could not be further from the truth. Indexing has been around for 100 years plus.

The idea that you can create an index and deploy it is not a technological advancement. It didn’t happen before that because it didn’t work. It made no sense from ’68 to ’82 for example, and other periods before, to put your money in stocks and close your eyes and wait for them to perform because if you did, you experienced a tremendous amount of volatility with negative real earnings, significant negative real earnings for a long period of time.

This was the time of the creation of hedge funds. It’s also the advent of derivatives, publicly-traded derivatives. Those aren’t coincidences. That was a period where being dynamic and actively managing your portfolio, it was also a great time for value investing. The relative fundamental valuation of things that we all talk about came about during that time. People have kind of forgotten about all those things for the most part because it didn’t work in the last 40 years.

But the reality is that in a period like what we’re likely to go through, passive investing will all of a sudden become uninvestable or there will be new at least products that are active passive products, which is I think what we’re going to see a lot of actually. I think the indexing of more active products is probably the next big trend, something that’s happened for some time but really hasn’t become central to finance.

So yeah, my view is that this idea that beta, and broadly 60/40, is what works and everybody thinks they’re an investor and everybody has been taught that that is what investing is. Investing is just owning stocks for the long run, you dollar cost average, you close your eyes, when it goes down, and you buy more, is the answer. Over a very, very, very long timeframe, that works. But that timeframe might be 30 years and I would venture to say most people don’t think in 30-year timeframes when they’re investing.

So my view is that, yes, we are going to see a significant decline in passive investing, probably at the worst moment. It will probably take 5 to 10 years. Just like now in the last decade is really when passive investing has gone through the roof, I’m guessing that you’ll see a decline in the next five years as it just doesn’t work and I think you’ll see a significant increase in active management, which has become basically dead as everybody has opined that why would you do it.

Look at the performance relative to passive, why would you pay those expenses? The reason you pay those fees for active investment is the same reason you pay those fees to a doctor or a lawyer or somebody else with a deep expertise. A deep expertise yields its knowledge and leads to some type of edge, some type of thing that will help you that you couldn’t get otherwise. So real investors who have an edge, whether they’re hedge funds or otherwise, do create non-correlated returns, and that is where I think the world will have to go in the decade to come.

[00:44:26] Niels

Absolutely. Okay. So, let me finish off with a question about what you expect into the May OpEx, which is a week from now, and maybe you can talk about what you think, and then I want to finish off this part of the conversation just with one follow up question. But just to finish off where we are because I know a lot of people follow you especially into the OpEx and so you may be already starting to form your opinions about that.

[00:44:58] Cem

Yeah. So we have pointed to May for some time. This is not new. We said there was a window in February OpEx, which we pretty much nailed that we would get some type of decline to the day of that Wednesday of expiration into OpEx. That eventually led to a good narrative false price the banking crisis. But the answer was very clear that if that didn’t have enough thrust and unpinned the volatility, which it didn’t, that eventually, that would lead to another rally and that we would then have to wait until May. Guess what? We’ve waited and bought that dip and played it into here.

Now, we would have liked to have seen a new high and a bit more of a thrust, a squeeze, if we were to really get the bigger decline we’re looking for, an unpinning. Again, we’re talking about time or price. That move in price often is what allows for a market to unwind. Why is that? Again, we’ll review. Because it underpins vol supply.

We slide to a lower vol as we go higher and that ultimately can take vol supply away from dealers in the broad market. That squeeze takes shorts out of the market because people have to get squeezed back in essentially. They have to underperform in their benchmarks. They got to go back in as well and then just simply you’re getting further off the ground, you’re creating more potential energy. So those three forces are what kind of necessity to unpin that positioning that we are still seeing. We haven’t seen that enough.

We can point on a calendar and say May is a great period for x, y and z reason, but it is also a conditional probability that we’re looking at. We’d like to see certain things to help increase our odds of it being the right moment. We would have liked to, like I said, see a bit more thrust here and we haven’t seen that. That said, there’s a lot of structural reasons, as I mentioned at the top of the show, that this is still a period not to be long specifically for the next week and a half, two weeks, starting the Monday, Wednesday a little bit earlier than usual, of this OpEx week.

It is a period to be cautious and be watchful of price action especially given where we are heading into with the banking issues as well as more importantly the debt ceiling and the way vol structure is pricing in there. Again, why is this May period? It’s not just because May is on a calendar and it’s a solid May phenomenon. Again, positioning-wise, there’s a lot of short vol in the June OpEx because it’s a quarterly OpEx. It’s exacerbated right now because of the debt ceiling in that area. So there’s less vol supply there. You’re in a serial right before that.

Think of Feb to March 2020. We’ve talked about this, but the market rallied and the Fed depleted all the vol that people had in 2020 until only shorts were left into March, and then the day after OpEx, that 30% decline began and ended the day after March OpEx. That’s not a coincidence. This is a structural reality of vol positioning and this makes for a dangerous window for markets especially after a rally like we’ve seen, especially given where vol and the potential energy is in some of those dynamics. So a dangerous period, as we pointed to on the counter for some time, not with quite the thrust that we’d like.

Positioning is shorter than we would like and more prepared for it than we’d like, but that doesn’t mean that the realities won’t and can’t potentially get going here. So that’s our view. We generally point to VIX-piration as the key point. It might start a little bit earlier. Monday, the biggest thrust on some of this modern charm and support that we see is the Friday and the Monday where we are today when we’re doing this. After that, it becomes less. Really, Wednesday of OpEx is an important moment.

[00:49:20] Niels

Now, not to get down to the minutiae in terms of what’s going to happen the next week or two, but let’s go back to the big picture for one last time today. My question is a little bit- maybe it’s a little bit unfair actually when I think about it, and that is what has to change or what would you look for in order to change your view? What could change your view of this frankly pretty bearish outlook? Obviously, it’s easy for me to ask the question. I don’t know if that’s easy to answer, but I’m curious.

[00:50:03] Cem

No, it’s a question I asked myself all the time. If I didn’t, I wouldn’t still be around 25 years later managing money. We are not dogmatic, as much as it may sound. We are very much looking for contrary evidence and testing our thesis at all times. The thesis is broadly tied to one very important secular reality, which is, are interest rates likely, and is liquidity likely to diminish and interest rates go higher broadly over the period to come? Are the knock-on effects of that which is deglobalization and other things we’ve mentioned likely to continue?

What I would need to see, if all of a sudden China and the US moved out of the trend towards Cold War back to cooperation, that would change my view. If I began to see interest rates… if the Fed would be able to lower interest rates to zero, back to ZIRP, us not see an inflationary result, that would change my view. If populism broadly and all the fiscal activity, not just in the US, globally, was to diminish and I was to see clues that that was turning around, that would change my view.

These are the things that are all tied up together in the secular trends that are really underpinning our view and why (to be clear we started saying this two, three years ago)? We continue to watch and it continues to play out step by step. You have little blips here and there, question marks. Is there going to be a rapport between the US and China? Quickly get shot down. That’s because of the structural underlying trends. They’re because of the people and the populism and the effects of 40 years.

These are big, structural things that are very hard to turn. They are not one person’s decision. They are not one government’s decision. It is the effects of 40 years of monetary policy.

[00:52:24] Niels

Yeah, and there’s some other policies that’s been going on for probably equally as long. I mentioned Stan Druckenmiller earlier in our conversation. I want to get back to that point as we wrap up our conversation today. I don’t know if you’ve heard him speak recently. There was an amazing speech he gave recently at a university. Since you’re nodding, I’m hoping you’ve heard that.

[00:52:52] Cem

I have. Some conference he recently had.

[00:52:56] Niels

Actually, I did not hear that particular one but it’s probably the same speech more or less he gave to, I can’t remember, UC California, something like that, where he was like on the 1st of May. But in any event, what he has been arguing for a while, and he was reminding the audience that he actually came to that university 10 years ago, warning about the period we’re almost getting to now, 2025 to 2035, as long as politicians were not willing and able to deal with the real underlying problem. Meaning, we are right now so focused on the debt ceiling discussion but the reality is that’s not what we should be focusing on. We should be focusing on why we are in the situation with the debt ceiling every single year. How do we solve the huge amount of debt that has built up?

Obviously, he’s talking about it from a US perspective, but it’s probably many countries, we could say that. Because in reality, this is something that is going to be so impactful in a negative way for the prosperity of our children, our children’s children, etc. It’s a huge discussion. I know a lot of people like to come to podcasts to get some kind of actionable advice about what they can buy and sell, but that’s not really what we like to do here.

We like to have these bigger-picture conversations because if you want to build long-term wealth, you need to think about these things. So this is probably more just wanting to hear your thoughts about his views because I encourage everyone to go and listen to these conversations. There’s no point in us regurgitating what he said. You should listen to him. He’s been around for a long time. He’s incredibly successful.

By the way, he also, I think a couple of years ago, started to, like you and I talked about, the dangers of inflation building up etc. So, anyways, long story short, the underlying problems of debt interest, which also Ray Dalio has been out warning about, how does that sit with you?

[00:55:05] Cem

Yeah. So both of those names are names you don’t take lightly. Dalio, Druckenmiller, they are thoughtful, very successful investors. I agree with I would say 95% of what Druckenmiller says, about 90% of what Dalio says. I feel good about that, being in good company. Druckenmiller has talked a lot recently about the lost decade that we’ve been talking about now for some time.

That said, I do think the debt issue, at its core, is not the primary issue. I think he really paints it as the primary issue. He completely agrees on the inflationary pressures, the populism, the deglobalization, all the things, and so does Dalio. But I think there’s a linear thinking that happens when you start thinking, relating a country like the United States or Europe to a human being and an individual about, oh, well, you’ve spent like a drunk sailor, there will be repercussions.

I don’t think markets really work that way. I know it’s not fair. In a fair mathematical model, that’s how it should work. Pretty simple. But in a Fiat world, which is what we live in, the exorbitant privilege of the primary currency of trade, which can change, I get that. There’s definitely a breaking point under which that is no longer the case. But until that point, the primary currency or currencies (can be multiple), have the exorbitant privilege of being able to create and remove debt without massive repercussions. I know that’s a heavy thing to say, but it’s true.

We have created $10 trillion of debt in the last several years. What happened to the dollar over that period? Tell me. What have been the net repercussions over that period? Actually, it has the opposite effect, generally it tends to drive money back to the center. So the question is, really, and again, I know there’ll be lots of people that disagree and that’s what makes the market. But the question is, where in a time of stress and a time of deglobalization, in a time of populism, in a time of military, economic, resource conflict, do you find safety?

If I look around the world, regardless of the amount of debt the US has or any other country has, I can’t find another alternative. There’s nothing that even comes close. This is an island that is on the other side of the world protected by two oceans. It’s the biggest economy in the world, the biggest military in the world. It is resource heavy. We have all of the food, all of the commodities that we need to produce. Most importantly, though, we have a rule of law and a decentralized rule of law. It’s not perfect.

There’s all kinds of ugly warts and problems to this country, debt being one of the major ones. But if you or I are going to put our money somewhere when the world is falling apart, I would prefer to have it here than in China or I guess we could argue maybe the EU as well. But there are problems in the EU as we know as well. This is not just a pro-American, I live here. Again, I want to be clear, I grew up abroad. I’ve lived here, I’ve lived in lots of other countries. This is not a pro-American statement.

The US has all kinds of major, major problems. I could go on and on about it in a separate podcast. But it does mean that your money is legally safe here as long as you follow the rules that the US, which is a decentralized kind of system, and there’s a lot of problems with the litigious and legal systems we have here, but they are decentralized and they do hold up. So my view is really that over the very, very long term, if we’re talking 500 years or so, at some point, that stuff may matter.

Think about what Nixon did in ’69 to ’72, with Johnson first and then Nixon followed up on, and just untied us from gold. That ultimately was a maneuver to say, look, we’re the big powerful entity in the room. We’re Rome. We’re going to tax all of our provinces. Until that changes, until Rome falls, and it usually doesn’t fall overnight. It’s usually a slow death. People always like to think about the implosion of an Empire, but it usually is a slow, slow decline.

I think maybe we’re heading down a slow decline. I can see the picture for that for sure. But is that happening in the next 50 years? I don’t think so. Is it happening over the next 200 years? Probably. So I think the idea here that that debt is going to ultimately be the cause of the major implosion that happens in the US is I think misguided. I think there are other issues that, broadly, are going to cause problems to economies globally. I don’t think the US is the specific problem.

[01:01:11] Niels

I’ve been quiet all along because it’s always interesting to hear which direction you go. It was a slightly different direction than I expected.

…

No, no, no. Not your view. But I wasn’t thinking about this as a dollar story, so to speak. For me, it was more like, what are we going to do, what are our children going to do or their children when there are no pensions, when we can’t afford pensions, when we can’t afford welfare?

[01:01:47] Cem

But Niels, yeah. I think that it’s important to understand that the dollar and the debt are intrinsically tied. At the end of the day, the Fed, much like Japan has, can take back all of its debt internally. They can just buy the debt. They can take it off the external books. If you do that, the Fed and the Treasury are the same thing. We’re just printing money. At the end of the day, you can print, I know it sounds crazy, but the US has done it, we just did $10 trillion of it. We printed $10 trillion dollars and our currency went up.

In this environment, as long as the US is the bully in the room or the primary means, we have the ability to make that debt disappear. We have chosen not to at this point because we don’t need to. I don’t want to say we. I hate saying we because it’s not us. But the reality is they have the ability. Japan did. How was Japan able to? Because Japan has been strong because the US sits behind them, and that’s the important point.

[01:03:02] Niels

I take that point. Again, I want to wrap up. But I will say, at the same time, that sitting over here in Europe and some of the other central banks, they print money as well. Even in the US, even though you printed all that money, certainly where I’m sitting from, you see even a country like Denmark which a lot of people will say that’s a decently run fiscal kind of country, you know the health care system is falling apart, completely apart.

Obviously, the UK where you hear about this, 65 hours waiting time to get an ambulance. At some point, I think people are just going to say, we’ve had enough. This is completely unacceptable. That’s what I meant. But let’s keep that for another conversation because I do want to just one final little question and maybe the answer is that we’ve already kind of talked about it. But I couldn’t help noticing that gold is sitting pretty much at all-time highs. Any thoughts, any views? Is it another attempt?

[01:03:02] Cem

I got that one right, spot on several months ago. Again, this is what happens during these regimes. You get significant volatility to commodities. Everybody was scratching their head at first. Precious metals, not all commodities, and everybody was scratching their head into that initial decline. But it’s always a function of positioning relative to secular realities. You have to wait for people to give up.

Well, guess what? The world kind of gave up on gold after it seemed like an obvious trade and here we go. Now comes the squeeze, and we’re at all-time highs and about to break out. I would argue that, yes, we will break out but as I’ve mentioned, it’s not just a matter of price. Everybody wants to know up down. It’s a function of volatility. The volatility has been too low in precious metals, particular upside calls. That’s how we suggested people played us from day one, and that continues to be the way to play this.

It will not be a straight line, much like it’s not a straight line with long-term treasuries, much like it’s not a straight line with the dollar. But certain trends are very much in place here and the right way to play it with those parts is playing the leptokurtic distribution that we’re seeing, there’s that word, and to really play it with the tails of the distribution here and particularly upside for gold.

[01:05:32] Niels

So it took an hour and eight minutes before we heard the word leptokurtic today, but there we are. We got it in finally. We can now end our conversation on a high note.

Cem, as always, it’s been fun, it’s been a pleasure, it’s been insightful. Next week, I’m joined by another fun, insightful person named Rich and no doubt, if you have some questions, he will be more than happy to tackle those. You can either email them as usual to info@toptradersunplugged.com.

If you’re enjoying these conversations, do give us a little hand to expand our listener base by leaving a rating and review. It is a great help for us and of course we love reading your reviews as well.

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

[01:06:27] Ending

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