250 Systematic Investor Series ft. Cem Karsan – July 1st, 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 the Systematic Investor series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global market through the lens of a rules-based investor. Cem, great to be back with you this week. It’s been a busy few weeks since we last spoke. How are you doing?

[00:00:39] Cem

Doing well. It’s good to be back as always.

[00:00:43] Niels

Yeah, absolutely. Now, we have got, I would say, a pretty awesome lineup of topics, even if I have to say so myself, which I can say because you brought up most of the topics, and we’ll be tackling them later. But before we do that, I’m always curious from a really big-picture point of view just some of the things that have been on your radar.

[00:01:05] Cem

Yeah, a lot of interesting times. I think we started talking six months ago or so about the likely way this ends being a blow-off top. We’ve been waiting for some upside momentum to squeeze shorts and change sentiment. So I think that’s a big thing that we’re watching and thinking about. The NASDAQ strength versus the Russell which we’ve seen has been remarkable. It makes sense. I think that’s an interesting thing that we should dive into.

Related to that tight end is just broad dispersion. Dispersion is having record performance. There’s structural reasons for that. So I think diving into the why and how that works is super interesting, and then just from a macroeconomic perspective, diving into a bit of how resilient the economy has been, which again, is something we’ve talked about for some time. This is a demand-push economy and kind of diving into that.

So there’s a lot of different levels but it’s a very interesting time with the Fed now being pushed back into the fray once again and markets starting to do some interesting things.

[00:02:14] Niels

Yeah, I always enjoy our global macro conversation. I’m sure we’ll touch a little bit on that as well. One thing that you and I don’t think have ever talked about on the Global Macro series and something that I saw on a tweet that came to my attention today was that apparently, the Hong Kong dollar seems to be struggling a little bit keeping its peg.

Some people, I think this was Kyle Bass who was tweeting about it. I know he’s been having a go at the Hong Kong dollar peg for a while, but still, it is interesting times. You have to take all of these small indications and say, could this be the beginning of something?

[00:02:54] Cem

Never mind dollar-yen, we’re seeing some real dislocation between the relationship between that and markets broadly and that might be a little canary in the coal mine as well.

[00:03:06] Niels

All right. Well, before we dive in, as usual, just maybe a quick update for people. I should say, first of all, that we are recording on the 30th of June, so the month is not completely over. We’ve still got a few hours, things can change. But from a trend following point of view, it looks like it’s been an okay month for most managers, slightly up, nothing dramatic, but still, it looks like it’s a positive month overall.

Looks like some of the old stories have come back. Fixed income, equities, doing well for different reasons. One, obviously fixed income having a hard time in terms of price so seeing almost new lows in some of the majorities and equities, of course, surprising a lot of people at the moment with the strong sentiment we see there. Actually also from a diversified point of view, grains and some of the other commodities have actually had a bit of a difficult time from a trend following perspective where some reversals came this month.

But anyways, as I said, looks like an okay month. My own trend barometer finished at 43 last night, so that is exactly neutral. So that probably sums up the first six months of the year. Looking at the numbers, it looks like the first six months of the year. The BTOP 50 is going to be down about 1% for the first six months, SocGen CTA Index also down about 1%, the Trend Index down about 1.1%, and the Short-Term Traders Index struggling a bit more, down 3.75%. While we know of course that equities are doing really well on all fronts and bonds this month in June are struggling a little bit.

Now, Cem it is always great to speak with you. But today, I think it is even better because it is this end of month, end of quarter, end of the first six months. So before we dive into your topics, I was going to ask you, how do you think investors are going to look back at the first six months? What do you think? I’m not talking about necessarily your takeaways, but how do you think investors are going to feel about the first six months of this year?

[00:04:42] Cem

Well, judging from everything we’re hearing, everybody’s ratcheting up future expectations. We were talking about the new bull market, we’ve had a complete about face in the last three months, never mind the last six months in sentiment and positioning, it really is accelerating here. I think that’s important. Markets are a reflexive machine. You can have really negative macro flows and macro issues and they almost always last. Markets generally hang in longer and go counter to what you might expect.

Things can stay irrational longer than you can stay solvent. That’s because of reflexivity, because of the simple fact that people are positioning to hedge against that. Ultimately, things end when that positioning itself get squeezed out and the macro realities still remain. So when you think about the last six months, we had a big overhang from a macro perspective, major issues that are well-documented, well-understood, with bearish positioning. At the end of the day, what that leads to is a shaking of bearish positioning. These things end with time and price.

Again, we’ve talked about this on the show enough, but whether it’s the real estate kind of bubble that we knew about in ‘06 that didn’t burst until ‘08, whether it’s the tech bubble which we knew about in ’98, ’99 which didn’t burst till 2000, whether it’s as simple as a shorter term timeframe as COVID which we knew about in December of 2021 but didn’t decline until February, mid-February, these things need to move in price and time in a way that shake shorts and conviction and reflexively undo themselves.

So that is what we have seen in the positioning. The positioning was on all metrics incredibly historically bearish at the beginning of this year and that critical point is what has really driven these flows. The macro picture in reality has actually continued to get worse. When I say worse, just from a liquidity perspective, just dollars and cents systematically has gotten worse. This is not like the macro. I’m not talking about geopolitics really as much or other things.

The simple liquidity situation is significantly worse and continuing to we’re now transit 2.0. The Fed has now once again paused and is now continuing. Just yesterday, we got GDP ratcheted up from Q1 in a significant way. So all of those things are pointing to what we’ve been talking about for some time that the macro slower moving liquidity picture is getting worse. But again, we are in the process of changing the narrative.

[00:08:40] Niels

Sure. Well, we’re certainly going to dive into that straight away. I just want to make one small comment, and I don’t mean to correct you here, Cem, but I think people might be confused. I think when you were referring to 2022, that was the Ukraine thing, but 2020 was COVID.

[00:08:55] Cem

Correct. I meant to say COVID. I apologize.

[00:08:56] Niels

Yeah, exactly. But actually, we knew almost I would say about both because in 2022, we knew that certainly inflation was coming back from COVID, so there was…

[00:09:07] Cem

It almost always applies. Yeah, you’re right. I was really referring to COVID in 2022.

[00:09:11] Niels

I know, and I knew exactly where you were going with that, so it makes sense. Now, you already kind of gave a little bit of a teaser on some of the things we’re going to initially talk about. I think you could say let’s start with the US-focused side of the equation. You mentioned real GDP. Why don’t you just start from your perspective and let’s go through some of the things that you’re paying attention to and sort of see how you feel it fits into what’s going on in the markets.

[00:09:41] Cem

Yeah, so it’s all about timeframes. I don’t think I emphasize this enough. I think in the back of people’s head, they understand that. But for the most part, people think if they’re bullish for the next three years, that they should be buying and if they’re bearish for the next three years, they should be selling and it’s kind of a set-it-and-forget-it thought process. Unfortunately, that’s not how these markets work. You can have 30%, 40% index moves up, if not more, in the context of a very bearish topping process.

Again, we’ve seen this during the tech bubble, we’ve seen this during the great financial crisis, bigger numbers. I don’t have the numbers in front of me but ’99 to 2000, I think the NASDAQ doubled in the last three to six months before it declined by 90 plus percent. Those are big numbers. People celebrate a 5% rally or a 10% rally. I often say be like water. You have to be flexible and move and position also on the distribution, which we talk so much about, as opposed to just being long or short.

So in terms of timeframes though, we’ve been on a longer timeframe. Just to kind of set it up, the longer timeframe, we’ve been talking about this for years now, I think, and we’ve been proven very right is we’ve moved to a much more demand-push economy. The fiscal stimulus is an order of magnitude bigger than anything we’ve gotten in real terms and that continues to work its way through the system. That is not something that is complete. That is a dramatic tailwind to demand.

To be clear, the lower part of the distribution is the key here for keeping inflation sticky and labor supportive. That’s not just money going to those people too. It’s just broad populism and the labor rights and whatnot that come with that. That is creating a situation where the cyclical game that’s been played for 30 years, the two-dimensional game we’ve talked about, is really not following the rules. Everybody’s like, why is this not working? The bond market keeps getting it wrong. The bond market is never wrong. What do you mean?

The bond market keeps being wrong because it’s playing this cyclical game and the reality is there’s a secular underpinning structural issue that is being ignored by many participants and that is what has led to what we saw yesterday. Again, GDP growth of 2% in real terms. This US economy is growing at 6.1% in nominal terms. Where’s the recession?

The recession is not here because we have a strong demand push that’s coming from money in people’s pockets in better labor position, more job security. There’s 1.7 job openings For every person looking for a job. We’re still at historically low unemployment. So guess what? Call it transitory again, and here we go again bringing them back into the fray and this is exactly what we’ve talked about before the first transitory and again here. At some point, people will wake up and begin to realize what’s actually happening here.

Now, the confusing part for people is people automatically assume if the economy is strong, that must be good for the market. That again, if you’re playing this cyclical game, makes sense. Historically, however, in inflationary periods, it does not work that way. Why does it not work that way? Because if you have sticky inflation and people begin to realize that, that perpetuates more inflation, and at the end of the day, that means there’s an alternative to stocks, there’s less liquidity coming into assets writ large, you have margin compression on top of that.

So GDP strength can be very strong, but margins can start to collapse in the face of significantly less buybacks, less demand for assets broadly, and then again now, you have an alternative 5.25% yields, 6%, 7%, 10%. At what point if you can get a 10% yield is anybody going to put money in the stock market? It is a real thing. We talked about TINA all day long every day for a decade or two and now nobody seems to be talking about the alternative, which is an incredibly important part of the story. So we’re facing incredible liquidity headwinds despite what is a very strong and robust demand push economy.

Enter the story of the late ’60s through ’70s, same exact type of market. It becomes ultimately a stagflationary type circumstance during certain periods and is something that is very hard for policymakers to manage. This is almost, I would say, impossible at the end of the day because there’s a populism that they have to feed at the same time as trying to deal with this difficult price stability versus employment circumstance. So kind of a deep dive in the longer-term picture, but again, that’s the longer-term picture.

So that doesn’t mean you sit here and you just start shorting everything and trying to buy the tail because the world is coming to an end. 1968 to ’82, for 14 years, the market went sideways in nominal terms and lost 67%, almost 70% of its value but you had massive rallies. You had 75%, 80%, almost doubling markets. You had three declines of 20% to 50%, three recessions in a relatively short period of time and a lot of geopolitical stress and major crises along the way.

The key was to be nimble and to trade it from both sides and to not be focused on beta, which is the key, because beta would have led you to, at the end of the day, 0% returns with a lot of volatility and losing 70% in real terms, which is the more important piece. So again, stuff we’ve talked about, but you need to be dynamic, and that’s where flows and liquidity come into the story and where positioning is so critical.

So with that framework, we move forward understanding that there’s a secular trend, but that doesn’t mean we’re not going to get dramatic moves in bonds, bond yields, and in stock market returns in the interim. Interestingly, now we go into liquidity. What is driving liquidity now? As I mentioned, record short positioning earlier this year which has had to be unwound. There are supportive things that lead to that happening and that is one of the things that I sit at the center of which is vol supply.

So when you start to get to a point in a down market where vol is very, very, very well supplied like we saw last year, at some point, a decline reaches enough of a level where it’s hard for it to continue and if vol is compressed, it’s hard to get a sideways type action in that with short positioning on the market writ large. Why? Because there’s structural things everyday that go by, which I talk about, which buy back stocks structurally. Some of that is just fundamental in terms of just earnings and other buybacks, other things that have a natural positive push.

Interest itself, markets increased by 5.25% a year. Fed funds is at 5.25, it’s just how it works. So they’re just positive flows from a fundamental perspective but they’re also underlying risk, vanna and charm buyback that happens every day, which is I think a much bigger thing than people realize puts the downside risk every day that that doesn’t happen that is a buyback that happens underneath the surface. So we’ve seen that happening.

That’s kind of what started the process and eventually forces sentiment to a much more balanced level. But generally, that accelerates at the end because people hold on to their shorts, they’re under-positioning. I say shorts, it’s not just shorts, it’s relative to their benchmarks. At some point, they are forced, they’re literally forced to buy back in or go out of business. It is fear at the end, and that’s the part that people don’t talk about. People associate fear with the downside.

There is a real existential risk to survival for those in the market who do not track their benchmarks and that is generally a benchmark that is pointing upwards. That fear is what accelerates these things towards the end. It’s what leads to a quick pivot by banks and other entities that have been overly relative in the short-term relative to where the market is doing, where they should be, and it forces a squeeze at the end. That generally tends to happen as vol starts to hit its nadir and you start to see what we’ve talked about a lot, market up, vol up. So vol ends up, it ends up bottoming and generally coming in with much more buying to the upside.

That ultimately not only has the function of pulling vol supply, which is what has started this whole initial process, it has the function of unwinding it over time here and pushing customers into a much more long vol circumstance and dealers into a shorter vol positioning. But it also ends up creating more and more in the squeeze. As you might imagine, the more simple idea, potential energy. We’re lifting something further and further off the ground creating realized potential energy, as well as importantly, the part I most first talked about, which was it now has fixed narrative and positioning and squeeze out shorts.

So this is how the game works. This is how the whole system works. You begin to ask yourself, where are we on that timeline?

[00:20:36] Niels

You read my mind.

[00:20:37] Cem

Yeah. The answer is, well, not early innings. We just talked about all the early innings, those have passed. So the key is that last part is, by definition, this is difficult. You can’t get a vol and if it’s easy, it just doesn’t work that way. That means people are not prepared for it. So the answer is, where are we? In my view, you’re at the point of the game where the tail is getting fatter and you continue to swing in shorter timeframes for the fat pitch, but you have to look at very short-term indicators.

These are not quarterly indicators. These are not even necessarily monthly. They are windows and times where narrative and positioning really enter a very dangerous period. So we’re really looking at high frequency, meaning like daily, weekly, up to monthly kind of data in the context of what is a declining picture on middle and longer timeframes. I think a great example is we were very, very vocal there at June OpEx.

June OpEx was a huge skew-positioned, structured product positioned cycle. It’s a quarterly cycle. It’s been around for a while, led to not surprising, and we were talking about this, big flows pushing it up into OpEx as we’ve talked about many times here. Those quarterly OpEx are very, very powerful, and guess what? As you’re doing it, positioning starts to squeeze all the call, speculation starts to gain fervor, everybody starts; whether it’s AI, polls or just looking at Twitter sentiment indicators, everything starts going parabolic in terms of sentiment and positioning. So that’s a spot to take a swing given the macro perspectives.

Take a swing, get 100 point down, vol doesn’t react, you don’t get what you need to see, because again, vol hasn’t gone far enough and positioning hasn’t gotten far enough, and that’s what tells you. So you take your winners and you kind of wait, you start playing for the next leg of the blow-off top. Again, these blow-off tops, is it going to be 20% or is it going to be 40%? Who knows? We’ll see.

I’ve been doing this for 24 years and I was early for 2000, I was early for (I don’t know who wasn’t), early for 2008, but I made a lot of money on all those and the reality is you’ve just got to be prepared and ready and understand how these things work. This is a good time to own upside calls longer dated, as I’ve said it before, to play what is likely more market up, vol up in this type of a market environment, and you can short stock against it in the windows and play accordingly.

You can fund that in other ways, in other parts of the distribution, which we believe are overvalued but there is an incredible opportunity here. Again, the best trading in ’99, for over a year, was to be long long-dated calls and short stock. You made money on the way up and you made money on the way down. You did that and then eventually captured the big decline that came. Again, that’s coming from a lot of old fogy experience of mine, but you started to see something very, very similar in ’07 and ’08.

Across the board, that is the one part of the distribution now, again, reasonably macro bearish. But before that happens, you tend to get a blow-off top and that’s how these things in the short term are likely to unwind.

[00:24:35] Niels

I’m going to venture into some questions that I’m not necessarily sure that I fully understand but I’m trying to catch up and always trying to stay close to the headlines as I enter into conversations with you, but I’m trying so let me see if I fully get what it is you’re saying and maybe we’ll touch on this in a slightly different way. So in a sense, you’re expecting markets to have this blow-up move. Whether it lasts six months or three months, who knows? That makes sense.

I think as you talked, you mentioned this is what we typically see. When I hear other people talk about volatility at the moment, there is a disconnect compared to how things normally move. We’ve had S&P up close to 6% this month. We’ve had VIX down only 3 points, at least it’s going down, but you’re talking about market up, vol up, and vice versa perhaps even. At the same time, I’m seeing these papers coming out saying with a flat term structure at the moment, it’s really, really hard to be long volatility at the moment.

So it sounds to me (and I’m sure you will be proven right), but it almost sounds to me that when this happens, investors might be really badly prepared for it because what tends to happen is that it is so expensive to try and stay long vol, and we’ve seen long vol managers go out of business in the last 12 months even though markets took a turn to the downside last year, where you thought, yeah, that’s definitely going to make long vol managers some money, but it didn’t.

Now we’re in a situation where you’re saying I think this could turn out to be the last hurrah before something major to the downside. It also sounds to me that you’re saying, and actually, there may be very few people being really prepared well for it when it comes because of a lot of these factors.

[00:26:50] Cem

Yeah. To be clear, the two are intrinsically connected. They have to be poorly prepared for it for it to happen, and that’s kind of the point.

Let’s dive into vol real quick. I think this is important. This is going to answer your question. What’s happened in the last year from a vol perspective? Vol came down, people were very well hedged on the index level, broad market level for the initial decline. We’ve covered this in depth. Vol didn’t work. All the institutional hedgers got destroyed on that move.

So if they were 110% long because they didn’t want to sell all their performing tech and they were hedged with 30 delta puts call it, or something along those lines which would notionally take them out of their downside, those puts continued to expire, not perform, and yet their beta got destroyed. So they didn’t perform as they would have hoped and expect that we’ve seen this throughout history. We’ve covered this. We won’t go into all of it again.

But there’s many other cycles where this has happened when people are hedged that vol doesn’t perform. That lead to an exodus from 30-day vol and any implied vol products and anybody who was short vol got inflows right. So vol beyond zero DTE, there’s been an exodus of hedging and an increase, a dramatic increase of selling vol.

I can’t tell you the number of conversations I have a day with, “Man, I made 30% plus a year just selling these puts and these calls” or selling puts and selling stock and people are just doing that now because it’s worked. That’s just how dealer positioning works. There’s a trend to something, it works, everybody crowds in and then it blows up, and then everybody gets out, and then it works for a while.

[00:28:49] Niels

Sorry to interrupt you here, Cem, but this is exactly what XIV was doing, right?

[00:28:53] Cem

Correct. This is going to dovetail exactly into that because we’re going to get into dispersion, we’re at that record dispersion level now. At this very moment, it’s like highest dispersion profits ever. Guess what? The last time we had that was 2017, and that’s not a surprise, because that’s just the way the system works. But let’s dive into why that is and what’s happening. That 30-day vol exodus happened.

It’s funny, when I was at the equity derivatives conference speaking, there was another panel before me that I was listening to and it was all institutional structured product shops and banks issuing structured products, and they were talking about how they were hedging their risk. To a person, they all said, well, we’re not really buying puts anymore. That didn’t really work. I don’t believe in its ability to work, which I’m guessing they wouldn’t have said in March of 2020.

But instead, what we started to do is actually actively hedge with zero DTE options. I am not kidding you. These are big, structural players hedging. The concept is not incorrect. What was working was that realized volatility was actually working quite well but implied vol did not perform. This is not just mom and pop yoloing zero DTE options. There’s a demand and desire to not be exposed to implied volatility insurance premia and simply to hedge your realized day-to-day risk. It means a much more active approach, etc. But that’s what happened early on.

There was a significant move to speculation both from speculators but also hedging into realized volatility products like zero DTE. Guess what? As soon as they started doing that, that stopped working. So now what have they done? Well, maybe we’ll just hedge less because the coast seems to be clear. So that’s led to massive now selling in zero DTE and there was a significant turn, call it six to nine months ago, and it’s only accelerated. Now it’s just massive sellers in zero DTE. Now you have sellers in both.

So we’re moving along a spectrum of people abandoning hedges and not just abandoning hedges but short vol sellers moving from what was a big fat pitch in this implied vol that was high and skew that was high to skew and vol that’s lower, to now zero DTE as well. Again, this is what dealer positioning is all about in the vol level. Now, there’s been long or short the market delta but there’s also been long or short vol. So not only is it important in terms of price, in terms of getting a blow off top to squeeze things, but it’s also important because of time, because of the decay and the cost of holding hedges over time.

So if we don’t get a blow-off top, the other way this ends is with time. Time itself unwinds, it leads to too much vol shorts that can lead to a convex outcome. That’s ’17, ’18. There’s a couple of other examples. So that’s why this is a function, I always say this, of time and price, the way this unwinds. It is not just shorts in the market being squeezed and potential energy and everything I talked about with blow-off top but it’s also the building of vol shorts and under-hedged positioning relative to benchmarks that can lead to the undoing itself of markets, and they both matter.

So price and time are your indicators, your risk indicators for how this is going. As it currently stands, all that vol selling first leads to (and this goes back to ’17), first leads to pinning. So the first move, it’s not like the more short vol there is to dealers, it doesn’t initially lead to a blow-up. What it initially leads to is a pinning which leads to a momentum factor which leads to more and more vol compression, which eventually gets to such an unbalanced positioning that customers themselves eventually have to pull out. Very hard. It’s, again, like a blow-off top right.

But in inverse, you’re getting blow-off top in vol essentially. You’re getting over-positioning into short vol that initially pins, so again, much like call speculation initially leads to gamma effects but eventually leads to the unwinding on the downside. So, again, where are we on that? Let’s see. You’ve got to play dynamically and look, but zero DTE vol selling has dramatically increased. Structured product issuance sits at the core of this. Not many people are talking about.

The underperformance of markets or the risky macro outlook all combined with higher interest rates means a boon for structured products. That means you can get 5.25% under the hood and then pair that with higher vol levels to structure really what looks like nice little investment opportunities relative to maybe the risk-reward you’re seeing in the stock market. So guess what? That leads to vol compression. Those inflows lead to pinning and vol compression.

This was another thing talked about at EQD is like the amount of issuance they’re seeing for all of these structural products is through the roof record years. But that all then flows to banks, which then need to hedge it and then dealers are also long. So it’s not just in the options market. I want to be clear, these are structured products, which are probably even a bigger part of the market. So we’re at a point in the process where the vol markets are at the center of the action that we’re seeing and very critical to understand in terms of what the outcomes we’re seeing are.

Importantly, it’s also what sits at the core of the lack of breadth broadly we’ve seen and the dislocations we’ve seen. Macro flows are negative, as we’ve talked about, which lead just in real terms to less buybacks. You have real estate slowing down. You have other types of things, bank liquidity issues as we’ve seen, but all kinds of things that ultimately drive poor liquidity for stocks, particularly stocks have to refinance debt, etc.

So you’ve seen pressures across the majority of the market, like negative pressures, but with vol pinned (and vol itself is the center, the S&P is the center), if the S&P is pinned (we’ve talked about this), what that drives is other stocks have to go in another direction. Generally, in order to make up for the majority of stocks, it has to be a bigger stock.

Generally, the most likely outcomes for that breadth to break down are not just big names, but they happen to be vol centers. If there’s a vol center that is now short vol, where the customers are buying vol as opposed to the index level which has pinned, guess where the weakest spot is? That point of that balloon that has the least latex, that’s the thing that’s going to pop out to relieve the pressure of everything going the other direction. What is that? That’s Nvidia, that’s AI, that’s tech. That’s where all the yellow call speculation is. That’s where the short vol is for dealers.

So if the index is pinned and the broad average stock is having negative liquidity, by arbitrage constraints, something has to go the other way and it tends to be the short vol tech, AI center. That is exploding because of that, because the amount of pressure coming from the whole rest of the market with the index pinned is so much going into one or two or three or seven stocks that it leads to dramatic historic, which is what we’re seeing. Changes in rotation and breadth, and that’s what we’re seeing right now. So that is so critical for people to understand.

Everybody thinks about stocks first. An index is a combination of those stocks, whereas the reality is both are critically important. Macro flows broadly affect single stocks from an economics with buybacks and other rates; real flows dynamic. But the index itself is more driven by derivatives and things that are tied to that index, structured products. So the interplay between these two is critical to understanding what is happening and how this stuff ends.

That’s what led to record dispersion in 2017 to answer your question. We had historic selling of vol at the index level and that historic selling of vol at the index level meant that guess what? We had to stay within two standard deviations, some level of idiosyncratic flows to single names, those particular ones that weren’t vol centers, and those would still react to a beaten earnings or the death of a CEO or whatever it was.

As those things moved, that meant something had to move in the opposite direction given that the vol was pinned. So that led to by 30%, the lowest realized and implied volatility in 130 years of history, a completely out of sample outcome. That lower implied vol, which is out of a historic precedent also was paired, again, this is how we know this is what happened, with the lowest correlation by 25% in 125 years of history.

So now we’re seeing those levels again. It’s because the market now has the S&P 500 and the derivatives and the structured products and everything, which themselves have an incredible effect, and I would argue are as strong if not more important than the single stocks themselves.

[00:39:25] Niels

So you describe a situation where you, as far as I understand, where there are a lot of similarities to what you and I, and a few people listening today will remember from the tech bubble, and more people will remember from the great financial crisis. I have two questions. Do you think that the zero-day options, which we didn’t have back then, are potentially making this an even worse set-up that this could get- it’s hard to think of something that gets uglier than an 87% down NASDAQ, but okay. It can be ugly in many ways.

But is this a more dangerous situation? If it is, I don’t know what your answer will be, but if it is, who should be the grown-up in the room saying, well, hang on, it’s not a good idea. We are kind of giving people not just a loaded gun, but we’re giving them like a machine gun because of these instruments that they’re really not equipped for.

[00:40:34] Cem

Yeah. So first, straightforward answer. The financialization and the amount of leverage and access that we give as this market gets bigger and bigger does create, whether it’s zero DTE or something else, dramatic changes to market dynamics. The more leverage there is on the tails, yes, it creates worse outcomes. ’87 itself was a function of insurance. It’s well-documented, which is not that different than what we’re talking about, in some ways.

Again, to talk about that Feb to March 2020, that 30% decline which was fairly historic itself, which is more recent, was 100% tied, and even though COVID was the cause, 100% tied and related to the tinderbox that is these derivatives markets. So the answer is, yes, it’s another kind of brick in the wall. I don’t want to make it out to be like this is dramatic change. Derivatives have embedded leverage that most entities don’t fully appreciate and that even risk metrics across the market don’t properly control.

Now that we have more and more participants entering that space, which I believe, again, is a secular reality because they’re superior tools, I’ve talked about this, but the rules governing them and the education knowledge is such that it does create reflexively more dangerous outcomes when positioning gets to extremes. That’s magnified when you go to parts of the distribution that are hard to hedge, that sit on the edge. What do I mean by that?

So something like zero DTE by definition is the most gamma that you can possibly have. Prices of those things change the quickest. It can have the most extreme outcomes on a one-day basis. But in some ways, it expires at the end of the day, and then it’s gone. Whereas long-term capital management, for example, things could go to whatever price because it was a long way out. So there are good and bad things about these. They can exacerbate good effects in the short term on a one-day basis.

But in some ways, you could argue that they are slightly less dangerous in the sense that after that day move, it’s over. I’m guessing after that move, you’re not going to have everybody selling zero DTE because it’ll be blown out. But yes, what it does is it increases the probability that if we get a one-day move of, I don’t know, 7%, it’s going to be 20 or something crazy. I would agree with that. All of these derivatives are structurally vol accelerating, increase the tail.

We’ve seen this again and again, and we can point through whether it’s ’87 or 2020, all of the interplay between these. I do think it changes the market structure and the set of potential outcomes, which is why positioning is important, understanding that, understanding the net effects of it. But I think you’ve got to be a little bit more specific than just, hey, is the introduction of this going to blow up the system? Because, yes, all of these products and anything getting too unbalanced ultimately does lead, and broadly, I would argue the vol marked and getting bigger, broadly is a bigger issue writ large than just whether it’s the zero DTE.

Actually, to that end, I’ll highlight the structured product thing I had mentioned earlier. Structured products can themselves become much bigger in a huge part of this market and likely will going forward as interest rates go higher. I think that ultimately might represent a bigger issue long run, but I don’t know that we’re there yet.

[00:44:44] Niels

Does it make any difference? I noticed that for example, things like margin debt right now actually is not at its highest. It’s I think sitting around 650 billion. I think the highest is closer to a trillion or about 900 billion. So in that sense, you could say people haven’t gone out full in or full out or whatever you would say. Does that help?

[00:45:07] Cem

I looked at that. I don’t necessarily believe that because part of the reason for that is margin debt is more expensive. When you can borrow money at 3% versus 7%, people are just going to take more. On top of that, I think there’s money going in other places or other alternatives. So I don’t know that margin debt is going to get to where it was by the end of this. But it’s something to keep an eye on for sure.

[00:45:36] Niels

Yeah, absolutely. By the way, who needs breadth? The NASDAQ is having its best first half I think ever, up more than 30%.

[00:45:45] Cem

Yeah. Obviously, if you were long this year, you’ve done incredibly well, and that’s the point. I don’t want people to hear from these conversations like be bearish. I think the big takeaway, people hear the macro and that’s what people gravitate towards and say, okay, I need to get out of stocks. Well, you know what? You need to be dynamic. The problem is I think the general average market participant doesn’t rebalance frequently and doesn’t want to pay attention to markets. So they want to know on a one-year timeframe or two-year timeframe what are markets going to do.

The reality is between though now and a year, we may be up to 20% and then down 40%, 50%. That type of reality means a different type of positioning, which is, again, long call, short stock type positioning maybe with some extra call or under hedge. Those types of positionings are actually the right trade over that interval. But if you’re just looking to be long stock or short stock, that’s going to be something that’s hard to manage for the average investor.

[00:47:07] Niels

Yeah. I think people hear what we’re talking about but they may not always be listening, and it’s a little bit the same with the Fed. You and I even have talked to people who definitely we would consider being super bright in this field, and they’ve argued, oh, yeah, but inflation is coming down, and therefore, you should own bonds, and they’ve been absolutely right. Inflation has come down, but they have lost money holding bonds.

[00:47:35] Cem

Again, this ties into that cyclical versus secular. You have to really understand timeframes and play timeframes and position across the distribution appropriately. That is one way to kind of more set it and forget it and just be invested to the parts of the distribution that are going to work throughout the cycle. But the other way is just to be very active in understanding of those cycles, and as the positioning changes, adjust your cyclical positioning in the context of a secular set of outcomes.

I wish that it was as easy as should I be long or should I be short. It’s just what timeframe, what moneyness, what outcomes, what markets, to be specific.

[00:48:29] Niels

Now, summer holidays coming up for many people. You talked about I think in your notes that there will be I think some support maybe or a few more weeks. Do you want to talk a little bit about that?

[00:48:42] Cem

Yeah, absolutely. Part of the reason that we were very vocal about taking a shot from the short side at June OpEx, that was a quick 2.5%. But it was a short window. Vol didn’t respond, but it wasn’t just vol not responding. That’s important. It’s knowing going into that, that we had a big up month in the market. We had a long weekend here in the US because it’s very important. It sounds silly, but it’s actually a big deal.

You have a July 4th holiday on a Tuesday with half day on Monday for markets where nobody’s showing up to trade. So you have a four-day weekend, which is a long, long weekend. A two-day holiday essentially is 10% of the whole month of trading. Then you have a situation where like where, as I mentioned, vol didn’t respond, vol was very compressed.

Then you get into that important part that I’ve talked so much about, that week before the week of expiration generally that leads to significant increases in vanna and charm buyback, which are flows that you generally want to buy into. So you start piecing together on July 20, the Monday after you took this week and changed long short, and you start to see what the next three weeks holds. This was as of yesterday, two days ago, the 28th.

Well, the answer is to go long and to go with the flows. To be clear, that’s in the context of what could be, again, a very cheap ball to the upside. So there are ways to play this that aren’t just long stock or futures. So to talk to the end of month, beginning of month of piece when you’re up 6%, the US equity market is about $40 trillion dollars, 6% of that is $2.4 trillion of increased asset value. For anybody who’s invested in the equity market, that means a dramatic increase in collateral and reinvestment into the next month.

People lose track of this but the average amount of incremental flows that push markets is $50 to $100 billion a day, $2.4 trillion in a couple of days. Again, to be clear, that’s not all going to work the next month. We don’t want to overstate it, but just cut it in half, cut it in a quarter, it’s still a dramatic set of inflows. So people know that’s coming, systematic investors get out in front of that. There are some other counterbalancing flows like risk parity and other things that go the other way that mute it, but the reality is that that’s very positive in a very short time window.

Add to that, at the beginning, as soon as you start the first day of the month, which is when that’s actually coming in is on the other side of essentially a long weekend, which is then supplemented with vanna and charm acceleration and structured product hedging acceleration, and then you’re in like a very positive week in change again. It’s never a straight line. But it’s liquidity and flows. There’s a point where you kind of wait.

So now imagine with the squeeze that we’ve started to see already, and the need that people have the speculation on the call side with the leverage that exists in some of these tech names and the people who need to get back on sides and are underweight, you could see what we’re seeing today. That’s what we talked about actually a couple days ago, publicly, and here it is. So this is what leads to blow-off tops and over acceleration, people pushing the flows and getting over.

I could imagine if we get to 4600 in the S&P within three weeks, that would start to feel more interesting next time to take a shot. So these are the way these things in short timeframes play out. But I think you can look again, timeframes into the context of a much longer, bigger picture and what we’ve been waiting for and see where the opportunities lie. Again, that doesn’t mean you short, it, flat short it. People will get hurt if they do that blindly. But looking at higher frequency data and information like I’m talking about and then playing these bigger picture things is how you really win in these types of environments.

[00:53:38] Niels

Now, it’s so wonderful to have someone like you who knows all of these numbers, and so I’m going to take the opportunity to get ahead of the mainstream media who will basically come out, that’s my forecast. At some point as stocks move higher, they will probably come out and say, oh, yes, CTAs and trend followers are pushing the market higher. I just want to remind people, that those were the headlines two or three months ago when equity markets were slowly moving higher, and yes, probably around that time, CTAs were getting some long signals and buying a little bit of this.

But it’s always worth remembering that as these blowout market moves happen, it has nothing to do with CTAs or trend followers whether it’s financial markets, or as we saw earlier this year, the articles about how we were pushing or had pushed agricultural markets up last year after the Russian invasion. We are not the ones with the flows once the trends are so well underway. It is other types of flows as you so eloquently described here. Nevertheless, these are massive forces. It’s just nothing to do with the industry I represent.

[00:54:51] Cem

Yeah, I wouldn’t say nothing but I would just add you guys are just a piece of the pie. You guys are not an overwhelming majority. You’re not causing it, for sure. But I think your flows are important as well.

[00:55:03] Niels

Yeah, well, I just want to push back a little bit on when I hear that, because what people don’t realize, and that is, as you see the parabolic move, most people in our industry today, they use dynamic position sizing. So as you get the parabolic move, we’re going to be selling, we’re not going to be buying. So this is what people sometimes I think don’t realize, that often, we’re on the other side of the move because of the expansion of volatility.

So of course, there will be some systematic funds, I’m not talking about the shorter-term guys or whatever, but I’m just saying, the longer-term trend followers who are often on the front page of Bloomberg and other people describing us as being the one pushing prices towards the end of a big move, I just want to say that that’s really not what’s happening.

[00:55:54] Cem

I tend to agree with that. I think it’s important to know you guys are part of our equations, right? Definitely part of the bigger story, but I do agree that it’s not like the higher the market goes, the more you guys buy. But there’s significant trend flows that happen into an uptrending set of markets. That’s almost by definition how it works.

[00:56:24] Niels

Yeah. Well, as long as volatility is actually compressing, you could say that there will be a little bit of adjustment potentially where we will be supporting the market. That’s a fair point.

[00:56:35] Cem

But yeah, making you guys out to the core force is not…

[00:56:40] Niels

I wish we were that clever but we’re not, but there we are, there we are.

Cem, this has been a wonderful world tour of volatility. Once again, we only have a few more hours left of the trading day, month, quarter, half year. There’s a long weekend coming. Anything you want to leave the audience with as you guys head into your 4th of July celebration,

[00:57:10] Cem

Honestly, think about timeframes stay, understand the bigger picture but understand that usually, these things don’t stop from standing place, they kind of jump and then fall. Like I said, time itself and the building of short interest in the vol markets will ultimately also play a role. So make volatility great again, I guess I will say, at the end of this.

[00:57:41] Niels

I actually have a cap saying that.

[00:57:43] Cem

Yeah, we’ll have to do a video version and wear them. But yeah, after July 4th, no holidays for two months, the longest stretch and there’s a reason that generally, seasonality is weaker. Seasonality is not just a concept broadly, it’s not just a trend. Those things exist for many structural reasons, as I’ve mentioned. Best off heeding them in the windows when appropriate given what we’re seeing.

[00:58:15] Niels

Absolutely. Well said, and it’ll be very interesting when you’re back next in a month and a half or so to hear whether we had the blow-off top or whether we still have some ways to go. It certainly sounds like Q4 of this year could be an interesting one as well. Now, if you enjoy these conversations, which I hope you do, then I would suggest that maybe helping us out a little bit by going to your favorite podcast platform and leave a rating and review. Share these episodes with your friends.

As you can tell from listening to Cem today, these are important times and it is very worthwhile having a portfolio that is somewhat prepared for what could be both an interesting time to the upside but certainly also a time to be well protected maybe later in the year. Next week, I’ll be joined by Rich so we will have lots of fun tackling some questions and probably some deep dive into more of the trend following side of things. If you have any questions, send them to info@toptradersunplugged.com.

From Cem and me, thanks ever so much for listening. We look forward to being back with you next week. Happy 4th of July and until then, take care of yourself and take care of each other.

[00:59:36] 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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