257 Systematic Investor Series ft. Cem Karsan – August 19th, 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 markets through the lens of a rules-based investor. Cem, great to be back with you. As always, it’s been a busy few weeks since we last spoke. How are you doing?

[00:00:39] Cem

Doing well. Summer is at its best part here in Chicago so we’re enjoying the weather here and school is about to start. We’re going to the fall, which I think has not only an effect on us as humans, but obviously the markets as well.

[00:00:56] Niels

Yeah, absolutely. Now, we’ve got a really good lineup, very expansive. We probably won’t get to all of the points, but we will be tackling as many as we can. But before we do that, I always like to know what’s been on your radar the last few weeks. There’s so much noise out there. I was just wondering if there’s anything that caught your attention other than the topics of course we’re going to be speaking about.

[00:01:22] Cem

Yeah, I think the biggest stuff is from 30,000 feet, the push and pull that we see from a macro overhang, things that move much slower, bigger liquidity issues, the news that keeps coming out tied to those bigger structural issues, and then the underlying flows, which have been very, very supportive actually in the context of that big macro liquidity issue. So that push and pull I think, that tug of war, which we’ve seen a lot over the last few years particularly becoming more prominent, more dynamic.

It’s a sumo market, you know these guys, a really big pushing back and forth, something I’ve referred to in the past. So I think that’s my biggest takeaway. There’s so much vol supply on the market. That’s really playing a dramatic role in a lot of the market microstructure. But I think we’ll get into that as we go here.

[00:02:17] Niels

Absolutely. Before we do all of that, I as usual will just give a quick update on the world of trend following which is incredibly uneventful at the moment. Another very quiet week, at least at the time of recording which is Thursday afternoon. But perhaps investors are saving up all their energy for Jackson Hole next week, you never know.

I actually did look at our own 30-year track record in our trend following strategy, and frankly, August has been pretty volatile historically. So perhaps, many of the market participants are on holiday of course during this month, and maybe that’s why we can push the markets from time to time a little bit more than necessary and that will give more variation in performance during this month of August.

But in any event, as I mentioned, performance is pretty steady at the moment. Flat, slightly down, nothing too much. I don’t know about you, Cem, it’s just something that I thought of now. Do you have any memory of how vol tends to do during August or the summer months? Is there some kind of seasonal pattern in volatility?

[00:03:28] Cem

Oh, my goodness, seasonality. Do I ever. Listen, seasonality, much like a lot of trend, is a function, not trend, I shouldn’t say trend, that’s the wrong word to use around you. I don’t want to trigger retaliation (laughter). What I mean by that is more technical factors tend to be a function of real core structural realities of the market, things that we study very closely. That correlation of the calendar to these factors is what causes seasonality, but they’re not as consistent as the calendar.

There are different things that have a tendency to be better or worse during different times. Some of that is direct beginning of month, end of the month calendar. Some of it is expiration cycles, which are middle of the month, middle of the month, and some of those things can be negative during these periods or positive as a function of other factors that tend to be maybe more positive or negative on their own.

So, I’ll give you some examples that are directly related to what we’re seeing now. August expiration is an expiration that as soon as you hit August expiration, which we’re about to by the way this Friday, you open up to the next cycle, next main monthly options cycle where there’s a ton of open interest and a ton of imbalance in the market on the option side. That’s the September quarterly.

There are four quarterly expirations. These are the biggest because structured products are tied to them. The overwhelming majority of volume that drives into these four expirations are March, June, September and December. December is less relevant because there are other factors. But the other ones, if you look at them, it’s not a coincidence that Feb into March, which we’ve talked about with the COVID crash and lots of other occurrences, it’s the second worst month, particularly the back half of February before the spring gets started.

It’s not a coincidence that “Sell in May and go away,” is a thing, because again, mid-May, you transition into that June OpEx and the risk that exists there. It doesn’t mean every month it’s going to be bad, to be clear, but there’s more tail risk and more potential volatility that exists in those environments. September, again, generally mid-August is when this stuff starts. People say September is the worst month, but really, from late mid-August, late August, through September is when things tend to happen. Again, this is a major factor.

There are other factors as well that play into this. There are less holidays during this period really since July 4th. There is a span from July 4th all the way, except for Labor Day, here in the United States, all the way untill you hit Thanksgiving, there’s only one holiday, and that means there’s just more volume and more time-weighted volume. It’s also about more participants coming back after the summer now and you get to mid-late August and September and those things all matter because now participants have to rebalance, have to participate or are more involved.

There are other factors which in an up year are very positive. At the end of each month, there is a collateral increase. The markets are about $40 trillion as we’ve discussed here in the US, $80 trillion globally, $450 trillion of on long assets. If the market is up 20% on the year, that is just in the US, $8 trillion of new collateral that can underpin new risk taking. Obviously, each month that you’re up, we’ve had 5% plus months recently, that means a ton of positive flows going into end of month, beginning a month.

However, when you start to see retracement of some of those gains, you see the opposite at the end of the month. Here we are down already in the month. We’ve seen some support going into August expiration, but you’re going to see less support into the end of the month than usual, if anything, some supply. You’re seeing the removal of the support from vanna and charm flows, which I talk so much about on here, going into this August expiration. You have a lot of risk sitting out there in the Sep OpEx and all the open interest there.

So these are some of the clues and some of the ways you think about seasonality and why the trends of seasonality exist. But they’re not tied to a calendar. They’re not a magical construct tied to the moon. They are tied to these other flows which are tied to volatility, expiration cycles about the repurchasing of assets as you go, the reinvestment of assets as you go into end of month, etc. But the fall tends to be weak for a lot of these reasons. It’s not just the fall in general, it’s particularly as we reach this August expiration here and we start to move into the Sep OpEx.

[00:08:26] Niels

What a timely point to have you on, I would say, after that explanation.

Now, before we jump into the topics, you mentioned quickly performance, S&P struggling a bit. My own trend barometer closed at 41 yesterday. That’s neutral. As I mentioned, it looks like so far at least this month, it’s a pretty flat month. BTOP 50 up 8 basis points, up 6 basis points for the year. SocGen CTA up 42 basis points, down 64 basis points for the year. SocGen Trend flat for the month, down 1.38% for the year, and the SocGen Short-Term Traders Index down 40 basis points in August and down 3.5% for the year. As you Cem alluded to, MSCI World down 4.5% this month, up 12.4% for the year. Government bonds are taking a hit again this month, down 1.23%, I’m sure we’ll come back to that, and the S&P 500 down 4% as of yesterday, up 14.7 for the year.

I want to kick off at a high-level question. People say that volatility trading is very complicated and it should be left to the professionals. But if we go back in history, a little bit at least, it strikes me that seemed to be a very “simple pattern” that started a few years ago. Let’s think back to 2017 when stocks were doing well and volatility kept dropping and these short vol products did exceptionally well, attracting a lot of investor capital.

We then had a short and somewhat unexpected for some equity correction around February of ’18, and volatility was rising significantly for a few days, maybe for a couple of weeks. All the naive short vol funds blew up, long vol strategies did well and became popular for a while. Central banks came in, calmed things down. Equity markets started to rise, long vol funds start to bleed and become unpopular, short vol funds start to do well, it sucks in investor capital yet again, and what do you know, a virus comes along. Then volatility explodes, short vol strategies get roasted and long vol funds do well if they managed to monetize their positions at the right time of course, and long vol strategies become popular again for a while.

But then something new happens. Stocks start to fall, but in an orderly fashion. So despite stocks going down, the pattern repeats. Long vol funds start to bleed and short vol funds do well, and that’s pretty much where we are today. So if I was a guessing man, I would say that the likelihood of something happening that would get volatility to spike, short vol funds to get hit and long vol funds to do well at least for a short period of time, is pretty high based on this pattern in the last few years. So I’m curious of course to know from an expert; Is vol trading that predictable?

[00:11:27] Cem

It is. Human nature is predictable. What I mean by that is you just alluded to the most recent several years. If you want to extend that sine curve, I can go back a couple more years. August ‘15, massive vol. We’ve talked about this at points, a massive vol event relative to the beta of the move. That was the yuan devaluation. Feb ‘16 was actually the biggest decline we had since ’09, 12%, massive underperformance of vol. What comes after that?

The vol apocalypse that you alluded to, ’18, followed by Ocnodise, the biggest decline we had since ’09 again, massive vol underperformance because it was three months, it was a slow grind in vol. It was very well supplied. Fast forward to COVID crash, vol overperformance again, and then now 2022 underperformance into the decline. So it’s not just three data points. I could go back further than that. It is a sine curve, and that is human nature. People crowd into what’s working. People always think the risk in the markets is to the downside. The reality is the risk is two-sided.

If you’re an investment professional, we both know if you don’t match a benchmark, if the market continues to rally, particularly for majority of long-only funds or thereabouts, they have to be more invested. The individual investor also feels that FOMO. But it’s a real existential fear that happens at the end of these rallies. People have to be in the market. They feel like if they’re not, they’re going to go out of business. For many people, that’s actually true. They will go out of business if they do not meet that beta. So people have to take risk when the market starts presenting itself.

But the opposite side of that is when you get a COVID crash, when you get a vol apocalypse, when you get these massive vol events, the people who are short vol get blown out. The people who held vol, who were brave enough to stay in through those cycles or to time it right get paid with convex returns, and that just changes the supply and demand dynamics under the hood in terms of who’s still around, but it also changes (guess what?).

People look at the recent performance, they say, “Oh, I like that fund, that fund is doing well,” and people invest in that. Why would you ever invest in a short vol fund? Did you see how many funds blew out during COVID? Guess what? Nobody’s talking about that anymore. So this is human nature, and this is why that sine curve exists. I think we know that just to make it very clear. So where are we on that spectrum? Well, everybody got taken out to the cleaners in ’22. That was long vol into that decline. Vol didn’t work. If you were long stock, long vol, it didn’t work.

So we are moving along a spectrum of people selling more and more vol, being less and less hedged and vol being less popular from the long side and being more popular from the short side. I wish I could say it happens every six months or every year or every year and a half or two. I wish I could give you the exact timing. It’s not that easy because there are other factors that rotate around it.

This time, and I think we’ll dive into this maybe a little bit later, it’s a little bit different because the vol supply is being driven by some other factors other than just short speculation. There is some structural vol supply and I think that may extend the picture even though we are heading down that sine curve.

[00:15:14] Niels

Yeah, we’re definitely going to dive into that because there was kind of a reason why I asked you this question. One other question came up as you were talking.

The first thing I thought about when I just heard your response there, I was thinking, what does that mean? I hope I’m not stepping on too many toes when I say this. Does that really mean that you shouldn’t buy a long or short vol fund really, you need to have something that can do both?

[00:15:43] Cem

I think you can buy a long or short fund as long as the person who is managing or the entities managing it are able to be fairly dynamic and have a deep understanding of these realities. I think this is the problem with the perception of vol. People say, well, if you’re long a vol fund, all they’re doing is going and buying puts and they’re buying the same puts or same put spread or whatever the strategy is over and over.

Yeah, if you buy an ETF that just does the same strategy over and over; that’s long vol or short vol, guess what? During certain periods, that’s not going to work. In other ones, it’s more likely to work. But there is a real ability to understand positioning and predict the probabilities of certain different outcomes with a higher degree of probability than random by a significant margin.

It’s also possible to look at a relative value and see what’s cheap and what’s expensive dynamically and use those two edges to really, whether you’re on the short side or alongside, create real alpha and provide both edge from a short vol perspective and long perspective, or from a neutral perspective. The key there, much like any strategy, is finding somebody who’s worth their salt and knows what they’re doing.

So no, you should not go just blindly invest in long vol strategies, and no, you shouldn’t go invest in short vol strategies either, because either one can totally blow up in your face, just like any strategy can if you don’t know what you’re doing.

[00:17:13] Niels

Yeah, that’s a fair point. Now, again, I’m building up to my bigger question, but I need to throw this in as well, and that is another thing that I think people probably have noticed with volatility. Again, you can obviously correct me if I’m wrong here. But it seems to me that these vol spikes, when they do occur, they’re becoming shorter and shorter in time. They last some of them just days. Is there a reason why that may be happening, so to speak?

[00:17:49] Cem

I think characterizing that over a more medium-term timeframe. Again, I try not to look at things in years, but in 5, 10-year perspectives. I think clearly, with the market there’s a lot more volume, a lot more participants. There’s a higher degree of sophistication broadly, even though there are also more naive participants involved as well. It’s a more mature market in that sense, and so people understand the realities of insurance and the realities of that there’s a premium that generally is priced to these things.

So there’s a popularity to being short them given the right windows where it’s more likely to be the case. I think that does create a situation where there’s just broadly more liquidity and more sophistication, participants who are willing to put markets back in line to some equilibrium. Whereas maybe in more illiquid times, that equilibrium was hard to reach because there just wasn’t enough liquidity broadly. So I agree with that broad concept.

That said, I think we’ve also seen more extreme moves. I think what you’re feeling is not just that they get dampened more quickly, which, I think in the last year and a half, is true because of vol supply. But I think the general reality is that yes, things get pulled back into equilibrium more quickly is probably fairly true. But I don’t think we’re giving enough credit to how extreme some of these moves we’ve seen and how historic they are.

Don’t forget, February-March 2020 was the biggest one-month move in history. We’ve seen dramatic moves under the hood in other, maybe not the index level, but in rotation and breadth, and extreme vol moves in, think about mimems and other things; crazy, extreme leptokurtic moves across the market outside of equities, bonds, precious metals, commodities. Oil went to negative$30 and then went to $120 in a matter of years.

So yes, I would say the characteristics of the market are changing, but that’s partially because vol markets themselves are playing a bigger role. They are more sophisticated broadly in the sense that you have more participants that are willing to hop in and put them back into place. But they are so big and they’re becoming bigger in the market in a sense that when illiquidity strikes, the moves can be dramatically bigger for some shorter period of time.

[00:20:20] Niels

Okay. All right, that’s great. So now here comes where I was going with this. You see on Wednesday next week, so only a few days from now, we will be releasing what I think is one of the most important episodes we’ve ever done, and it’s with Neil Howe, the New York Times bestselling author and co-author of the book The Fourth Turning. But perhaps more relevant, he just published his follow-up called The Fourth Turning is Here.

Now, of course, you have not listened to this conversation yet, Cem, but what I can reveal is that Neil is quite worried about how bad the fourth turning could end, which isn’t until 10 years from now really, and he does expect a lot more volatility in the years ahead. Now, since he was pretty spot on when back in 1997, I think it was, they wrote about the period we’re going through right now, I have little reason to think that he will be wrong in his prediction.

I wonder if you can imagine and perhaps even describe what it will take to have a much higher base level of volatility. So instead of an average of the VIX say 15 to 20, perhaps it goes as high and as long, much higher, much longer at a base level of 50. What will it take? I know I’m asking you to speculate here, but I think we can go there. What will it take, do you think to get to a level, because I don’t think necessarily you completely disagree with what Neil is expecting?

[00:22:03] Cem

Wow, this could be a two-hour conversation. I have a lot to say about this. For one, I will go on record for saying I completely agree that we’re entering something that I think is fair to be characterized as a fourth turning. I have laid out my reasons for why I think that’s the case which are somewhat different. They’re related, but somewhat different than Howe’s. They’re related, but I think I have a broad framework for talking about this and it’s really tied to this inequality and populism factor and what that means demographically for the younger generation. That’s really the driving factor.

In my opinion, that’s why these things happen, that’s why these cycles happen, and that’s how it’s playing out. Again, this is almost like looking at technicals and understanding what happens and then understanding why, and I think I have a very good hold. We’ve been taught about this for three years. We’ve been pretty spot on with it, not just in terms of what markets are doing, but more importantly in terms of what the trends are in political and social means.

When you start to look at what’s happening under the hood and you are a student of history and you look at the other periods that are related and try to understand what might happen during these periods as a function of that, you now begin to be able to say, okay, the probabilities on a 10-year timeframe, based on what we know, are x, y, and z. What we’ve seen during periods of inflation, during times of increasing interest rates that are generally tied to populism are periods where you have less global trade, deglobalization broadly, more conflict between countries economically, militarily in every way.

Why? Because populism, people are local. People care about their people, not the other people. When you talk about supply-side economics or monetary policy, that is international. When you send money to corporations, corporations work across borders. To break down borders, it is the power of entropy, and to get to the cheapest, most profitable place, that’s incredibly powerful. That’s what we’ve been experiencing for 40 years, but that created inequality and now the populism is what about my people. Fiscal stimulus is to the people of a country. So that’s what we’re amidst right now.

That deglobalization takes us from a time of cooperation to competition. It causes resource scarcity, it causes OPEC to stand in and say, I’m going to control price. The food crises that we’ve seen during these periods, the energy crises, these aren’t coincidences. The fact that we started the last Cold War in the 1970s, the fact that we had our last Hot War in the form of Vietnam War, not a coincidence that we’re seeing the same things. We kind of covered this. These things are all connected and these give that thrust to the cycle.

Again, because it’s not just stratification, because it’s generational. It’s based on the experiences of the young and the young are labor when they leave high school and college. They are the bottom of the distribution. That leads to a broad societal change. That’s why we’re entering the fourth turning among some other bigger, longer cycle factors coming to a head at the same time. So the natural supposition there is volatility must increase. We’ve done quite a bit of work on this.

In the 1970s, we had three recessions, quite a few from ’68 to ’82. We had a tremendous amount of volatility in economic volatility, global volatility. If you talk to somebody in the late ’60s, early ’70s, about what it felt like, people felt like the world was coming apart at the seams. We had race equality conversations here in the US and globally, not a surprise that those things are coming to a head as well now. All of those things, felt like the world was coming to an end. A lot of assassinations, JFK, Robert Kennedy here in the US, all of these things are connected. Sorry, go ahead.

[00:26:21] Niels

No, I just want to say one thing for those who may not be so familiar with Neil’s work. You’re absolutely right in pointing these things out. But the ‘70s wasn’t a fourth turning. So that period is a transition period as well. It’s an awakening, which actually are labeled in the US as well. So definitely not a coincidence at all in what you say. But fourth turnings are even worse.

[00:26:46] Cem

Right. So I do think this is a major turning point, like a 40, 50-year turning point. Again, I think we’ve seen, I could go back to the 40, 50-year period before which is the ’30s into the ’40s, which was obviously another time of dramatic conflict, etc., and for a lot of similar reasons. It’s not a surprise that we had the New Deal in the ’30s, we had the Great Society program in the ‘60s, we have now the Biden fiscal COVID stimulus now. But the bigger point here that I’m trying to get to and to tie it to volatility, which is your question, is that ironically, during periods like this when you have inflationary periods, assets are nominal, particularly equities and other assets are nominal.

So the first-order effects of inflation, which is a natural output of this populism, is to dampen downside volatility. If you get 10% inflation a year for 10 years on average or whatever it is, markets will naturally normalize. That will decrease the value of longer-term skew in the market. This is the old shaving of coins. You can fix markets nominally, without people noticing, by simply taking away the buying power over time. You haven’t actually reduced real volatility. Your real volatility is probably still just as high. But from a nominal perspective, you can dramatically reduce volatility.

During the 14-year period, ’68 to ’82, as we’ve talked about, markets went nowhere in nominal terms so they lost 70% in real terms. Ironically, from 1929 to 1943, you take that 14-year period, markets also in real terms lost 70% of the value. The losses were much more dramatic in nominal terms because you didn’t have inflation, you had deflation, and the reason you had deflation is because the Federal Reserve was not dominant. We were still tied to the gold standard. They didn’t have the flexibility to shave the coins like they’ve been able to do in the last crises, and we still have that flexibility.

So my belief is that yes, we’ll have real volatility in assets, in hard assets and stocks even, but that actual nominal volatility, ironically, is not going to be as high as people expected. If anything it will continue to get compressed over time because the put in markets will become bigger and bigger. In ’68, we had a 24 approximate price-to-earnings ratio, record price to sales at the time. By ’82, it was a 4.5 price to earnings and margins had dramatically normalized so price to sales was much more normalized. GDP growth was strong.

Yes, we had three recessions and more volatility under the hood, but net GDP growth was strong. That should be the case in this populist type environment that we’re entering as well. Now, that doesn’t mean we’re not going to have a volatile world. I think that’s a distinction that’s very important. We’re going to have a volatile world. I think, as we saw in the late ’60s through to 1982 as well, we saw dramatic asset volatility outside of long assets. So FX volatility, precious metals volatility, rates volatility, these things were historic and didn’t stop for a decade. They normalized to dramatically higher levels.

Actually, the opposite was true for let’s say industrial commodities. Industrial commodities had dramatically low volatility. Yes, they had an upward slope and they continued to work their way higher, but they had a new put in the form of resource scarcity and entities with more power, much like the Fed had a put. That oil put was in the market during that time and that dramatically reduced volatility.

So anyway, I think it’s nuanced is my point and understanding that we’ll be getting likely volatility, we’ll be getting leptokurtic outcomes in terms of the world and certain parts of the market. But it’s important to also understand that nominal is not real and that financial assets can often create less volatile situations. Anyway, a bit of a diatribe. That’s why I said this could be a two-hour conversation.

[00:31:14] Niels

No, I took you there, so I really appreciate that. I think you have a very interesting point. By the way, in fairness, what Neil will also talk about, in a few days when we release the episode, is the fact that you actually never know how a fourth turning pans out, which is the scary part in his view. He is worried, not least about volatility in his view, but it could be also as you say geopolitical volatility of course, but also inflation and interest rates. But we’ll leave that for now. Maybe you and I will talk about it once you’ve listened to the episode and we’ll do that next time you’re on, so we’ll see.

Of course, you and I have talked about this. I have shared this view about high interest rates and inflation for two or three years and I know you have as well, so I think we’re very much in line. It kind of ties a little bit into something I noticed in your latest news update or quarterly update, which I thought was interesting, not necessarily we want to go there because you’ve got a lot of topics as well.

But you did go on by ending the quarterly update by saying, “Powell’s idolization of Volcker and current embracing of his own Volcker moment is politically expedient, misguided, and destined to fail. The long end of the curve has yet to wake up to this reality as inflation stabilizes at a higher plateau in the years to come. The coming loss of credibility at the Fed will likely mark a period of increased global volatility and the second letdown.”

What I wanted to say with that is credibility is of course very closely tied to confidence. You and I are recording, in only a few days, with perhaps the foremost expert on confidence, namely, Peter Atwater, who we last spoke to in June of last year, you and I, and it’s a very timely point for him to rejoin us for our conversation.

All right. Now, we don’t coordinate our topics many days in advance, let’s put it that way. So there was another point I actually found in your latest quarterly I wanted to ask you about. I hope that’s okay.

It’s a little bit tied maybe to what we talked about here. But maybe there’s something in it when I remind you of it that makes it even more current, maybe you have a different angle, and it’s actually something you and I never really discuss a lot other than we did a little bit with Peter Zeihan last year, and its demographics. I noticed you spent quite a few pages and you have some great charts with the Gen Z, millennials, and Gen X and all of that population. You talk about ownership of these different generations and you also talk about unions at Starbucks. Do you want to say a few words about that particular topic? I actually find it very interesting.

[00:34:13] Cem

Yeah. Listen, a few things are as direct to supply and demand and future outcomes as demographics. Demographics is destiny. But that doesn’t just mean the number of people. The reason it’s critical in this time is because millennials represent a new bubble in terms of the number of people, importantly, the number of voters coming to political dominance as the last bubble is dying. That is a handoff that’s happening every year. Every four year election cycle, there’s a dramatic change in the number of voters, and this shift could not be more dramatic in terms of political beliefs between the two.

Again, to Howe’s point, these things happen and this isn’t a coincidence. They almost are defined relative to one another. They exist because of one another. Millennials grew up during a period of massive increasing wealth inequality. We had 1.75% average real GDP growth over their 30 years of growth coming to maturity, and only 0.75% of that went to labor per year. The other 1%, for the whole group, went to the top 1%. So it was almost 100% growth in the very, very top 1% in terms of wealth, in terms of income. All of that has, if you do that for 30, 40 years, that’s a lot. Compounding at 100% is quite a bit for 30 years.

We’ve gone from a 0.32 Gini coefficient here in the US to I believe it’s 0.46 now; a dramatic change in inequality and the distribution of wealth. We’re in line with most third-world countries now. This is not a political comment on my end, it just is. If you have a population that was by definition, and I think this is the critical point that people don’t make that it’s not just a wealthy versus poor. It’s older versus younger.

If you were a baby boomer, you had assets and as assets went up and corporations did well, you did well. If you were coming out of college or high school at that time, at the beginning of that or throughout this process, it was difficult to get a job, it was difficult to gain more wealth and more labor power as corporations did for all the reasons we talked about. So there is a universal feeling among millennials that the system is broken and doesn’t work for them.

They have 40% of the household formation, 40% of the wealth creation that baby boomers did at this age. That’s the critical point. They are way behind. Many of them are living in their parent’s basement still unable to afford a home, etc. Those things create a real distrust for government, a focus on justice and equity and equality and fairness. These things we’ve seen again in other periods lead to political change, and that is what’s driving populism.

It’s not just the generational piece, it’s also that they’re so big and they are gaining more and more political power every year. It’s not a coincidence that starting about a decade ago, the left moved dramatically left, Bernie Sanders and AOC, and that the right also did the same thing. We had Occupy Wall Street, we had Tea Party. Left and right, similar things starting about a decade ago, but it took a bit more years, almost another decade, for Trump to bring the right left populace in terms of rhetoric at least, kicking and screaming, and the left to go even more left.

A spark in terms of COVID, and then comes the fiscal waterfall and the move towards populism. So demographics is destiny. But it’s not just the size of the group. It is the zeitgeist of the group and how it gets formed and why as a function of stratification as well.

[00:38:29] Niels

Yeah. I really truly hope every single one of you will tune in on Wednesday when we release the episode with Neil Howe. People should just be aware that it is the millennials that will actually rebuild not just the US, but pretty much the world because these turnings have now become synchronized because of the big world wars we’ve had. But they’re the ones who are going to rebuild after everything falls apart, and that’s why they’re so important.

All right, Cem, with that little appetizer for our regular topics that you brought along, we’re going to dive much more into the here and now. This was some big picture stuff that I just wanted to hear your thoughts on. We have had (obviously, a little bit after we last spoke) what you describe as a three week kind of stair step-down action in the equity markets. There’s a big tug of war going on at the moment between flows and macro. Can you take us into that world? What’s going on? How do you see things at the moment?

[00:39:42] Cem

Absolutely. Last time we talked, we had a conversation about some of the coming at the time liquidity drain coming from the Treasury and the Federal Reserve. Liquidity up until call it two months ago had actually been quite strong relative to what people expected, and that had played a significant role. We all know all the correlation graphs between broad liquidity and market performance. But we weren’t the only ones pointing that out. This was kind of well-known, well-telegraphed broadly that there would be a significant liquidity drain. It was a function of two things.

One, in March, when the quantitative tightening was really getting going, we had a banking crisis and there was a bunch of liquidity pushed in to save those banks. But then on the back end of that, after that, we had a debt ceiling issue here in the United States, and that forced also a TGA, a Treasury General Account drawdown, which also pushed a bunch of liquidity back in the market. So starting really back in July, maybe even late June, it was clear that we had $1.3, $1.2, to $1.6 trillion of new issuance that was going to be coming on the market in the next nine months. Well, what happened?

The Treasury was very aware of the potential risks, whereas people thought they’re going to fill $800 billion of this in the next month and a half, they’re going to have to. Well, they cut it in half, they shortened the duration. They started to really step lightly into it because they wanted to make sure it didn’t disturb markets. What happened? Well, given that people were reflexively preparing for it, we began to see, yes, the liquidity come down, but markets take off. The decline was not that dramatic.

By the way, in these liquidity graphs, there’s like a 0.97 correlation. You see one-year periods where they diverge. It happens. They just come back in-line. Notably, 2019, starting in early 2019 till February 2020, in the crash, there was a massive divergence between these models. Then, guess what? They came back in-line. So these things aren’t a straight line. You can’t use these models. These are big macro liquidity flows. They matter. Historically, with a .X in correlation, they will eventually come in line. The question is, how long can they diverge?

But we talked about these things and that they are a macro overhang and nobody really seemed to care for a couple of months. The markets kind of kept going. But then all of a sudden, you start like a hollowing out the inside of a sand dune. You don’t see it from the outside, but the fragility continues to build, and then all of a sudden, that last couple pieces of sand happens and things start to cave in a little bit. I think that’s how I would characterize these liquidity draws. Guess what? They had to soft-pedal it early on, so now they’ve got to accelerate it.

So they started announcing, okay, we’re going to extend duration, we’re going to accelerate the amount we need to do. I think from a political perspective, I think Yellen and Biden were (obviously, this isn’t a conspiracy), the Chair job is to work directly under the President and do his bidding. I think the political thought is well, we’d rather get out in front of this now because we can’t just keep putting it off, because otherwise, we’re going to have a problem come election season a year and a half from now. So they came and announced that they’re going to have to do more issuance, extend duration, etc. That market didn’t like that all of a sudden this month. Guess what? These are all part of the same thing. These are the things we’ve been talking about.

Right as that’s happening, Japan (coincidence?), starts to say, “Well, we need to raise interest rates too, and the market started to worry. Well, if they’re raising interest rates, that probably means less liquidity for US bonds as well. Guess what? The yields started going higher and higher and have been working their way higher, and then guess what? Fitch all of a sudden opens her mouth and says, if you’re going to issue so much debt, maybe we’ve got a downgrade, this is a problem, and then Moody’s chimes in.

So everybody points to each one of these as something new is happening, markets are at risk, macro, that’s why markets are going up. Nonsense. The reality is, yes, they matter. That’s all we know and we’ve been talking about for several months. Things can diverge for a while until the actual core liquidity accelerates and it overwhelms the flows. So that’s the macro picture. That’s what we are up against, and it’s not linear, it doesn’t happen week over week or even month over month. But once you start talking quarter over quarter or year over year, it really, really matters in the prediction.

The flows however are a different story. Several months ago, let’s go back three, four months ago, five months ago, markets were pretty imbalanced. People were under-invested, a lot of short interest in the market. That has completely changed. People are back in the market, sentiment is near all-time-highs (well, not all-time highs), but recent three, four-year highs. You’re seeing a lot more speculation, call buying in tech. Tech beta has dramatically outperformed, yada, yada. The market on its core is much more balanced, so that’s important.

Underneath the surface, there’s this thing I kind of alluded to at the beginning of the show of there’s dramatic vol supply. So markets are actually fairly in the core and the S&P 500 really… Vol is well supplied and very well offered, similar to a 2017 type scenario. Obviously, there are higher macro flows and macro risk, but overhead there is this vol supply where dealers are really well balanced and well supplied with convexity. I can get into a little bit more detail on that in a second.

But with that context, and broadly higher skew, and more concerns as the market rallies, there is underlying support that naturally happens in markets. The more markets go up, as we talked about in the seasonality conversation, the more momentum there is, the more trend there is, the more all the things we know that can push things higher for some. During a seasonally stronger period or less dangerous period where there’s less liquidity and broadly more structural quantitative supporting flows, that will go on until it hits a point of turning. So you’ve really seen this push-pull.

The support here, as we go in August expiration, very timely, has been quite strong. But during that week and a half, two weeks now, people realize what’s coming, that there’s not going to be this demand underneath as much that we’re starting to see more macro liquidity coming off. So we’re reaching this tipping and rolling over. There are other participants that realized the risks here at this moment. But that didn’t diminish the fact that we had structurally positive strong flows into here.

So what that’s created is this really stair step, very slow… If you think about it’s been three week, we got to 4,600 or 4,625 in the S&P, and now we’re 4,425. Two hundred points over the course of three weeks is, yes, it’s something, but it’s not volatile and the way it’s played out has been very straightforward. But now we’re beginning to approach, again, a point, as we go into September expiration, where there’s more potential tail risk, and the potential of volatility becoming a bit more unpinned, and the macro flows not having the counterbalancing flows for some short period here (maybe call it three weeks), this window represents potential significant risks in the market.

That said, if it doesn’t get going in this window, which is the critical time when the flows do not exist as dominantly, as you get early into the September expiration, if we don’t start to risk the gamma (the downside risk in the markets), we don’t get the momentum and the vol unpinning that needs to happen in this period, that will actually lead to more buyback and more structural flows, and more than just in this August period, actually, a significant amount of vanna and charm flows into September, which can then really extend the cycle a bit longer, or at least counter these macro flows to a significant extent again, and can extend the cycle a bit longer.

So we’re at a very critical three-week period here. I know that sounds very specific and sounds almost silly relative to these big flows, but that’s the reality. In order for these macro flows to take over and the market supply and demand balance to become very, very supplied and potentially create more macro risk, you really need those flows to not be as present during this period. Those flows, they’re just simple demand, if that goes away it can create a significant problem.

But again, we’ve front run it a little bit, which reduces some of the potential volatility in the short term. There are people probably better prepared for it, partially because guys like me are out there talking about it. People see the trends and the technical realities of these things. But again, if we make it through this three-week period call to Labor Day without a significant vol unpinning or some clues that this thing is getting significantly more unpinned, it’ll likely be bought back into Sep OpEx for the last two weeks or so of Sep OpEx. Then sitting in November, December, up year, significant collateral increases that got to go to work at the beginning of the year. Very different than last year.

We highlighted last year that Santa Claus and January Effect wouldn’t exist last year because guess what? It was a down year, and a lot of those flows, which everybody thinks those are positive periods were actually negative periods. This year with the market up, if we don’t get some kind of real drawdown here that will be supportive, not to mention all the holiday season coming and all of the things that the holiday of the time-weighted volume decreasing that will likely lead to a very positive November, December, early January if we don’t get going here soon.

So these are the reasons again why seasonality kind of exists like it does. It’s not just a counter effect, but it is structurally a very important period and critical.

[00:50:29] Niels

It’s interesting you mentioned that. I have not studied this myself, but I did see someone, I don’t know if you call it tweet about this anymore, whatever you do on X, but post something that said, well, because this bear market had now retraced more than let me just say 80% or 85% of the drop, history just basically says it’s going to go and make a new all-time high. Thoughts?

[00:50:56] Cem

Yeah, I think this world, be very careful just extracting some numbers like that and drawing a line. We haven’t had inflation at all for 40 years. That kind of changes some of those numbers quite a bit. We have a very unique macro environment here in the sense that we have inflation for the first time in 40 years.

The last time we had inflation, we didn’t have structured products and we didn’t have derivatives. Structured products, derivatives are a dramatically important part of this market, they are, in certain periods, dominant to the whole market, while at the same time having a completely different macro reality than we’ve had. So it’s unique from a flows, a macro perspective, and a market structure perspective.

I think drawing any broader conclusions based on, “Oh,the market is up 85% so it’s going up,” would be very flawed. That having been said, go to all-time highs, if we don’t get a shot here and these things tend to go longer than you ever expect. Like I highlighted 2019 to 2020, almost a year of complete divergence from liquidity, and the market eventually came back in line.

[00:52:08] Niels

Which is one thing I remember you talked about actually that even though you might see things go “wrong” at some point, you did say, earlier in the year, that yeah, I mean, we could very well have a massive melt-up before we get to that point. Exactly. I want to add one more thing just to make sure that you have talked about it the way you want to because before we pressed record, you said that one thing that you are really watching is actually the NASDAQ. So do you want to talk about why that is the case?

[00:52:42] Cem

Yeah, so this is I think a critical thing. I’ve been trying to talk about this a little bit more. This is so important to understanding markets is the connection between vol and broad markets and how they move the way they do. We have a very, very unique situation here in the sense, like I said, last time we had inflation, we didn’t have structured products or derivatives at all. That’s creating a completely new never been seen before situation where there’s a new massive feedback loop.

It used to be that markets would, if interest rates were higher, money would just simply move to the bond market, which was pretty isolated from the stock market and would decrease the demand for stocks in a significant way. What we’re seeing now is yes, that’s happening. But at the same time, people aren’t just going into bonds exclusively. People are looking for yield on top of those bonds. There’s a massive demand and increase in structured product demand.

So what you’re seeing is money moving out of the stock market and into a lot of structured products, and things that essentially say, okay, yes, I want that T bill of 5.5%. But that’s not enough. I’ll take my collateral and I’ll stretch it to 8.5%, 9%, maybe 10%, by supplementing it with some type of vol compressing tool. So that vol compression then is a massive wave of derivative supply to dealers which now has a feedback loop into the stock market by all those metrics we’ve talked about.

It enters the market, allows it to levitate a little bit longer. By definition, the way a lot of these strategies work, if it levitates long enough or it doesn’t liquidate, then come back all the buyback vanna and charm flows, all the things we talk about, all the natural flows that come in all the time to continue to hold it up or push it higher. So ironically, higher interest rates are driving vol compression, and at the same time, support for the market. This is not something that existed before so it’s dampening volatility. This feeds back to our volatility conversation as well, and it’s very unique.

You can’t look at the ’70s in a market performance per se because it didn’t have this element. This element is an important feedback loop that is changing. This is not vol selling like vol selling you would think people are shorting XIV speculatively or selling iron condors. These are generally low-leverage. People are moving from the stock market, de-levering in a sense, to go into structured products. So these are strong hands, they are not weak hands.

If the market goes down, they’re not going to go up their structured products. They may not do any more and that might increase vol once those start to roll off. But ironically, interest rates coming down now, when that happens, if and when it ever happens here, is probably going to be a period for less structured products issuance and maybe an unpinning of volatility much more than the opposite from a vol perspective. So it’s a somewhat stabilizing force into this liquidity situation and a very unique, very important topic that nobody’s really talking about that I think is critical to understand.

[00:52:42] Niels

Yeah. Actually, even in my little trend following world, we see kind of the same thing. People are coming out with products, they call it return stacking and all sorts of things where they just do exactly what you described.

[00:55:59] Cem

It makes sense, right? If you can get 10%. It’s not just how great those yields were. Structured products would yield 4.5 before, now it’s 9.5. It’s not just the yield. Great. Yeah, that sounds amazing. It’s the fact that this market is also more dangerous, has other risks and the liquidity is coming out. As an alternative to the stock market, it looks incredibly appealing when you look at the last two years and what’s happened and what’s happening from a global perspective. So a market that went up for 13 years almost straight averaged 12% a year.

A 4.5% structured product is essentially irrelevant. A market that’s gone nowhere for two years and has all kinds of overhang, then you can get 10%. Wow, that sounds pretty amazing. So this isn’t speculation, it’s not crazy risk. It’s simple realities that you can stack and use capital efficiency of derivatives which didn’t matter forever, to get some really interesting structured product returns. So to carry that point on now, why is this other than what I just already mentioned important for market structure?

Also, what it’s doing is now that vol is very focused on one part of the market, which is the S&P 500 or the major indices globally as well, but the S&P sits in the middle. So that vol supply is really focused in one place. What does that mean? We’ve talked about this before. Well, that means there’s other places where that’s not the case. The geopolitical risks and the rotations are dramatic. We’re seeing them. Interest rates are going higher. So you see parts of the market dramatically move. But if the market is pinned in the middle, that means rotation.

So we’re seeing historic rotations, not just one way, one way then the other way. Starting in 2021, we saw dramatic decline in growth versus value relative to history, historic in many ways. Tech, starting in ‘21, had already declined significantly before the decline of markets, and then guess what? Got to February or so of ‘23 and everybody was positioned long put, short call in Tech, people were betting against the Nvidia because China might invade Taiwan, new narratives.

Now the rotation begins the other way and it’s very powerful. It’s been incredibly powerful since February, March. We highlighted this by the way in February of this year, saying it had gone too far and it’s time to start playing the other rotation. Guess what? As of a month ago, we highlighted both of our macro flows and we’ve been pretty public about it. Well, guess what? All the call speculation in AI and all the Tech, it played out its course, the prices had gone high enough, market makers were demanding more, it was too crowded, and we know index vol is pinned so prepare yourself for a pretty heavy rotation and here it comes.

I think that’s the important part when we start talking about dispersion, this word dispersion is at a historic level again. Single constituents versus the whole is right back to 2017 levels, which itself was out of context from 125 years of history, not a coincidence. This is because of that vol supply in the middle of the market and the S&P and the feedback loop that exists there. So when you start to understand this market structure, you can start to play what’s important in the market, which is these rotations.

You can start to see when everybody goes to one side of the boat, well, prepare yourself because it can be pretty violent back the other way and you’re going to have people running to one side of the boat then running to the other side of the boat. Not just in growth value, small-cap, large-cap all these things that we’ve seen which are historic; have driven these historic lack of breadth and all the things we’ve been talking about, but it can even be in commodities, it can be in rates, and it could be in precious metals, areas which are not as big a vol center that can really, really see dramatic rotations as these things start to move. I think it’s critical to understand that dynamic.

[00:56:33] Niels

Yeah, true. You mentioned about rates going higher. It is of course interesting that on the day where we are recording here, Thursday, I think German bunds actually made a new low now in this downturn lower than last year, and the US is not far behind. I haven’t checked any of the other markets. So we are certainly at some really pretty critical levels.

[01:00:21] Cem

Yeah. Transitory 2.0 is also now looking wrong. At what point do people start saying, wait a second, transitory 3.0 might not be a thing either. I think that’s the critical point that you brought up in the paper we had. At some point, the market starts to lose that confidence from the last 40 years that oh, this is just a cyclical story, and it’s about short-term supply and demand. There is a structural move in rates afoot and it doesn’t go in a straight line. But as markets wake up to that, that becomes a reflexively inflation reinforcing mechanism as we know and that is really the biggest risk to markets.

[01:01:00] Niels

Yeah. Therefore, it really is very timely and it’s going to be very interesting for you and I to have that conversation with Peter when we record next week, and it’ll come out in a couple of weeks. The other thing, of course, is that I think a lot of people are surprised by the fact that bonds keep falling. You and I have had some of the smartest of our friends from the global macro fundamental side, I should say, on the show. Even last year, they started talking about being bullish on bonds. So not to call them out, but really just to say, I think there are a lot of managers, portfolio managers, who basically just got too bullish too soon.

[01:01:39] Cem

Yeah, I think the best thing, for the bet on higher inflation and longer-term inflation, that could have happened for this year was the February, March dramatic decline in yields; the bank run. That trade was very crowded as we reached 4.1% in the 10-year because it had gone straight up in yields and so everybody was really betting on higher yields at that point.

If you look at this market now, and talk about people being on one side of the boat or another, people are broadly stuck and still in deflation mode now with that 10-year rate climbing near recent all-time highs. When you have the macro effects we talk about now coming into line with positioning, which much more is now, that’s when you have to be careful. I’m not the only one highlighting it. But these levels in the 10-year are very important and you could really see a pocket if it starts to go, and that is really the greatest risk.

Again, I think the risk there too is once it happens, you start to break out to these higher rates, higher yields. At the end of the day, that might be a loss of confidence broadly.

[01:03:06] Niels

Cem, you know what? There are so many more topics that we have written down for today so what I’m going to do is just simply ask you if there is one that you want to pick out that you think we definitely need just touch on or we can wrap things up as we are. I think we’ve done pretty well in covering quite a few important topics.

[01:03:26] Cem

Yeah, I think we covered quite a bit today, I will say, from microstructure to macrostructure. The one thing I guess I would leave people with is I’ve been doing this for 24 years, markets are reflexive machines. The reality is these things can go on longer than you expect. That doesn’t mean they’re not going to happen. We saw 1999, 2000 happen. We were talking about 1998 in markets. The NASDAQ doubled before it dropped 92%. That’s why we got the blow-off top there. Similar in ’07, we were talking about the housing crisis in late ’06, early ’07, it didn’t happen till ’08.

Again, it doesn’t mean these didn’t happen. It didn’t mean they weren’t historic and dramatic when they did. It’s just that the reflexive market machine forces shorts to get squeezed, forces implied volatility to bottom, and there are forces much like these structural products that I allude to that can extend these things longer than you could possibly imagine. It doesn’t mean macro doesn’t matter. It very much matters.

You have to keep your eye on that ball, but you have to be flexible and understand that there are other flows under the hood that matter in the short term that can extend the cycle and you have to be flexible. I always tell people, be water. That’s a critical point that you have to understand.

[01:04:53] Niels

Yeah, you mentioned the word structure products, but I imagine, and I want to hear your words, not mine, are you also referring to the passive investment flows that we have seen?

[01:05:05] Cem

Not specific to the passive but they definitely play a dramatic role as well. The more vol is dampened, the more those passive flows naturally take us higher. So vol dampening, if you can get markets to not move or not move big or not to become unpinned, there is a natural drift that comes from so many factors, not just the vanna and charm, the passive flows, just simple interest rates say that arbitrage constraints of the market has to be higher 5.5% a year. There are so many natural positive flows, buybacks, etc., from simple earnings that you cannot, in a vol pinned market, during periods of strength of flows, really try and bet against it.

But there are windows and there are times when those flows are not present or the macro realities have a tendency, historically, not all the time, to play catch up. They can sometimes do it very quickly during those windows and it’s important to be prepared.

[01:06:09] Niels

You know I said earlier in our conversation today that I think the episode on Wednesday will be one of the more important ones we have ever released. I think our conversation today is one of the most important ones you and I have done because I think we covered so many things and I just think that unfortunately, I’m not sure people are fully prepared for what’s ahead, but you are doing a great job in highlighting all of these risks. So I can’t wait to have you back in a few weeks again of course.

Now, if you love these conversations as much as I do, please go to one of the favorite podcast platforms that you like and leave a rating and review. It really does help us to grow the show.

Next week, I will be joined by Rich, so this will be a fun and certainly very educational conversation, no doubt. But we will also be able to take some of your questions if you have some. Of course, this will be going from the vol side to the more trend following side I’m sure. But if you have a question, 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. Until next time, as usual, take care of yourself and take care of each other.

[01:07:21] 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.

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.