268 Systematic Investor Series ft. Cem Karsan – November 4th, 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 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, it is wonderful to be back with you this week. It feels like it’s been quite a while since we last spoke. How are you doing?

[00:00:41] Cem

Doing well. It’s been a busy summer and going into fall for me. So, in the last month I have been all over the world meeting clients and potential clients and at speaking conferences. It’s been fun, but I’m excited to be back in Chicago and settling down spending time with family and with work. Getting back into more of a routine.

[00:01:04] Niels

I know exactly how that feels. I’ve been on the road myself and it’s actually really nice to be back home.

Anyway, we’ve got a pretty good lineup of topics thanks to you. Before we tackle those, we also have a couple of questions.

Before we even get to that, one of my favorite questions, as always, is to pick your brain for a couple minutes about a few things of the big picture; sort of what’s been on your radar, nothing linked to the topics we’re going to talk about. Just something that you picked up on your travels, maybe that you find interesting.

[00:01:35] Cem

Oh, from the travels. I think there’s a lot of similar hammering globally about to come to a realization that we might be in a new regime. I think that was not the case six months or a year ago. People were still holding on to this hope that this was all transitory and things would change.

So, I think there is a broad acceptance that we’re in a global time of strife, geo-politically and economically. I think from a financial market side, people are really trying to pivot and adjust. These things don’t move fast. These are trillions of dollars of capital trying to reassess. So that’s been really interesting for me. A lot of those conversations, things we’ve been talking about here for maybe three years or two and a half years, are really now becoming more central to the narrative. There’s a lot of talk about inflation, and what that means and whatnot, as well. I think that was the overwhelming takeaway.

People are confused by vol more than ever, which I think is a great opportunity. I think vol, as you and I were talking about, has done some unique things relative to history. Everybody is waiting for it to mean revert to where it was. I think it’s not going to be that easy. We’ll leave it there.

[00:02:58] Niels

We’ll leave it there. That’s is absolutely true. I agree with you on some of the topics you just talked about.On my travels that’s certainly also what I have come across.

Also, I think people are just confused about the whole fixed income space and bonds. I know we’re going to dive into that as well.

Before we do, as usual, let me just quickly mention a couple of things about trend following, partly because, we’re just recording in the first couple of days of November, can’t believe it’s already November. And so October just finished.

Of course, the outbreak of another war in the Middle East is tragic. It was really something that had an impact, I think, on trend following performance. I would say it’s flat to down for the month of October. The main correction in performance was coming from energy prices that took a dive in global equities, which continues to slowly correct even though the last couple of days have been a bit better. Many sectors were pretty uninspiring, frankly with only small gains or losses. As I said, the industry looks like it’s overall pretty flattish, actually, heading into the last final stretch of the year. So we’ll see how it all ends up.

My own trend barometer finished the month, I think yesterday, at 41. That suggests a neutral two week reading. That is in line with the numbers I’m going to quote now. Because the BTOP50 index was down .71 for the month of October, up still 1.78 for the year. SOCGen CTA index down 1.2%, but up 0.57 for the year. SOCGen trend down 9 basis points. Looks a bit low anyways, but probably right. Up 86 basis points for the year and the SOCGen Short Term Traders index down 47 basis points, up 1.35.

Although, when I look at these numbers, I’m not entirely sure if I mistyped them. Anyways, what I did mistype was that the MSCI World was down almost 3% for the month, up 6.38% for the year and the world government bond index down another 71 basis points (not having a great year either this year) and the S&P 500 down 2.1% and still up 10.69%.

All right. With that out of the way, let’s move on to the questions.

First question comes from Tim. Tim writes, “Welcome back from your well deserved holiday. For your conversation with Cem, I would be interested in getting his insights on the following. The firm I work for runs a systematic risk premia strategy with a trend following bias. Hence, equity market corrections and risk off periods, in general, can be profitable for the strategy depending on how these turn out in terms of speed and length. Since we are medium term in frequency, like most CTA’s, a significant tail risk for us is far short term movements against the underlying trend. The question then is, what systematic strategies would Cem consider suitable for hedging this type of risk? And at what cost?

I’m asking this question in light of the developments that took place post COVID, when many investment banks offered newly tailored defensive/tail hedge strategies that were supposed to protect against major equity drawdown while not being as expensive as purchasing put options. The range of products was wide with strategies based on correction, variance, dispersion, etc. Unfortunately, many of these products were over optimized to show good hypothetical performance during COVID. But most of them failed to protect subsequently in 2022. Many thanks and regards, Tim”.

Okay, well, I know nothing about these products. Hopefully you know a little bit, Cem, what Tim is referring to and maybe you have a few comments on that.

[00:07:04] Cem

So, I think the idea here is that you can digest premium, hedge it with other forms. This is essentially warehousing risk that happens all the time, there’s edge and ways to do this. They can be profitable strategies. And they can even perform quite well as they did last year, right into a decline that vol doesn’t perform particularly well on a fixed rate basis. It’s less than the general basis of these systematic risk premia strategies. The problem is they have a tail.

This is selling vol at the end of the day and the question is; how do we hedge this tail without paying a lot of money? At the end of the day the answer is (I think I can attribute this to Chris Cole or Corey Hochstein, they both said the same thing), you can’t destroy risk. You can only change its shape; change where it is, it can only be transformed, I believe.

So that’s true. There are different parts of the distribution that you’re subjecting yourself to in time and space, whenever you harvest risk premia. If you’re trying to get a tail, not all tails are the same. Everybody wants to think in two dimensions, up and down. What will hedge my tail? Well, there’s not one tail. There are different parts of the tail, and what you want and what you’re willing to pay is a function of that.

Now, some parts of the tail are more expensive, relative to their output in those scenarios. You also have to think about probability. When it’s expensive, expensive is in two parts. One, it’s relative to other things. Statically it is more expensive. And the other part is relative to its actual predicted probabilities.

The reality is, both of those things can be edges. If you can really look in relative value space and say, this is cheaper, this is more expensive, you have an edge. And if you can also say, hey, the probability of this is less likely than people expect, or more likely than people expect then you can also have an edge. I think the key is to find ways to take advantage of those two things.

There are generally not systematic ways to just do that. You need systems and you need expertise. And so I can’t sit here and say, hey, if you just go by X puts. Now there are trends to this, I could give you general tendencies, but those things change over time. The reality is that, up until more recently, gamma is a more…

There’s a reason theoretically that long term capital management was created. Long term capital management was created because theoretically long term skew and vol is overvalued, relative to short term, and gamma pays more than vega over the long run and is more consistent. That’s generally been a structural way to do this as some people sell calendars and buy extra units and premium neutral and do things like this to cover their tail.

The problem with that is exactly what happened to long term capital management, there’s a liquidity premium. That liquidity premium works and works, and then at some point has the potential to… Long dated things can go anywhere. There’s some risk to that in the interim, and you have to be able to size appropriately and manage position.

I know that is a lot of hedging, if you will, to the answer. But I think the point is, it’s complicated.

[00:10:42] Niels

It’s complicated. Just sitting listening to you, and this might come out as a super naive question, actually, I come from a world where it’s very science driven. The trend following the world is very science driven. But I wonder, could you say that when we talk about tail hedging, and all of that stuff, those types of strategies, that it really is more of an art than it is a science. It is very hard to come out with these purely systematic approaches to tail hedging.

[00:11:18] Cem

I would qualify it as a science, but it is a more complex science. When you have something that is incredibly complex it is hard to model all of the factors or at least explain them in two dimensions. We’re talking about a very multidimensional question. Now you can, because it’s complex with opportunities, as well, and you have the ability to manage math and science, there are great things to do.

I guess my point here is, if you’re looking at a cleanly packaged ETF with a very clear, simple rules based strategy, good luck. We’re dealing with items that are nonlinear, and multi-dimensional. And there are trends that you can take advantage of that will do broadly better than others. But that does not mean they will consistently in all scenarios perform as such.

[00:12:18] Niels

Okay, I think that’s perfect.

All right, one more question. And then we’ll dive into your incredibly exciting topics.

It’s a question from Rick. Rick has been very patient because I think he sent in the question quite a long time ago. He wrote, “Hi Niels, looking forward to the next TTU with Cem. If possible, would you ask him if he views the Jan. 24 opics as a possible inflection point to the downside? Thanks so much”.

[00:12:45] Cem

Yeah, I’ve actually been pretty vocal about this. I’ve even circled the date on people’s calendars. But to my own detriment, I do this sometimes, because there’s reflexivity in the market. January 17, I’ve circled as a very important date if (and this is the key conditionally), we do get a bounce back here into the end of the year. To be clear, I also circled November 1, as a date, for the beginning of that rally inflection, which was pretty spot on. I also highlighted that it could very likely be a violent move off of an area somewhere between 4,100 and 4,150.

So these numbers matter. And there is a reason that we point these out. I would pay attention to it. Markets are reflexive, and we’ll get into this for the topics, but not just from a structural perspective. This is Vanna and Charm. This is the dealer’s taking on positions and then forcing a reflexive outcome that we’ve talked about. These structural flows get stronger going into the end of the year here, but also markets are reflexive from a macro perspective, policymakers respond to markets.

That’s what we’re seeing incrementally here from the Fed and from the Treasury into the end of the year. So the more risk there is, the more the Fed tries to dampen volatility that the Treasury tries to manage more. That’s particularly true going into the end of the year as well, because there’s other factors at the end of the year that can accelerate and cause problems. It’s an important inflection point, center of gravity, if you will.

So that reflexivity of the market factors (and we’ll get into this a little bit later in the show), what the fundamental flows are doing, paired with all the seasonal, strong structural flows that are just systematic relative to conditional probabilities that happen in the market are likely, as I mentioned, to drive positive flows here into not only the end of the year, but into January 17, specifically because a lot of those flows are January 1, and then you have a very strong seasonal buy back to Vanna and Charm flows into that January Op X which should continue to support it and maintain that momentum until that window.

This is why February, the last back half of January and then February is actually the second worst month, seasonally, and it’s really a function of the positive flows that come before it more than it is the negative things that are coming. But removal of positive flows in the context of negative flows is very negative. So that January 17th, date, which is the Wednesday of the expiration of Op X, before Gen Op X, I would highlight is a very important time, if we do get the seasonal positive flows here that I think we are going to, that we are beginning to get where we’ve had more than 5% rally in three days. That is a very important date and period to highlight if we can get that positive move.

[00:15:46] Niels

Great and well done. Good call on that Cem, another one. All right.

Well, let’s dive in. I think the first part will be labeled macro. Which is something you and I love to talk about. You also kind of labeled it, what’s new. So I’ll let you lead with that. Then we’ll see where we go with that.

I have a couple of things I wanted to ask you. But why don’t you talk about what you think might have changed. So what’s new in the macro space?

[00:16:18] Cem

This will dovetail right into what we were just talking about. So policymakers are reflexive. We had a 12%, it didn’t feel that violent. But we had a 12% pullback off the highs over the course of the last month and a half until recently. Importantly, bonds started experiencing some serious volatility. That was the primary driving factor, I would say. Actually, I would say it’s a secondary factor in the sense that it’s not really the bond yields that’s the problem. That’s how people talk about it on CNBC, and whatever. It’s actually the thing causing the bond yields to go higher which is the amount of issuance that’s happening, and the liquidity draw that’s pulling out of the markets that’s affecting supply and demand, not just in the bond market, but in the stock market. Again, that’s an important distinction, because I think people just think, oh, numbers, like the yields going higher. So that’s bad for liquidity.

No, actually, what’s bad for liquidity is that the Treasury is issuing so much paper, and there’s not enough liquidity to support it. That money has to come out of the market broadly, and how does that come out? Well, if yields do go up, somebody has to take the other side of that. If they’re willing to take ten-year at 5%, they need to make room for that on their balance sheet. And maybe they need to sell some equities or lighten up, or maybe instead of buying equities they’re buying bonds. So, all of this creates a liquidity draw. And it’s been significant.

We talked about this, by the way, months ago that this was coming, it’s just you had to see it happen. Sure enough, eventually, as always happens, it keeps going, and then it starts to move faster. At the end of those, yields really started to move. In a seven day period the ten-year went from 4.5%, to over 5.05%. That has been an incredible move in speed.

In the last three or four days, we’ve seen it go from that 5.05%, back down to 4.65%. So this is an incredibly volatile price action in what’s supposed to be the most liquid market in the world. So the reason for some or a little bit of concern, I think for policymakers, especially when those yields were starting to break out fast to the upside. You’d hate to see an air pocket, 5.05% to 5.5%. That, given the speed of moves, that’s a real concern.

It’s not that the 12% drawdown in the markets is a huge deal. It’s not that a 60 basis point move and yields over the course of a month is a huge deal. It’s the volatility, it’s the liquidity picture, and the concerns that come with that, particularly as you get into the end of the year.

Why is the end of the year, why is the seasonality part important? Regulatorily banks and entities have to have a certain amount of capital on their books on December 31. So if the liquidity picture gets bad in the next month, you have a real pocket of liquidity where people, “A”, don’t want to come in and provide liquidity, but, “B”, there’s a draw on liquidity broadly coming back into balance sheets and that can create an even bigger liquidity issue.

So, the Fed and Treasury should be on alert more than usual during that period. Then it doesn’t help them now (to the part that’s probably geopolitically, this is a much slower moving thing, this is not a one or two month thing, but a very important development), there’s a new front on World War Three, I’d call it. I know that sounds bombastic, but that’s what it is. And I don’t think people are talking enough about that.

The Hamas/Israel peace is not an independent activity that’s happening in a part of the world. Obviously, it goes without saying Iran is backing Hamas in this endeavor. And Iran is very vocally a part of a group, which is Russia and China, trying to exert leverage and they’re doing it because there’s another front going on in Russia and Ukraine. Then, in my opinion, there is a potential front coming further east, and I think people know what I’m talking about there.

This is a stretching of resources at challenging and testing of boundaries, by a much bigger set of entities. And this is a proxy war, much like Russia/Ukraine is a proxy war. And explicitly (the last thing I’ll say about this geopolitical peace is), it is a very strategic move too. It is not just opening a new front. If you have a coming World War, broadly, you are trying to take entities that are on one side and really convince them to be on another. Nowhere are there entities that are more walking that line, that are easier to win over to the Russia, China, Iran front than in the Middle East. Nothing is more of a lightning rod than the Palestinian Israeli conflict.

Particularly something more that’s true to my heart, which is Turkey. Another one, which is very important for commodity reasons, which is Saudi Arabia. These are two very important allies in that part of the world, to the west. They are entities that are now very much against what’s happening in Gaza. If you saw the crowds in Istanbul, protesting what Israel is doing. (By the way, I have very different views on a lot of these things. I want to make sure this is not an argument of what should or should not be happening.) This is simply power and struggle. And I want to be clear this is an effective means to separate or at least bring question into the alignment of Turkey, and Saudi Arabia, with the West. And that is a major problem. Honestly, I believe Israel is politically taking the bait here, in something that they should not be doing. I think the US is aware of that and tried to talk them down a bit. But we will see.

Anyway, the geopolitical piece is important. I know it’s interesting. We could talk a lot about geopolitics but, we don’t want to get too far down that rabbit hole. And that does not matter as much for the one month, or two month predictions of what will happen to markets in the very short term. But it does matter if we’re starting to think okay, things are heating up a bit. These are strategic moves. Why are these strategic moves being made? What does that mean for timelines on other fronts and other bigger conflicts? What does that mean for an acceleration of what we’ve said is coming, which is this broad geopolitical conflict. But those things move much slower, and markets react to those things on much slower timeframes.

[00:23:16] Niels

On a personal note. I very much agree with you in terms of the importance of these events, and the fear of where this could go. It’s actually not just the countries that you talk about where you start to see cracks, even within Europe, in terms of alliances. So this is something that you and I will end up talking more about on the Global Macro Series, I’m sure. We need to find a few people to come in and help us digest and navigate some of these things.

I wanted to pick up on some of the things you said before we got to geopolitics. A couple of things you talked about a lot is the situation in bonds. Now, we talk a lot about the VIX. We don’t hear much about the move index, which is the equivalent for the bond markets. I don’t follow the move index. But is it behaving the way it should, so to speak? Because we know that there has been a bit of a decoupling between what the VIX has done and what the S&P has done. But is the move index actually behaving as it should? Are a lot of people trading it? I don’t even know how you would trade it. So can you talk a little bit about that?

[00:24:37] Cem

So bond volatility, as you mentioned, has been relatively insane on a realized basis, and on an implied basis it’s also quite strong.

Yes, things are moving much more in line, I realized, versus implied than maybe on the equity side. We highlighted this about a year ago. You and I talked about it at some point, I know, about how, during inflationary regimes, different volatility performs very differently. If you’re in a period of non-inflation, vol tends to be correlated because things are much more about cyclical realities. In secular inflationary periods, you get real breakdowns and real changes.

We’re entering a period (without going back into the whole thesis of broader geopolitical strife) on competition, as opposed to cooperation that leads to more pressures and commodities; some breakdowns in certain types of businesses that cause more rotation. So all of these things lead to higher volatility historically. There’s loss of power by the Federal Reserve, broadly, because the Fed is in a box that has a dual mandate that it’s struggling with now. Questions of dollar strength, dollar weakness come in geopolitically.

So, during these times, FX, rates, precious metals, all of these things tend to get incredibly more volatile. Not just more volatile, but the vol increases on them as well. Whereas certain assets, ironically, get more volled in than you would expect.

We said this about oil a while back. When oil vol exploded on an implied basis, and gold was very cheap (I don’t know if you remember that), we were very vocal that the gold vol was too cheap for that reason. But oil vol was actually too expensive. Sure enough, oil vol has actually settled in a bit and we continue to see this put, that we’re not getting convex moves to the upside. We’re getting more kind of choppy, sideways action, because OPEC and other entities that have power are able to underpin price and exert power that continues the trend higher, but broadly, it is not a volatile move higher.

Whereas gold is starting to act more volatile and vol is increasing from those lows, as we’d highlighted this over a year ago, and this is what happens. So to your point, rates vol is. yes, it’s disjointed from equity vol.

By the way, equity vol is very broadly, very poorly, on a medium to long term basis. I would highlight it at 60 to 82. The market went nowhere for 14 years, that’s not very volatile on the long term basis. Yes, there were some incremental short term vol in between and there’s more disjointed moves.

Term structure should broadly change, but equity vol, it makes broad sense that it would not be dramatically higher; if anything a bit lower, but disjointed from rates vol and FX vol and other vol that people have not thought as much about in terms of hedges, and probably should be.

[00:27:43] Niels

Absolutely. I want to, again, before we leave fully the global macro, but obviously also tie it into the fixed income side.

I also wanted to hear your opinion about something that I heard from our friend Grant Williams, on one of his latest episodes with James Aitken and Bill Fleckenstein. I think this is, well first, there are two things that really stood out for me in that conversation. And we probably, you and I, should get Grant back and talk about this. One is that I think James Aitken (who sounds incredibly smart every time I listen to him), was where he was saying a lot of the stuff that I’ve thought or believed in for the last couple of years, I really need to unlearn that. Things are just not playing out the way they should and there are probably some reasons, and I’m not going to go into that side.

But the other thing they talked about, which I actually think is quite interesting, and that is this risk of Japan actually going into their own rate hiking cycle, and what that might do not least in terms of who’s going to be the buyers of all these treasuries that we’re going to be issuing and so on and so forth.

So is this something that you’ve thought about as well in terms of what the next leg will be? And even though I think we both know, at some point, the US bonds are going to get a break, and they’re not going to continue down forever, at some point, at least for a while.

But then there’s this joker of Japan and if they start doing their thing that might put pressure on at least yields staying high for a lot longer than people might expect.

[00:29:38] Cem

Well it brings up a very important mental model on this. We’ve talked a lot about the deglobalization and the geopolitical issues that come with protectionism, which is a cousin of populism. We’re getting more protectionism and more geopolitical striping, driving competition. That, importantly though, extends to liquidity.

When you’re talking about big liquidity, like borrowing issuance of trillions of dollars of debt; when we’re in a cooperative world, and China and Japan can fund debts themselves, and were more stable and cooperative, liquidity is great. But when that starts to break down, you can be fine for a while. But the tale of liquidity there; who’s going to provide that liquidity, when there’s very few that are willing to, it really becomes a bigger concern. I think that’s what you’re essentially highlighting.

It’s not just Japan. Japan is a vassal (there’s people on here who aren’t going to like that). But it is a smaller economy relative to the US and its ability to keep its rates down as a function of the power of the West and its support of Japan to a great extent.

These are not separate entities is my point, and the liquidity question is broadly a problem across the board. But it would make sense that, in particular, Japan, which has gone the furthest negative, will have the most room to normalize in a scenario where things get ugly.

I actually, at the Cboe’s RMC conference, where I was at several weeks ago, met up with our friend, David Dredge. He and I had a lot of great conversations. The topic of Japan came up multiple times. He is very involved in Japan, and is of the opinion that we’re pushing on a string, and this is going to not be pretty. It’s hard to say when but at some point, it just has to normalize.

I agree the pressures and the incentives are there such that unless we unwind this reality that we’re seeing in terms of geopolitical strife and broad competition globally, that is going to normalize at some point. I do think that many people are seeing that.

The question is; when people are seeing it, how will it transpire? Will it be in steps? How long will it take to transpire? Those are questions that are harder to answer. But I agree with you.

[00:32:16] Niels

Yeah, maybe as a final point, before we leave bonds for a while.

At least one thing that I think people may not be so familiar with, for the longest time we’ve always thought about bonds being the safest assets, and so on and so forth. You highlighted that actually, volatility in fixed income markets are now higher than in the stocks. The Bloomberg also had an article out on the 22nd of October, talking about that.

But there’s one statistic or little analysis that I did, which I thought was quite interesting as well. And that is if you take the max drawdown of different asset classes, and you divide that by the annualized volatility, because again, you want the lowest ratio possible for the smallest drawdown. But what you find is that bonds just blow out everything else: stocks, trends followers, CTAs, whatever, so much more, downside, volatility, compared to its annualized volatility. And this is always the danger, that things that may look safe, turn out not to be so.

I think what we will find, and I actually believe you and I completely agree on this, because we’ve been talking about this for a while, and that is, we are probably heading towards a world where lots of investors are completely wrongly positioned. They’re simply positioned for the world that was, not realizing the world we’re heading into. And that will have major consequences in many financial markets.

[00:33:56] Cem

I would highlight two things to that really quickly.

One: People come to me all the time and say, “How am I supposed to make money in this world? This seems impossible.” But the problem is not that there’s opportunity, there is more opportunity than ever to make money. We’re in a regime change. If you want to make money this is what you want. You want new opportunities and things that are mispriced. There’s tons of that everywhere. But you have to get out of this prescriptive that this is 60/40 and is the way things work and how you make money. It’s so hard because it was so simple.

Everybody did the same thing without any education for so long and was taught, indoctrinated, that this is how you invest. It’s low cost, zero fees, buy and hold, buy the dip. It’s based on a lot of assumptions that held true for some time for structural reasons that we understand.

So I think that everybody has to be willing to look outside the box a little bit and say, okay, there are other opportunities that are significant. We just need to stop trying to do the same thing over and over again.

That’s one, and then two; I think that the reality is geopolitical realities are such that we’re going to get dramatically more change. Not only is the system going to be different, but there’s going to be real tails. The Fed, the Japanese Central Bank (the JGB), everybody has compressed volatility. What did we say? You can’t get rid of volatility, you can only transform it.

So what’s happened is that we’ve transformed it in the bond market to a very low vol but with a really fat tail. That’s what you’re essentially asking about with Japan’s central bank. they overly suppressed vol to a point where things have gotten to a price and area that, when it does break, the normalization is going to be dramatic. I think that’s true globally for bonds. And I think the volatility itself is starting to expand to adjust for that. Hopefully, it also expands more before the tail comes so at least those ratios are a little bit more in line than what we’ve seen historically.

[00:36:10] Niels

Absolutely. You have a section in your topics, where you talk about markets being reflexive, and we’ve talked about that kind of already. But I want to spin it in a slightly different way. Maybe a little bit towards… just a comment, maybe a thought, I’d love to hear your reaction to it in terms of another topic that we speak a lot about, which is inflation which underpins the whole idea of where interest rates may go. I think maybe what I’m sure many people have thought about by now, but maybe not a lot of the people who go about their own day to day in terms of investing.

That is when you have all these global conflicts that we now have. As you point out, that could be more, it puts an enormous amount of pressure on spending on the military. Lots of this is just pure deficit spending, especially in the US. But probably in a lot of countries. I wonder whether that additional spending is simply going to be what, to a large extent, will underpin inflation, and keep it high and simply not allow central banks to do what they had hoped for, because they didn’t know what was going to happen in the Middle East. They don’t know what’s going to happen next if another conflict breaks out. So all their projections, which by the way, rarely holds up anyways, but all those predictions could be thrown out the window, potentially, if we just continue to see this demand for military spending.

[00:37:54] Cem

We highlighted this two years ago. Sorry, I keep saying those things, but we did. We said, look, everybody’s talking about fiscal two and a half years ago. Fiscal driving this inflation and in the comment was to look back at the 70’s. Yes, fiscal was part of it. But the bigger story is not just fiscal, it is populism that’s driving the fiscal. It’s the populism that’s driving protectionism, and deglobalization, which is then causing more global conflict and more investment in war.

It’s the populism that’s driving that protectionism and that’s driving entities like OPEC to put more pressure on commodities. If you look at the 70s, if you go online and you Google what causes inflation, you’ll hear three independent things: people will say fiscal spending from the Great Society Program, the Vietnam War, and geopolitical wars, and three, the OPEC crisis. They’re all the same thing. To my point, to what you’re saying, the funding of wars is going to be a major driver to more fiscal. There are costs to it.

These things are stimulative. But they’re also very inflationary, and there has to be more issuance to cover it, which is going to mean yields go higher, which is a liquidity draw in markets, these are all related. They’re all the same thing. I think that’s the thing that policymakers very rarely speak about and really understand. But 100%, there’s a reason that the echoes are so similar to the past.

I’ll make one last important note, Niels, is the funding of wars is not only likely, given the geopolitical issues, but it will allow for the continuation because people will pay for wars. This gold may not be popular at some point, people may say, whoa, stop spending. You’re spending too much on discretionary things. War is not considered discretionary. War is essential. Defense is essential, I guess I should say.

That is what happened in the 70s. Even though there was a broad understanding pretty early politically, there were lots of fights over the Great Society Program. You can look back at it. The fiscal continued through all kinds of election cycles because of the Vietnam War, and broadly the support of that war and we can look back to World War Two and there is a similar analogy as well.

[00:40:28] Niels

All right, we have two major topics we want to discuss before we wrap up. Both are very interesting.

The first one is flow, this is something that you always bring up. You are the maestro of explaining this so that we all understand it. We’ve touched upon it a little bit already. But let’s just make sure that we get your full take on the flow side of things as we get into year end.

[00:40:55] Cem

Yeah. And things I’ve talked about before. So I’ll try and be quicker about it.

[00:41:01] Niels

I know you mentioned a little bit about Thanksgiving. You mentioned a little bit about a couple of holidays coming up?

[00:41:07] Cem

Yeah, there are a couple of nuances, which I think I haven’t highlighted enough. Which I would like to highlight.

But first and foremost, seasonality is not a matter of construct. We talked about this, particularly this early January period, this (called it) two and a half month period, which is a pretty long part of the year. There’s a reason it’s structurally more positive, and particularly windows of it that are structured more positively.

One: volume weighted time drops dramatically. What do I mean by volume weighted time? There’s just less trading going on during this time. There are more holidays. There are more people not participating in markets. Thursday is the official holiday for Thanksgiving in the US. But Friday is essentially a holiday and nobody’s here. Things like that. Christmas is one day as far as all day, but guess what, that whole week is dead.

So if you look at volume weighted time to try and adjust for this it is dramatically less and I think that’s an important distinction. Not just that, but this is an important thing that I haven’t really highlighted. I talked about different windows where there’s more risk. We see this. There’s a reason. If you can’t see it now you’re not paying attention. After big expirations, you get significantly different moves in markets and there’s more risk during certain periods. People are waking up to this. The windows of weakness tend to be after big structured products expirations.

It’s important that these biggest holidays, or the vacuum of time and trading happens after these OPEX’s. We haven’t really highlighted that. But Thanksgiving is directly after November OPEX. It’s this week where there should be, generally, a risky week, but there’s nobody trading, people are on vacation. So we accelerate through this risky period of Christmas. It’s the same thing. It’s right after December OPEX.

Then, a week later we have January, New Year’s Day. Those big holidays are actually, interestingly, even more vol compressed and even more positive for markets because of where they’re situated. I know that sounds like why would that matter? That sounds insane. If the holiday was two weeks earlier, would it really matter? Yeah, it would because the way it lines up with structured flows is important and that dynamic is very important.

Importantly too, is the massive open interests in December OPEX and January OPEX. Why? In the indexes, broadly, people hedge at the end of the year. These are the options that are listed as leaps, years in advance, that have tons of open interest and that are big structured hedges. Structured products are therefore tied to these expirations as well. December monthly expiration is the biggest you have. A December end of the year expiration which tends to be big. Then, historically, January has been the biggest expiration. We can get into all the reasons why that developed that way or why it is, but it’s still a major expiration right at January 24.

So all of this open interest and, importantly, skew; all the puts in the market they’re on are priced high, dealers are short them. As those disappear, if we do not get a volatile event, which we had managed it here going through October, all of a sudden that starts to come out of the market and the hedges have to be bought back.

So time gets compressed. The where time gets compressed and is softer, the amount of buyback is much bigger, because these are important end of your expirations. This is all from the OPEX flow side.

Then, on top of that, we have all the structural product issuance that’s new. That’s been there around the last year or two, that’s really compressing and holding things together. So it’s limiting the odds of a bigger move that’s going to disrupt these natural structural effects.

Then lastly, the end of the year flows now up the market continues. There’s a momentum factor here that continues to be relatively strong and hanging in there. Time is not a bear’s friend I’ve said. Why? Because there’s a natural momentum factor higher. The more momentum there is, at the end of the year there’s more collateral to reinvest at the end of the year. That is a big amount of flows.

Again, we’re talking trillions of dollars of flows that kicked in on January 1. New entities are putting money to work and people see that coming. So at the end of the year, Santa Claus tends to be strong when that’s the case, and the January effect tends to be strong. Those things are not a coincidence. So that’s the flows picture.

It’s very positive for risk here if things continue to hang in, which they, obviously, people are picking up on what I’ve been saying and buying the indexes the last several days.

[00:45:48] Niels

Okay, well. The last topic will be interesting and fun, I hope, because it is your takeaways from the recent Cboe RMC Conference which, of course, took place in a very exotic place where there was a Formula One race going on recently in the US. I don’t know how much of the details you are able to share. But I would love to hear as much as possible from what you took away and about, maybe some of the people you spoke to and the topics discussed, because clearly there was a big group of smart people together at the same time.

[00:46:26] Cem

Yeah, this is like the premier conference for derivatives, and vol specifically. Globally, I would say, the Cboe is smaller in the sense that it’s not as big a reach as some other vol conferences. But it really is a who’s who in terms of proprietary trading firms, entities that are really in the weeds and trade derivatives provide liquidity for derivatives. So, it is really the gold standard for thinking about what’s next and seeing who’s doing what in the space.

I was fortunate to be asked to be on a panel of about 15 people to discuss new products of the Cboe for idea generation, as well as working on details of how products should work and problems that they may be facing. That was really incredible. Again, a who’s who in that room of people who are practitioners and entities leading the charge on a lot of these products. That was fascinating, a lot of discussion about the dispersion index that the Cboe has released in dispersion, broadly, and other products they are looking at and thinking about the dispersion index. It will have futures coming in. They announced that in that small room, and then more publicly later in the conference.

So if options on futures, all of those will be coming for the dispersion index. I think that is particularly important. Development in markets, not because it allows people who are practitioners to do dispersion as much, but because it provides access for more structured products and ETFs, and other entities that can now, more systematically deploy these strategies and provide broad market liquidity into these strategies as opposed to just niche players who have access, and whatnot.

Given the size of the dispersion trade and the imbalance of the liquidity, that you and I have talked about both from structured products and the bidding of indexes, but also from the broad increase of volatility in the single list for more idiosyncratic risk, this is what has driven this historic dispersion that we’ve been seeing; an imbalance of supply and demand different from the index center. With constituents on the other end, providing liquidity there and allowing access for broad assets will be a very important and interesting dynamic as it transpires to market structure. I think that’s a critical takeaway. I will say, there’s still a lot of evolution, this is not going to happen overnight.

One of my big takeaways was that the index is not vega neutral. It’s a long vega index. They did that on purpose. So it would be more mean reverting and the number would make more sense to the average person. It’s meant to be an index and more of an indicator at first and then they’ll put products on it. But as a deploying of the dispersion strategy, it’s not actually the proper structure to deploy the dispersion strategy, per se because it’s not vega and neutral. My guess is that some of the input that I gave and other people gave is that they really need to launch a vega neutral version at some point. We understand that will drift and that there’ll be other issues for those products. But I think that’s what the world really needs and wants.

If not, there’ll be innovation outside of the exchanges to deploy a more vega neutral version of the dispersion index. Anyway, that was very interesting. The staying power of dispersion and what I’ve been talking about now for years, why it’s happening has become a little bit more talked about for the first time at these conferences. I think that is becoming more central to the zeitgeist.

People are waking up to the fact that dispersion is working for certain reasons, based on structural supply and demand imbalances. This is not something, even at those conferences, that was broadly understood or talked about. Which I thought was very interesting, it’s entering the zeitgeist. I think those were all very interesting topics related to dispersion.

There are a lot of other issues. Our guy, David Dredge, again, got up and he spoke at the conference. I thought that was (as per usual) one of the better speeches that was given. He gave real historical, big picture context to several things. One, he talked about how vol, broadly, has been compressed relative to (this touches on what we were talking about earlier) us looking at 800 years of history. Which I always love. He goes really deep and looks at these things. He was looking at British records that they still have going back 800 years, and volatility of assets was dramatically higher across all scenarios except for maybe one 20 year period in the late 1800s which was maybe related to the last 20 years, up until two years ago was across assets and the lowest volatility that we’ve seen. That was a really, really interesting historical point.

We’re starting to see some mean reversion to higher levels. And his prediction is that should continue to be the case, particularly if interest rates stay higher. Because you look at when inflation is higher, when you look at those periods vol tends to be also considerably higher. Again, we’re not just talking about equity vol, we’re really talking about rates vol, we’re talking about the move index that we highlighted, and other things, broadly. That’s where the volatility tends to be higher. So that was an interesting look.

He also really highlighted something that he talks a lot about, and I’ve heard, which is an incredible point, that the majority of the returns in markets can be defined by simply what happens to the top 10% of outcomes, and what happens to the bottom 10% of outcomes in equity markets and markets writ large.

If you take those two out of the equation, or you take one out and add the other one in, the performance goes to dramatically negative or 10x positive performance. He brings that up to highlight the importance of the tails and hedging the tails. Not only hedging them, like making sure the worst case scenarios are well hedged, but also making sure that when a positive occurrence happens that you capture it or maybe even capture an even bigger amount during those moves.

Those tails are incredibly undervalued to the importance of a portfolio. This being a risk management conference it is an important thing to highlight.

He highlighted several ways to take advantage of that. But I think the big takeaway and again, it’s hard to express how dramatic the differences are if you take that 10% of occurrences out or into the portfolio. It’s pretty impressive when you look at. I’m happily tha he has. I know on David Dredge’s website, he has the actual presentation on there. So I recommend that people, maybe, go take a look at that if they’re interested.

Lastly, two more things actually, I’ll say. One other important topic that was covered was this idea of the era of nominal illusion that, again, we’ve talked about here. But everybody talks about assets in terms of nominal. An overwhelming majority of assets are priced nominally, because nominal and real haven’t been that different for 40 years. There’s a need for innovation to make sure that assets are more looked at in real terms. Everybody thinks it’s great that they’re getting 5% in the 10-year, and like well, no brainer. But in real terms, how are you really doing? That’s the thing that very few people think about and is so critically important. Again, we’ve talked about the 70s.

There’s a dramatic need to focus on assets as real assets. And there’s very little infrastructure that allows people to do that. The big question is big money looking around at entities that can do that for them? And there aren’t many that do that well. We even talked about it in that private little product innovation conversation, if you’re looking to hedge breakevens but not do it just trading breakevens, how do you do that with convexity or nonlinearly? There’s literally no way to do that. It’s inflation.

We’re talking about one of the most important dynamics in the world and there’s no way to broadly hedge it? That seems like a problem. So these are the ideas of it. We’re in an era of nominal illusion. I thought that was a nice semantic way to express it. I think it was an important takeaway.

Then lastly, we’d be remiss if we didn’t mention 0DTE. Of course, that’s not going to go undiscussed at the Cboe’s RMC given that something like 40% of their volumes. They’ve been putting out studies that have funded this, like drug companies, they always find the data that expresses how their drugs are great. The CBOE funded a study. I love the CBOE, obviously. But I thought it was an interesting study. They were very adamant about how the balance of trading and 0DTE is incredibly balanced. The supply and demand between these things hasn’t been imbalanced, between dealers, and customers. And it represents how robust and stable those markets are, and have been. That was something that was highlighted and discussed. I actually raised my hand. Another gentleman raised their hand at this panel, and I think led to some very thought provoking conversation there at the conference. I’ll share with you what a couple of the questions were.

The other gentleman that was at my table, Noel Smith from Convex, and we’re friends broadly, we’re talking a lot. But what the point I highlighted was, the margining issues was 0DTE and how there is no real time margin for any of these, and they all expire without any margin. So you’re essentially dealing with a market, I mean, it’s the wild west that has zero margining. There’s zero regulatory margining for these things. That’s insane. I think the fact that it’s gotten to this scale, and that hasn’t been dealt with is a major issue. I brought that up.

There was a lot of back and forth about whether it’s coming. What I learned is that the regulators are really looking into this and focusing on it and that things are coming there. So I think that’s something I’ll highlight here, before anybody else. I would not be surprised if there starts to be new, different marginal regulatory things that change the landscape, busier 0DTE a bit. So that’s a big, big thing that was brought up.

Then in the middle was asked a great question, very simple, but very important. So if everything’s so great, what could go wrong? That’s always a great question to ask. There was a lot of hemming and hawing and it got quiet first. Like, nobody wanted to put their hand into the fire. But then I was actually very impressed by the gentleman from Capstone, who was there and is like their head of global vol. He stood up and said, look, there are major risks to 0DTE. And the risk primarily is that we’re providing liquidity. There’s a lot of trading and a lot of liquidity happening and a lot of changing hands. They said, we do not hedge these.

I thought this was interesting. You cannot hedge them, I agree with this, with deltas. With other options you can go out and you can sell your futures or you can push liquidity to the rest of the market. These are so far on the tail, you can only trade 0DTE with 0DTE. You can only hedge one with the other. That’s great as long as liquidity is there. But all of a sudden, if somebody comes in and sweeps 0DTE, and there’s nothing to hedge it with. now dealers are very imbalanced. You can have a major flow problem, and it can happen instantaneously. So things can appear very balanced. But things can change very quickly. There really is no way to push that liquidity to the rest of the market. So 0DTE things can not only be very violent and dramatic, but it’s a small sphere that can only hedge against itself. I think that was a really important takeaway.

Then the last thing that was mentioned is that the other major risk is that there’s a lot of innovation happening in the area, and a lot of ETFs and other entities, other liquidity coming into the market that can be one sided. So up until now it has not been very one sided. But if there’s an ETF, which there is one being launched right now that is short vol 0DTE, or something along those lines, that can then lead to very one sided flows. That can make that market more structurally imbalanced than it has been.

There are fears that may actually happen. Much like it’s happened in, let’s say, GME and MC and all these other things. If you get one sided, other entities that are not two sided, then you can start to get some real imbalance that could cause more structural issues. So that was the other thing that was very interesting at the conference. There’s more I could talk about, but I think we only have a limited amount of time and maybe we do another pod at some point or talk about these things.

[00:59:41] Niels

So no, absolutely it does sound like I missed out on a great conference. And we may have to go back to this because I did note, from your notes, that in one of your points you even mentioned the words trend following, which piqued my interest of course. So, yeah.

[01:00:00] Cem

Yeah, there was some talk about trend following as a solution to dampening some of the volatility of portfolios. David Dredge mentioned it and another gentleman there had a graphic that was essentially showing trend following’s historic performance, outside of the last 10 to 15 years, for hundreds of years of history, and how dramatically superior it has been, historically, than the last 15 years up until the last years, obviously, it’s been a good two years as well. It really expresses how this period could very well be a mean reversion, much like volatility has done better, historically, as we break into a less compressed, less two dimensional world into something where things can start to trend and then trend for a while or if we’re in this type of regime shift. It might be a very great time for trend following broadly. That would be dangerous to look at the last two years and say, well, this is outside of the last 15 years of history. The point was that you might really be missing the big picture, which is that there may be a normalization of these strategies relative to broader history.

[01:01:12] Niels

I completely agree. We’re not going to talk about that in more detail right here now because of time constraints. But what I will say, I just got back from our own headquarters, and Dunn has just celebrated our 49th year in business.

So very few firms and very few strategies have an actual 49 year track record. It gives us the “advantage” that we’ve actually traded through some of the regimes we’re seeing now, coming back. What I will say, when you look at different periods, whether it’s high inflation, or even from ‘82 to almost ‘99, I think, where we had low inflation, but not necessarily stable inflation, which could be where we’re heading, but it doesn’t have to, necessarily, go completely crazy. But it’s not going to be as stable as it was from 2000 until 2019 ish.

And yes, you’re absolutely right. We see that in our track record as well, that there were some amazing opportunities. So I share the optimism expressed at the conference. And I’m sure you and I will debate this with some of our friends.

[01:02:21] Cem

I feel like we’re like the Cboe or we’re talking about our book here. Oh, yeah. I obviously agree. That was the broad takeaway from the conference. So I thought that was really interesting.

[01:02:31] Niels

Yeah, no, absolutely. Good stuff. This was wonderful. Cem, great to catch up with you.

I’m sure the audience will appreciate all the insights that you, once again, have shared today. As I said, I think you and I need to identify some of our friends to come back and talk about some of the topics since it’s been a little while since we caught up with them.

Anyway, if you enjoyed this conversation, please go to iTunes, Spotify, Amazon podcast, or wherever you listen to your podcasts. Leave a rating and review. It really does help and we so much appreciate it.

If you have questions for the next co-host on the podcast, which is next week when I’m with Katy Kaminski, the queen of crisis alpha, if I can put it like this. She will be delighted to tackle your questions.

And as usual, you should send them to info at Top Traders Unplugged. From Cem and me. Thanks so much for listening. We look forward to being back with you next week. And until next time, as usual, take care of yourself and take care of each other.

[01:03:36] Ending

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