Liquidity, Leverage, and the Lie of Calm ft. Cem Karsan

[00:00:01] 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 polls of the global markets through the lens of a rules-based investor. Cem, it is really great to be back with you this week. Very excited for our conversation.

I’m thinking it’s going to be a little bit more free flowing than what we normally do, but first of all, how have you been?

[00:00:46] Cem

I’m doing well, it’s summer in Chicago, so always nice. The kids are away camp, so also have some time. Haven’t had much time like this in a long time. So, my son’s off to school soon. That’s kind of what’s next.

[00:01:02] Niels

It’s a big change. Yeah, are you also having some time off before the autumn starts?

[00:01:08] Cem

Yeah, not really any vacation. But again, Chicago in the summer, no kids, is kind of like a vacation for me, so.

[00:01:17] Niels

I know what you mean.

Now, as I said, in terms of the topics, we’ll see where we go on that today. I’m sure it’s going to be a great lineup, as I always say, but I’m not entirely sure what the lineup is going to be. But that only makes it more fun, I think.

Anyways, what I do want to know, as always, is a little bit about what’s been on your radar, what you’ve been thinking of, not necessarily to do with the markets or whatever, but just something that you find interesting at the moment to keep an eye on.

[00:01:47] Cem

Yeah, I think the growth and scale of both hedge fund investing, the investment size in hedge funds has grown dramatically as well as the structured product. And those two things are starting to interact. So that’s kind of where my head’s at a lot. I’m thinking a lot about how positioning is dramatically different than we’ve seen in the past and what that’s done.

[00:02:14] Niels

Okay, well, I’m sure we’ll dig into that.

On my side, there are a couple of things that I thought were interesting, and this is of course besides the all-important Tour de France that I’m following at the moment because we have, still, a Danish rider who who could win it, I hope. But besides that, something I thought was very relevant, I’ve actually mentioned it on the podcast the last week or so, and that is just because you correctly called… And we’re not going into, right now, the future of what you think is going to happen. But what I thought was interesting about the last call you had, where you did expect weakness coming into the second quarter, what we then subsequently learned, actually, is that the recovery has been the quickest that we’ve ever seen. I think 57 days from a 20% drawdown or more and it’s without the Fed doing anything. And I thought that’s very interesting.

And I was just wondering specifically, now in hindsight, whether there was anything, from your world kind of below the surface that we don’t see usually, that was kind of indicating that it could be such an unusually quick recovery in the equity markets.

[00:03:30] Cem

Yeah. So, on the next U Got Options that we are going to record, we will be meeting with the Cboe quant team and getting some deep insights and data that they’ve been looking at. One of the things that I’ll tease is, in that last drop, the explosion, the VIX actually came from a very unsuspected place you really wouldn’t necessarily suspect, which was massive call vol, call buying into that decline. And in the S&P 500 specifically, that led to a dramatic increase in vol.

It was not from the put side. It was not a skew event, which is very different than what we experienced last August. So, both had similar vol reactions, but from very, very different parts of the curve. And so, the VIX levels look similar, but, again, if you look at attribution, and where it’s coming from, and what drove it, they’re very different. So, there was a call squeeze that came once it got started, for sure. And a lot of that was driven by some big buyers in the S&P 500 into that decline.

[00:04:42] Niels

Well, I can’t wait to hear that one, of course. And I think we’ll be publishing that in three or four weeks. We obviously, this week, published your latest conversation with a true legend from the markets, Rick Santelli, you and him on the Cboe floor.

[00:04:56] Cem

Yeah, that was fun.

[00:04:57] Niels

It’s a very interesting and fun conversation. I really hope people will go and check that out if they haven’t already.

A couple of other things that I noticed this week, maybe even this morning, that I thought was interesting because we don’t really talk about it as such. There has been a lot of talk, of course, about how trade relations and interactions with the US is under pressure and probably diminishing at the moment.

And then I see this headline that, actually, China’s build and road investments and construction activity is hitting record highs this year, which I didn’t expect necessarily that whilst we in the west potentially are kind of doing a little bit less with other countries, so to speak, but over here they are just powering away and setting new records. And it kind of shows the difference in maybe the mindset and maybe the long-term planning that they’re doing. I thought it was interesting. I’m not sure I have a question there. Maybe you have a thought about this?

[00:06:01] Cem

Yeah, I mean I think the obvious comment here is, and I think this is, you know, if you try and bully people around and push them in a corner, they’re going to look for alternatives and I think it shouldn’t be a surprise. And China is taking the long view. And this represents an opportunity for them to look like, kind of, the stable, mature government in the room. I never thought I’d be here, telling you China’s more free market than the US.

But that is the approach they’re taking and it’s a very strategic, important kind of approach for them, particularly when it comes to resources.

[00:06:49] Niels

Yes.

[00:06:50] Cem

I mean, that’s a big focus that you and I have had in a lot of our conversations. That’s going to continue to become a bigger, and bigger part of the conversation. I had a lot of conversations last night about kind of energy and where it’s going. I’m sure we’ll cover some of that today.

[00:07:04] Niels

Okay, yeah, and I look forward to that.

Actually, interestingly enough, you mentioned materials. Of course, I’m sure most of the people listening today are aware that the US department of Defense has taken a stake in a rare earth mineral company recently.

But I saw a headline today which may not be new, but also Apple, now, put in half a billion dollars in a rare earth mineral company in the US. It’s interesting, a few months ago they were all starting to build up their own nuclear power supply of energy. Now they’re buying into rare earth minerals. It’s not what you would expect from a tech company a few years ago, that’s for sure.

[00:07:46] Cem

Well, I think it’s going to be interesting. Again, we’ve talked about this here, but it’s coming to fruition. Who the benefits of AI accrue to has not been made clear yet. And we have been talking about it for some time that it’s likely to actually to go to resources.

You know, the amount of power needed to do this, the amount of resources needed to generate this. This massive advancement that we’re seeing is dramatic and we’re seeing that every day.

And I think there are several other places that maybe are not intuitive. But yeah, I think that’s going to continue to be, especially given the pace of AI growth that we’re seeing.

[00:08:29] Niels

Yeah. So, I’ve mentioned two things that I felt were a little bit under the radar. I have one more thing that is a little bit under the radar. I’d love to hear your thoughts on this.

We have talked, over the years, about systemic risk and the risk to the system. And, of course, in your world this is something that you can certainly see maybe much better than in other types of investments because it deals with fear, and uncertainty, and risk, and hedging, and all of that stuff.

And then I was reading, this is from the latest earnings call from Goldman Sachs, and I think I’m quoting now a Bloomberg or some kind of news headline about it. And it says, that on the earnings call with the CEO of Goldman Sachs, I think it was, it basically said that it is now among the top three brokers of 125 of the world’s 150 biggest stock trading clients. And I’m thinking, wow, that’s a big concentration risk.

I mean, five, six years ago they were down, you know, maybe they had half of that, maybe a little bit more, say 80 relationships like that. But I feel that that’s another risk one could see play out in a crisis if all of the big stock trading firms are doing business with the same few firms.

[00:09:52] Cem

Yeah, definitely the volume is becoming very concentrated and it’s honestly true. I mean, you can relate it to all industry right now. if you think about where we are, you know, big companies are getting bigger. It happens in technology, like the Mag7. We have just these massive businesses now and it’s happening in finance as well. And yes, there are benefits to those firms. And this is true in all things, absolute power corrupts absolutely. You’re big enough, you’re more powerful, you can bully up, but there are costs to that and fragility is definitely one of them. We do not have the ability, if something goes wrong, to kind of pivot as much. And yeah, I think that’s very true for us writ large and where we are going, it will not take much for the sand pile to kind of collapse once it does.

[00:10:59] Niels

Sure, sure, absolutely. All right. Okay, let’s do a quick trend following update. July is off to a very, very quiet month. Actually, it’s unusually quiet, I feel, when I look at daily returns from our industry. I don’t know about how you feel about July so far, but so far in our industry it’s been super quiet, very little movement every day. It’s pretty flat at the moment still for the month. Of course, that is better than what we saw in Q2 where every day was like a challenge almost.

But anyways, there have been a few opportunities such as, still, metals on the long side, especially copper (as we may touch on if we talk about terrorism during our conversation). Equities still moving along nice and quietly, but to the upside.

And of course, the other interesting theme (which I’m sure we will touch on later on) is the kind of short exposure to US fixed income markets, unlike European fixed income markets which have been more exposed to the long side among CTAs, for sure, maybe with the exception, lately, of the Italian bonds that have been under some more pressure I would say. Also, there has been a little bit of profits to be had in currencies.

However, the British pound, which has been a decent performer in the last few months, is under a bit of pressure this this month, in July. So, that’s where we are right now.

My own trend barometer actually reflects this perfectly. It stands at 45 which is completely neutral. So ,neither bullish or bearish for that matter.

In terms of performance, as of Tuesday evening, we’re recording on Thursday BTOP 50 down only 13 basis points in July, down 3.38% this year. SocGen CTA index flat, up 2 basis points, down 7.59% this year. SocGen Trend down 21 basis points, down 10.18% this year. And the SocGen Short Term Traders Index doing a little bit better, up 72 basis points but still down 4.61% so far this year.

In the traditional world, MSCI World is up 30 basis points so far in July, and up 10.10% for the year. The S&P Aggregate Bond index down 81 basis points for the month, up 3% for the year. And the S&P 500 Total Return up another percent in July and up 7.25% so far this year.

Now Cem, we had two questions come in, but the second one really is about sort of your outlook comments to what’s happened so far. So, I’m going to keep that to the end where we’re going to go into that segment which I know people love to hear your thoughts about.

But, before that, a question came in from Rick. Rick says Cem had an incredible call, probably 12 to 18 months ago, on buying gold calls. I believe he was simply looking for a low implied volatility at the time. And a $3,000 call seemed ridiculous at the time, which is probably why it worked.

What other asset classes vols are mispriced at the moment? And is positioning ever on his radar when considering trade setups? If so, how do you specifically look at this data?

[00:14:24] Cem

Yeah, so it was about two and a half years ago when gold was really out of favor, which is hard to even imagine now. And it didn’t make sense at all. And by the way, at the time oil, you’ll remember, was flying and the call was not just hey, look, historically if you go into these populist periods, ‘60s, ‘70s, we talked about, these periods where you get inflation, and that structural gold is going to be the best performing asset. And it makes no sense where it was.

But the other part of that call was that vol, historically, during those periods, gold was the most volatile asset during that time as well. So, the call was hey, go buy really long-dated calls. This is going to be a win/win in both directions.

And sure enough, it wasn’t just a big rally, but the volume has dramatically increased as well. And the opposite is true for oil. To kind of build on that, we said, go sell puts in oil. Both assets tend to be very bullish in these periods, but very different in how they are bullish. And that is something maybe people don’t think enough about.

Oil tends to perform well, but very consistently well and has a floor to it during these periods because of geopolitical conflict, which we have seen plenty of since then, which has driven a floor. That was our big comment, and you’re likely to continue to see this kind of floor.

Now, trade comes down during protectionist times. So, that also makes it such that it doesn’t rally too fast or it’s kind of a push/pull. But there is a consistent trend to oil that does very well, over the long run, in these periods. And so yeah, we sold puts in oil, we bought calls and gold, and both have been incredible winners over that period.

So, yeah, going forward, still love those plays. Obviously, they’re not nearly as much of a home run. I do still like selling puts in oil. That’s something that I’ll continue to do. Historically, during these periods we talk big picture.

[00:16:48] Niels

Yeah.

[00:16:48] Cem

When we’re talking about this and this is not just a one week, one month call. These are (no pun intended) long-term calls. That’s why, you know, we bought long-dated calls.

The things that work best, the volatility that works best is actually not equity vol, which is the first thing that people think about. People think, you know, the markets are going to be shaky or they’re not going to perform well. We need to buy equity vol. The reality is, during these periods, through inflation, you kind of get a decline in real terms.

But in nominal terms market equity markets end up going not much of anywhere over the long run. You can get a lot of down/up in the meantime and there’ll be a lot of geopolitical conflict. But net/net you can find yourself going not much of anywhere.

If you go back to 2021, at the peak in 2021, we’re only up 25% or so in four years, or three and a half years. And at the lows, by the way, just in April we were unchanged. And so, this is what I think this decade looks like.

And by the way, it’s been three and a half years we’ve been talking about this, like three years we’ve been talking about it, and everybody thinks all these things have happened. But like, really, what has happened?

We haven’t really gone anywhere. So, I think equity vol, particularly indexes, I would avoid as your hedge instrument if you can. If you are going to be in equities, it’s about rotation, it’s about dispersion. You are going to see, under the hood, dramatic rotations coming.

And I think one that we haven’t seen yet is growth versus value. And I think that’s one that I think really, really eventually is going to hit here.

So, if you’re going to play something with options that has an incredible opportunity for a big payout, it would be that cross factor play. We are actually seeing a very interesting (and we’ll get to this a little bit later) summer momentum versus value breakdown. And that’s significant. We saw this last summer. It’s being driven by some of the same factors. I don’t think this is the beginning of a massive move yet, but I do think that part of the market is very, very interesting to me right now.

And, by the way, a couple of big players, Druckenmiller being one of them, has made a ton of money on Russell calls, two times now. And speculating that that he’s doing it again, here, because there’s been a big buyer of calls in the Russell relative to other places in the market. So, that is a very interesting area.

In the equity market, if we start talking about other things, commodities and other areas, I think you’re going to see something in uranium that is going to be wild. You know we’ve seen a bit of the plays on it happen, but it is… Any place where you have a rare concentrated good, I think that’s going to become a convex outcome at some point.

We talk about rare earths. That’s something, by the way, you and I have talked about for years. But it’s not a novel idea. But there are other things that are very concentrated. Uranium is one of them. Most of the uranium in the world comes from just a couple of countries. Kazakhstan being the biggest, Canada being the other.

So, Kazakhstan is not exactly in a very kind of stable neighborhood. So, that is something to think about. I mean there are other assets like that. And copper actually is also…

[00:20:47] Niels

Sure, yeah., the biggest one day move since 1968 only a couple of weeks ago.

[00:20:52] Cem

Copper production is very concentrated in Chile and a couple other places.

Remember, the OPEC crisis happened because OPEC is able to control, at the time (not as much anymore), completely control the price of oil. When you get into geopolitical conflict, at some point somebody’s going to want to flex their muscle and it’s strategic, if it’s easy to do that, because it’s concentrated. This is, again, we talked about concentration just as it relates to financial companies – similar idea.

If it’s an asset that is concentrated in one place, it becomes unstable. And in a time of geopolitical conflict it is more likely to become an issue at some point. So, the more strategic it is, the more critical it is to everybody, the bigger the deal. So, I would be thinking about those things a bit.

And then lastly, the thing that will continue to perform for the next decade, in terms of vol is FX. FX is going to be the best play in vol for the decade. It will… you will see dramatic… And that’s part of why gold has performed as well.

Gold is not really a commodity commodity, it’s a currency. And that’s part of the thesis of why you want to own the FX and currency vol, and not really the commodity volume. It doesn’t mean you’re not bullish on both, but different play. And FX will continue to be an Incredible opportunity.

[00:22:14] Niels

Before I let you go on this topic, what about bond vol. I mean, it’s a massive area of anyone’s investment portfolio. Any thoughts?

[00:22:26] Cem

Yeah, bond vol is also a dramatic buy, I would say. After FX, that’s probably the next best area to be in.

[00:22:35] Niels

How long, how far out… I mean, not that we are giving any investment advice specifically here, but two things brings to mind. One is, how far out should you even consider buying this vol?

And, in terms of timing, do you care at all about that or is it just something where you say, I have no idea if it’s now or six months from now, but I have enough duration on my investment that it’s not going to be too sensitive to the timing?

[00:23:08] Cem

Yeah, I don’t think there’s any reason to do anything less than a year because this could take several years. I think, you know, you should… I’ll put it this way, the next three and a half years, till the election, are going to be a crazy time for bonds. Just look at what happened yesterday with kind of the Powell commentary.

If you don’t see the similarities between Nixon and Arthur Burns, I can’t help you. And I think we know what happened then. So, you know there are going to be dramatic moves.

I think we’re also inevitably heading, as we’ve said, now for years, towards a debt jubilee. And I think that’s sometime, you know, in the next 5 to 10 years. And so, that’s going to mean volatility in the bond market.

And it’s going to mean cross-country volatility in currencies as well. You see what’s going on in Japan. We’ve talked about that for a while. We already saw last August, and we had talked about that. It’s a massive. There was the Yen/dollar carry trade, blow up. This is not a one and done. This is not something that is just…

And by the way, we’ve called the steepener, from three and a half years ago, that we’ve seen that’s been dramatic. This is just the beginning.

[00:24:40] Niels

You know what, I’m already looking forward to our next conversation with our friend Dave Dredge on this because you know, you and him on vol is very insightful, to say the least.

[00:24:52] Cem

He’s the FX master, right? Yeah, I love talking to him for that exact reason as well. Yeah.

[00:24:59] Niels

All right. Okay.

So, let’s move into something a little bit of free flowing here in terms of I’m going to let you kind of talk about things that you wanted to express. I might jump in with a few topics, but normally you like to talk a little bit of macro initially, kind of yield inflation kind of stuff.

What are you thinking at the moment?

[00:25:25] Cem

Yeah, a couple big things come to mind, one, the placidity of the markets. The summer of gorge (which we’ll get into on the prediction side), and the crumbs at the end.

But I do think there is an historic amount of vol compression happening which is tied to these massive inflows (as we’ve talked about before) into structured products, and structured product like instruments, that are vol compressing. In the summer, vol goes down, people are at the beach, people are not trading. And that paired with hedge fund, (as I alluded to at the beginning of the conversation) positioning, which has also doubled in about five years/four years, is creating massive behemoth size positioning that the market is not used to. And it’s changing dynamics. Those two things are starting to interact.

So, in a summer where there’s no volume and positioning is, you know, gross leverage and long short equity at hedge funds is usually 3x, sometimes bigger. It’s by far the biggest. You know, it’s about 50% of hedge fund assets go into long/short equity or 40% to 50% and we’ve doubled.

And with all the gross leverage in there, and they’re all coming from the same pods that then go off and start their own. So, there’s also a kind of a similar set of Barra factor models that everybody uses. And at the end of the day we’re also all human and we use logic.

And so, everybody, despite trying to not get stuck in the same trades that everybody is, and people creating factors on positioning, they had the same positioning. And in a no low volume environment, not to mention with a vol compression, how do these two things connect? This is the big aha.

If you have massive vol compression and no volume, and you have long/short equity positioning, that’s gross, that’s massive. What happens from the vol markets when we have massive volume compression? Dispersion, because the compression is happening at the index level.

And so, that index level compression is leading to everything moving away from each other – a pressure that forces everything away from each other. And at the end of the day, if that’s happening, what do you think’s moving up and what do you think’s moving down? It’s a pain trade.

In the summer, gorge has become a very painful trade in the hedge fund space. And so, that’s one of the biggest things we’re kind of watching and thinking about. Hedge funds are under a lot of pressure and pain.

Last summer this exact same thing happened. That’s why you’re starting to see this momentum value roll over, which we saw last summer, that led right into the VIXpiration last year, in July.

And at VIXpiration we started a decline that kind of filled those jaws – momentum value versus value often leads the market lower.

It’s a leading indicator, a very good one that people who by the way, may not watch these things as closely, but should always have up and be looking at. But last year those jaws opened and at VIXpiration it start. The market started to follow momentum value lower.

That was a function of hedge fund pain last summer. The difference is that hedge funds weren’t really short last summer. Hedge funds were actually equal weight, if not more. Now they’re short and the pain trade is getting hit, you know, right on the long/short equity side. That’s what that momentum value turn is.

And by the way, this is what I think Druckenmiller and others are seeing when they go buy that value call. It’s a positioning play. So, they’re squeezing it, and retail is squeezing it, and piling on and the shorts are making it even more painful. So, this is, again, a summer of pain in hedge fund land right now. And that could end badly.

Part of what happened last summer is that hedge fund pain eventually led to a degrossing that, once the yen/dollar carry trade kicked in, kind of exacerbated the move again. I don’t think of vol that’s coming this time.

[00:30:02] Niels

Right.

[00:30:03] Cem

Because it happened last summer and we’ve talked, we can get into all those dynamics and predictions going forward. But the point is, that’s the big thing that I’m really watching and looking at. The positioning in the market is massive, and both of those dynamics… And eventually that’ll go the other way.

But for now, as long as volume’s low and vol is well supplied, this is a deleveraging, degrossing event that’s happening in a very illiquid market.

[00:30:33] Niels

Can ordinary investors follow this easily and kind of have an idea when something like that might get triggered? I mean, what would be kind of a telltale saying, well, now the game is starting, so to speak?

[00:30:51] Cem

Yeah, there’s no explicit hedge fund pain. I think momentum value is a good kind of extreme. I would watch that.

The other thing is, you know, as we’ve talked about, these calendar dynamics are even more important. If you go look at the last two years, and look at kind of expirations, I mean, we’ve talked about it for years, it’s always been good. But it’s getting to a point where every expiration is a turning point.

I encourage listeners to go, just bring up a chart of the S&P 500 for the last two years, and just draw the expiration dates, and just look. They are massive inflection points because the options volumes are becoming dramatic during those periods. And so, the relief… And here it is, by the way, we’re recording this on expiration, you know, Thursday. Friday, tomorrow morning, is expiration.

[00:31:46] Niels

Is July an important one for you?

[00:31:48] Cem

Not, not nearly as important as, let’s say, an August or September, or a May or June, or a Feb or March. The two, the one leading into…

[00:32:01] Niels

Quarter end…

[00:32:02] Cem

Yeah, quarter end is the biggest. But as we saw last summer, sometimes they get started early and then the continuation happens. And again, we’ll talk a little bit more about kind of what we see happening as it relates to that. So, it is important, but not nearly as important as next one.

[00:32:23] Niels

Sure.

[00:32:24] Cem

So, we’ll be watching that closely.

[00:32:26] Niels

Okay, cool.

[00:32:28] Cem

From a macro perspective, I mean, the biggest thing right now is the economic numbers from the tariffs are just coming, starting to come through. And this is earnings season. And the way I think about how we begin to see this is that it actually starts with earnings.

You know, if you think about tariffs, a tariff is a tax, obviously. And that tax gets borne by who? First corporations, eventually people, but first corporations. And corporations then have to decide, okay, am I going to pass this on or am I not going to pass this on? And depending on what they decide, depending on what they can do, they either hit the profit margins or they don’t. And at first, it’s usually a profit margin hit right away. And then they say, okay, can I increase the cost out? So, I think we’re going to see that this time.

This earnings cycle is very important for that part. We haven’t seen a massive increase of inflation yet, although numbers under the hood are definitely increasing. And the numbers from the government are not really showing that. And that’s true for employment as well. We can kind of talk about that a little bit at some point here.

But the reality is, you know, what cannot be hidden is in quarterly reports. CEOs have to talk about their earnings. They have to be forthright with what’s happening there. And so those numbers are not going to lie. And I’m really, really watching these big earnings coming.

[00:34:17] Niels

The first quarter, with pretty soft tariffs, Right? Because a lot of it was rolled back. So, we haven’t even seen the worst to come. And certainly with the noises that the administration is making, in terms of where they may land.

[00:34:34] Cem

Guidance is really what’s going to be important here. The first guidance they kind of… The last time they cut guidance they weren’t sure how this is going to play out. It was very kind of new. There’s going to have to be more, more guidance coming there. So, so yeah, I think that’s really important.

The first step, I think, would be to see margins compression and then would come, you know, inflation kind of numbers to start ticking up. And I think we’re starting to see that under the hood. But I think that’ll be more clear. That’s a month or two from now. And then comes the employment number because if you start getting less profits and more inflation, that becomes a cost on people, ultimately. And I think the employment thing is very, very interesting, particularly given what’s happening with AI at the same time.

There’s a confluence AI effects and we really haven’t talked about them here, which we should probably start talking a lot more about, which is how AI is kind of interacting with the kind of tariff, and protectionism, and all the populist stuff that we’ve been talking about.

And those two, the confluence of effects, I mean that is a ‘bitches brew’ of potential problems, particularly because it’s concentrated on the young – on the college graduates. And that is where,also, the pop is coming from, is the younger kind of cohort. So, I think there is a very, very interesting dynamic developing there.

[00:36:04] Niels

Yeah, for sure.

Actually, I’ll probably want to touch on this a little bit later in our conversation today, given something I listened to this morning, actually, although it’s about a week old, but it’s really important.

So anyways, before we leave completely the whole inflation, you kind of alluded to it and I do think it’s important for people maybe to be aware of this. On one side you could say, yeah, CPI came in a little bit hotter and obviously that justifies the Fed stance then PPI came in, I think actually better than expected.

What people should know, a couple of things actually, and that is CPI includes imports. PPI does not include imports. So, very important when we talk about numbers, at the moment, given what’s happening on tariffs.

And the other thing, something that you and I spoke briefly about but I was simply not aware of this, but I got, this morning, an email update from the good folks over at Odd Lots and I love their topics that they bring up. And one thing they wrote about today was how the numbers that the government publishes, so the BLS when they publish CPI, how they’re constructed. And apparently, pretty much since February (this is, of course, a little bit interesting timing) the portion that essentially is an estimate has gone up from 9% of the number to 35% of the CPI in June which was based on estimates which to me doesn’t seem as objective, let’s call it, or could be less objective than a real numbers, or a survey, or whatever.

[00:37:57] Cem

Yeah, people are going to perceive this to be political and it’s not a political comment. I want to be very clear. This happens in every banana republic in the world, and China is well known for completely changing the numbers to benefit how things look. And I’m not saying that Biden wasn’t doing something similar. And by the way, the last four years there was a tremendous amount of revisions happening on the employment side that were dramatic, and consistent, that made all the employment numbers look great and then would fix the old ones after the fact. But I will say that those kind of playing with numbers seem to be happening, and there’s no way to know and no way to force the issue.

But given the threats of firing Powell and the desires to have certain outcomes from the Fed, and given that the Fed is data dependent and a lot of the data that they look at, I mean, it makes sense that the administration would want those numbers to look a certain way so they could get the outcome that they want. And you know, where there’s smoke there’s fire. The incentives are there and then you start to see what’s actually happening.

And by the way, historically estimates were 10% or lower forever. If you go look at history, all of a sudden it’s gone to 30%. And why has it gone to 30%? Because Doge or… They’ve removed, actually, resources from the BLS and said, well, you don’t have enough resources. You’ll just have to estimate.

And then there’s a whole series of who’s estimating… You know, this is how you remove the true data away. You make it kind of a qualitative assessment and then you put the people in charge that you want to be making that qualitative assessment. That makes sense. It sounds like conspiracy. You know, listen, it’s logical. I’d argue that if somebody was in power and what was their outcome? These are the types of things that anybody would do.

And then lastly, we see the same thing in employment. I already mentioned that under Biden it was happening dramatically. You don’t have to go any further than just compare the last private payrolls. ADP came and showed a dramatic, you know, loss of jobs. Big surprise, right? Everybody was like, holy cow.

And then, the non-farm payrolls, the government number came out and was like, nope, everything’s hunky dory. And it was a dramatic departure, one that we don’t see that often. Not that it’s never happened before, but it was dramatic.

And then you go dig under the hood and see what’s happening in non-farm payrolls and it’s like, where did all those divergences come from? They came from government jobs. It was massive. Oddly, we just had a bunch of government jobs created this period.

So, there’s a lot, Again, where there’s smoke, there’s fire. But I think we’re going to have to start taking the government numbers with a greater grain of salt and start looking a little bit more at the private numbers, which is what we’ve been doing for a while now.

[00:41:21] Niels

Speaking about smoke and fire, of course this week a lot of the headlines have been… And I think yesterday was another day where the potential firing of Jerome or removal of Jerome Powell was front and center.

And what’s interesting about this is that, you know, recently the focus has shifted a little bit towards something where you think that this just isn’t really relevant for, how you said, monetary policy. But apparently there are cost overruns on the construction or refurbishment of the Federal Reserve. And, of course, the only way to remove him would be for ‘cause”.

And so, it seems like the rhetoric is now shifting a little bit towards, oh, maybe we can use this overrun of cost as a ‘cause’ because it’s happening on his watch, and so on, and so forth. I mean clearly Trump wants an uber dovish Fed chair. He also wants someone who’s a growth guy and a loyal guy to Trump.

But it is interesting to see how the narrative is changing. And also, as you said, the reaction in the markets yesterday were pretty prompt.

[00:42:41] Cem

Well listen, so this is an important thing that not many people are talking about, actually. Everybody talks about the Powell thing, but I think what they’re not talking about is how maybe the best outcome for Trump is not to fire Powell, but just to make it believable that he could do it at any moment. Because if you think about it, listen, if he fires Powell, they’re not going to be able to just lower interest rates the next day.

You know, first of all that’ll create some instability. And as we saw, by the way, when that first news came out that like he had signed a letter to remove (tat was the initial news by the way). He was actually in Congress weaving a letter apparently, that he had signed, saying (he didn’t say ‘this is the letter’), I’m going to fire… you know, I’m doing all this stuff and that’s why the market just did, what it did suddenly.

And then he was meeting with the head of Bahrain immediately after, and they asked him like, are you going to fire Powell? No, no, no, I can’t fire Powell unless he committed fraud. You know, so, this is then the market rallied back.

But the point here is, that threat may be better than the actual reality because the market perception, that they he could at any point now actually start lowering interest rates, become in charge of the Fed, is the psychology. And with hedge funds short, and all the things, that is a real threat. And that allows him to support the market and to control kind of the narrative on the market side. The reality is if he fired Powell, as we saw, the initial decline, the 10-year will not like that.

Yeah, you talk about a steepener trade. You’re going to see the front come down and the back go up. That is part of why this continues to go this way. And, you know, that threat is a problem for him if he actually does anything about it.

On top of that, it’s not like firing Powell and putting Bessent in will allow him to lower interest rates. There’s a whole set of board governors that have to vote. And if he fires Powell, I’m guessing that’s not going to make everybody at the Fed very happy. So, you know, he could have a Fed that is not cooperative if he fires Powell. So, I think it’s more about the threat.

This is essentially like a shadow Fed move where you’re moving in and you’re projecting policy without actually doing anything. And I think that’s essentially the game plan. I think that’s what they’re doing. I would be surprised if they actually fire him. I think it is a narrative to help support what he wants done.

And I actually encourage people think about, well, if they do want interest rates lowered, ultimately, and they want it timing wise before the midterms so that markets can be in a good spot by then, what needs to happen for them to get that outcome? How do they manage to get that outcome? I think, you know, you probably need some weakness.

A, you need no inflation. And the only way to really do that, given the structural effects of the terrifs and everything, is to see a slowdown – a cyclical slowdown.

That’s A. And B, you probably want kind of markets a little bit lower as well. So, I think as much as they were projecting that (by the way) early, and that’s part of why markets had a decline early on and then they pivoted because it became a stressful event. I think a controlled demolition and an economic kind of slowdown might actually be what they want for right now so they can then get their outcome early next year, So, something to think about as well.

[00:46:53] Niels

All right. Now before we get to your outlook and crumbs, I want to take the opportunity of bouncing a few things I heard in a recent interview on Bloomberg. I think this was from June 11, so that’s about six days ago. And it was with the one and only Paul Tudor Jones. And I thought it was very interesting.

I just took a few notes and I’m going to try and remember as much as possible and kind of fire at you. One of the things that became clear from his comments was that, first of all, in Trump’s first period, he kind of normalized 4% deficits. That was suddenly fine. Now he’s kind of doing the same with 6% to 7% deficits.

I think what Mr. Jones is saying is that, at some point, the markets are going to cut, are going to force whoever is in government, at the time, to basically stabilize the debt to GDP and try and really tackle the deficit issue. I think what he was saying, also, was that he felt that when that time comes this will mean lower bond prices, lower dollar, lower equities.

Once the market accepts this reality, I think he said that the dollar probably will go lower just because of interest rates – I mean short term interest rates of course. Which is also why he needs the uber dovish Fed chair at some point. And he basically also said that, generally, this idea of normalizing budget deficits at 6% or more is generally going to be a drag on equity returns in the future and that what we need to have will be negative real rates – so, say, inflation 3%, 3.5% but short-term interest rates, Fed funds, down at 2%, 2.5%. That’s what they should do. And then finally (and I’ll let you then comment on all of this), he said that, for him, kind of an ideal portfololio (although I don’t agree with this view but I’ll let you comment first) he felt that, on a volume adjusted basis, gold, Bitcoin and equities would be where he would invest kind of thing. Although he did also say that his, I think, highest conviction (and again, I’m careful not putting words in his mouth), I think his high conviction right now is actually the steepener trade, as you also mentioned.

[00:49:52] Cem

Yeah, the steepener trade will continue to be the trade. It was an easy trade. It was inverted, yields in the back curve were low. It is becoming a harder trade but that does not mean it’s not going to continue to work.

Actually, I would argue that the steepener could move even faster now because before (and we talked about this I think a while back), before it was easy to hedge inflation, it was easy to make these hedges. So, when a trade is easy it’s not going to move fast.

But once it becomes hard to hedge inflation and it’s already moved now, it’s a hard decision for people to go out and deal with this long end of the curve. It’s expensive and so it’s more likely to move now. But the price is not great, I will tell you, relative to where we were.

So, that’s one. I completely agree with that. I’ve been hammering that for three and a half, four years. So, I couldn’t agree more. That’s kind of at the core.

I don’t want to like toot my horn but we’ve been saying everything that Paul Tudor Jones is saying now, for years. And that’s good company.

I don’t agree, again, with his… I agree with his view. His view is, yes, what’s inevitable at this point is the debt is growing at an unsustainable rate. The amount, it’s devouring the budget. You know, what’s important and how I kind of am a little different on how I think about that is I actually am a believer that at least (and this sounds Pollyannish) for the next several decades, probably more like 50 years, that the primacy of the US dollar is not going away. And as long as the US dollar is… and that’s just because it’s so entrenched. It doesn’t mean it can’t get degraded marginally over time. And that’s happening.

But as long as we’re the reserve currency, you know, the US dollar is the reserve currency of the world, yeah, the debt can be monetized. And you don’t have to be the only reserve currency. By the way, look at what the Japanese did for 20 years. I mean, they monetize their debt. Yeah, debt to GDP is 260% or whatever, but less than 10%, I think it’s.8% of that debt is external. And so, you know, their bank owns theirs. It’s all internal. It’s not really a real debt number.

So, the US will do the same. If you think the US is going to go into some austerity and government officials are going to stop spending. I’ve got some beachfront properties to sell you in Arizona. That is not going to happen. And so again, we’ve talked about this for a long time, spending will continue to increase, budgets will continue to increase the debt. And it is unsustainable. All of this are things we know. What will happen is eventually the Fed will have to start monetizing the debt.

I think that’s inevitable. If you don’t see that like, you know, and the Fed can. The difference is the Fed can. The question is what will the rest of the world do when the Fed does that and what will the effects be? And I think that was the, again, talk about convex trades, like those are the things you should expect. And eventually it will come down the pipe, and they will cause dramatic kind of issues.

To the point that people don’t talk about, when the Fed starts doing that, and essentially it’s going to be a soft default, basically. They’re better off doing it all at once. And I think they’re going to try and be aggressive and get it out of the way. But they probably won’t because, again, politically that’ll be unpalatable. And so, you’re going to start seeing negative rates. And they’ll do it on the front end, but that’ll cause us a massive steepener, and then they’ll do Project Twist, or some type of trying to switch it to long-term.

The problem with that is, if you keep long-term rates negative, short-term rates are one thing, but if you put long-term rates negative, you drive more inflation, you create an inflationary loop. And the short end could do that as well, to some extent. We saw that again with Arthur Burns and summer interest rates, etc. But the long end getting manipulated down can be very, very bad for structural inflation. Because listen, if I know I can borrow money at, let’s say, 4%, and inflation is 6% or whatever, what is everybody with any money going to do?

They’re going to borrow money and buy everything pinned down that they can, like any energy, any commodity, anything, any house, anything. They’re going to buy everything.

And if everybody’s buying everything, that leads to inflation. And they’re going to pull forward demand. They’re going to borrow to pull forward, you know, inventories and everything as well. And this is how you get into this, you know, spiral. That’s part of why, you know, everybody thinks, oh well, long in the curve’s not a problem. The Fed has absolute control. They’ll just lower the rate and everything will be fine.

Well, yes, that will drive a spike in assets, but it also will drive a spike in literally goods and all things. And that will then just drive a worse outcome. And again, this is what we saw in the ‘70s. This is what we saw and this is a worse situation because they have to do even more of it to control the debt issue. Back then we didn’t have a real debt issue.

So yeah, like inflation. Inflation may seem subdued now. It hasn’t gone away for a while, and we’ve talked about why it was not going away for good. You can kind of normalize it a higher level a little bit here, but that will come to a head, and I think it’s way sooner than people think too. I think it’s in the next 5 to 10 years we’re going to have a, a serious issue there.

[00:56:15] Niels

Yeah, absolutely. And also maybe, and I’m thinking where did we hear this first or who did we talk to about this first? And I’m not sure. It could have been Peter Atwater actually. But there’s this American wrestling term, kayfabe or something. I’m not even sure what it is, but it’s this idea that you know what you’re watching isn’t real, but we’re still watching it.

And then until, I mean, since I’m Danish, we would just say, well, it’s like the emperor’s clothes, the fairy tale where he didn’t have any clothes, but everybody talked about it until the little girl says, well, you know, there’s no clothes there, so there’s no dress. So, it’s that moment, in a sense, that I think more and more people are just waiting to happen. Which is a weird thing to say, but that’s just how human behavior is. We, we don’t want to face it until… It’s a little bit like the Biden moment.

[00:57:10] Cem

Yeah.

[00:57:10] Niels

Remember, you know that debate where suddenly everybody could see it, you couldn’t unsee it, in a sense.

[00:57:17] Cem

Correct, yeah, and I think the place you’re starting to see it are the 30 year bonds, particularly in Japan. Because the reality is markets, in terms of short dated markets, can be manipulated, controlled… not manipulated, but you know, more control. Buyers and sellers, it can match. And if there’s an understanding it’s going to happen, you know, it’s less likely to happen there. But the illiquidity at the back end of the curve, and the finality of (once you go far enough out) that outcome, is really starting to show its stripes at the very end.

[00:57:52] Niels

You know, another bond that’s interesting, I do agree with the 30-year in Japan, but also the 30-year in Germany hits its highest level in 14 years this week, I think. So, you’re right, absolutely.

[00:58:05] Cem

Yeah, the one thing I want to touch on, I didn’t get to with Paul Tudor Jones is his asset allocation, which you mentioned.

[00:58:12] Niels

Yes, let’s talk about that.

[00:58:13] Cem

Yeah. So, gold, bitcoin, am I bullish on those assets? We already talked about that, yes, I am. And I have been in this structural period. But on a risk adjusted basis, again, I already mentioned how volatile gold can be, and we all know how volatile Bitcoin can be, and if you’re going to be that concentrated… And by the way. I mean you can lose 50%, 75% in both those assets in a matter of months, a year.

[00:58:45] Niels

And in fairness, he did say and stress ‘vol adjusted’ just so people didn’t think he would want to buy equal amounts.

[00:58:52] Cem

Yeah, yeah, but it’s still 20%, 20%. These are big, big allocations. Or. I think he said a third, right? A third, a third, a third.

[00:59:01] Niels

No, no, no, no, he just mentioned those three assets. He didn’t put a percentage.

[00:59:04] Cem

I think he did actually, at least maybe the time before, he mentioned that he’s been very, very oversized on those things. And then he says the third one is equities. I cannot agree less with the equities comment.

And any asset that is not a kind of a store of wealth, like gold and Bitcoin (and we’ve talked about this), in the structural inflationary periods we see, performs incredibly poorly. It is an awful risk/reward. And in ‘68 to ‘82, we talked about this, the S&P 500, during that 14 year period, that inflation inflationary period lost you know, about 50% or so of its value in real terms. And that’s 14 years of holding on to a volatile asset and then getting paid off with negative half your money.

People think, think equities are a hedge for inflation. They’re not a hedge for inflation. I want to be clear. And people who are scratching their heads of that, it’s because of the discount rate, stupid. The reality is, in 1968 we had a, call it a 5%, 4.5% yield on the 10-year, guess what, the earnings yield of The S&P 500 was? About 4.5%. It was at 22, 23 PE, which is similar to 4.25%, a very similar dynamic. In 1982, and again we’ve talked about this, 20% yield in the 10-year bond, guess what? 4.5 PE, which is like a 22% yield.

Those two things are integrally connected because if you can go get a 20-year bond or 10-year bond for 20%, why the hell would you ever buy the S&P for anything less?

And it may not, on an annual basis, or a monthly basis, or quarterly basis, be in line but you better believe on a multi-year basis, you know, those things are going to hold true. And so yeah, if we’re getting a steepener, and the long end of the curve is going higher, like he’s saying, like I don’t understand why you want to own equities or any yielding asset at large. That doesn’t mean own no equities. It doesn’t mean like no kind of equities.

There are some equities, you’ve got to be very tactical, that will expand profit margins into increasing interest rates. And that’s a small subset, about 20% to 25% of the S&P 500. Those are the businesses that actually can counteract the multiple contraction. They will also be subject to multiple contraction. But there are companies that do very well.

The problem is equities writ large not only get hit by the discount rate, which is the most important thing, but most of them have their profit margins contract. And we were talking about how we think we’re going to start seeing that here in earnings coming soon. But that is the big problem.

If you can find the equities, which we can talk about those on another show or another time, which I have a whole list of, and we do that for our clients, you want to be focused on the companies that have negative working capital and have improving outcomes on the equity side. But again, you’ve got to definitely reduce the equity exposure that you do have, if any, as a result. So, there are way better non correlated… My approach would be more non-correlated investments. And these are actually not assets. I think he just talks about assets there.

We think 30% to 50% of a portfolio should be non-correlated. And we can do that now. This is not 1980s investing, this is not 1960s investing. And I think Paul Tudor Jones, much like a lot of other people, the majority of people, only thinks investing is buying assets. And I think that’s part of the problem there.

[01:02:53] Niels

Yeah, the good thing is I, I’m hopeful about Paul Tudor Jones simply because not only is he very successful, also he started out as a trend follower, which obviously he goes very high in my book. But there was another reason why I just thought, when I heard it, I thought interesting allocation.

Because I thought, well, if you’re really worried about high interest rates, is gold really going to help you with that? Or is bitcoin, in a high interest rate environment, really going to skyrocket? It could go up for other reasons, of course. I mean if the whole thing blows up, maybe gold and bitcoin will do well, and under the current administration, where there’s a lot of support for these crypto assets, of course.

But anyways, I do want to get to one other point, because you mentioned it briefly and it was actually also something that Mr. Jones touched on before we wrap up today, and it was actually AI. He had a whole section about AI. Pretty scary actually. Obviously, he gets invited to conferences and to talk to people that we don’t for sure.

But maybe this was actually public news that he was quoting. He was quoting the following one. He said that Elon Musk is saying that there is a 20% chance of AI wiping out humanity. I thought that was a big number.

The other thing he said that the head of Anthropic, Dario Amodei, who’s the CEO and founder of that company, is saying that he could see 10% to 20% unemployment in one to five years due to AI, which is white collar jobs specifically. And also, the Big Beautiful Bill has a moratorium on AI Regulation that was mentioned, which means no safeguards. I mean, we can really go anywhere it sounds like. So, those were very interesting things.

[01:04:50] Cem

Yeah, the one that I was kind of insinuating, and let’s dive into it, is unemployment. What happens when, again, I do think those 10% to 20% numbers, in the next one to five years, that’s likely.

And that’s, let that sink in. Yeah, that is a big deal. The unemployment rate for college graduates this last year is at 9% in the United States. It is 4%, give or take, for the total public. And by the way, just a year ago, I think that unemployment rate for college graduates was like s6%, 6.5%. And the year before that, it was more or less in line.

It does tend to be a leading indicator of unemployment increases, by the way, because companies first stop hiring before they start firing. But it’s even more dramatic than we see in history. And if you dive under the numbers and you look at (and we don’t know for sure that AI is the cause here)… And there are other things going on, as we talked about.

But if you dive under the hood and see where the high unemployment number is the highest, computer science graduates, electrical engineers, people who are programmers, are completely not getting hired. And it’s a lot. Almost every category that’s high is one that is being quickly replaced by AI.

And so now I can tell you anecdotally, I mean, I’ve hired a lot of people in the last year and when I have, we thought that we would need to hire more. More recently those hires are now doing the work of three hires, four hires each. And so, it’s happening, and it’s happening way quicker than I expected.

You know, this is like, I’ll do a mea culpa here. I thought this would be a one, two, three year kind of forward dynamic. It is happening fast and we have to start seriously talking and thinking about those effects on a much quicker timeline.

But yeah, I do think, and again, as I mentioned earlier, what we need to start thinking about are the political ramifications of that, particularly if, you know, the lack of hiring and the younger generation is going to be the main primary issue. That is going to lead to a lot of already frustrated, angry young kids stuck in mom and dad’s basement.

We have these millennials on down we’ve been talking about who’ve been driving this populist rhetoric. If that populist rhetoric is only going to increase due to AI, which is not the core driver. It was already unequal. You know, populism is not only not going away, it could be in hyperdrive.

As baby boomers, who are the more capitalist kind of side of things are starting to pass on, it creates a very, very volatile political environment. And if it were happening in a non-populist cycle, let’s say AI started to thrive in a period when it was 1982, okay, well, free market economics, we have a more equal society already and we’re already going to supply side economics. You can manage that, potentially. This seems like a very volatile situation.

And never mind the lack of regulation, the size of the corporations that are running this, so, the centralization of power that we also talked about already, those things combined create a very us versus them environment. And we are already in us versus them. It is only going to create a more unequal and concerned youth.

And so, yeah, UBI is coming, by the way. I’ll tell you that right now. And we can point back to this. I’ve talked about it for a while, but it’s become increasingly clear that we are going to have to go to a… And again, how do you deal with that, in terms of a budget?

If you’re going to have to redistribute money to people on the bottom. And that is going to continue. And you’re going to have to do more protectionism to protect your people against other people. This is the whole cycle and it’s only getting accelerated, I think, by AI. So, I would watch that very closely.

I think in three and a half years, you know, never mind a year and a half, it’ll start to be an issue. But by the next election, that creates a very volatile situation. And I mean, it’s going to be populism versus populism. How do we out pop… And fiscal spending, you know, look for fiscal spending to dramatically increase again as we go forward.

[01:10:06] Niels

It ties so well into our conversations, which I’m not going to recap here, about the fourth turning, and we still have a few years left of that. But one thing that really took me, also, by surprise, and then I’ll move on to your crumbs (which people are probably dying to hear). He also said very specifically that in the last year or two, he’s come to the realization that libertarianism is as big a threat to the US as socialism. And I thought that was a very interesting comment, that you simply can’t let people just do whatever they want with no safeguards. And obviously, that may have come more to the forefront given what’s happening now with AI. But I was surprised to hear that.

[01:10:56] Cem

Yeah, I think that’s been the case. It’s actually, again, I don’t want this to come across as in any way political, but the reality is, this last bill actually does the opposite of what the populace wanted. The spending is still there, but it’s actually… Now, the tariffs are doing what the populace wants. So, it’s kind of a balance. And I think that’s part of why they had to do the bill the way they did to try and balance some of the effects of tariffs. But yeah, the Doge piece. Right?

And by the way, I think this is part of why Elon is kind of getting or got pushed out the door, which we talked about. Most people didn’t believe (that was actually when we were talking about it last) that there was a conflict and there was a divide. It’s clear now.

But, I think, I think it‘s really important to note that the Doge movement of really hollowing out regulatory authority is going to give more power to wealthy corporations. And that’s the main focus. That’s being sold as like, oh, there’s all this fraud or we’re cleaning house.

But the reality is, what it’s done is we’re seeing, with the BLS we just talked about, is an ability to control and for the people with money to go more unchecked. And that’s why they’re hollowing out the IRS, in particular, and all kinds of other laws like that.

So I think the AI deregulation that comes in the bill is another example of that. And I mean, if you’re not going to give people what they want and you’re going to keep continuing down the path, which is the path that things go to – absolute power corrupts absolutely. At some point the angry hordes will come for you.

The question is, are our AI overlords going to be able to control that? And I know that sounds… But that’s where this is heading, and we’ve been talking about it for a while, and every year we’re going further and further down that path. So, yeah, fourth turning, we’re walking directly into that path.

[01:13:18] Niels

We should have been recording this 3 days ago Cem, when we talk about these things because it was Bastille Day in France. Of course, we know what happened then.

Anyways, before we get too excited about that, one thing that people will be excited about is always to hear, kind of without this being in any shape or form investment advice, but you have volunteered some interesting calls over the years and I’d love to hear where your thoughts are right now in terms of where you think markets are heading.

And maybe I can add to that because that is part of that second question we got early on was, maybe also some of the reasoning for why you think markets might go where you think they will go.

[01:14:11] Cem

Yeah, so summer of gorge, we already talked about. Placidity driven by a dramatic vol supply which is based on structured product issuance and low volume, and that compression that leads to supportive vanna charm flows which support the market, and reflexively also leads to lower realized volatility that is what we’ve seen, again, and that shouldn’t be a surprise.

It looks a lot like last summer and the summer before, honestly. The added part, as we mentioned, is the hedge fund positioning which is creating that dispersion. And so, we’re in a full-on pain trade at this point. It’s been several months of that, and again, the dispersion that comes from index compression is driving more pain, particularly underneath the market. This year, as I mentioned, institutions are also cut short. So, it’s even worse and it’s driving a continued kind of tick, tick, tick, tick in the market. That short positioning by institutions, until it’s resolved, this market can’t go down in a meaningful way.

So, when we do get a decline or sideways action, that deleveraging is important because as deleveraging happens the fuel comes off the table for the up move and the decline will have less demand underneath it from institutions. So, we’re watching the deleveraging – the short position come down, that’s critical. It’s being forced upon institutions.

And so, as that’s happening, we’re also starting to see sentiment percolating to kind of record levels. So, this is a process. We think that short positioning, which, by the way, happens for a reason… There are a lot of reasons, from a macro perspective. I don’t think I have to point too far in too many directions to show you all the risks and the issues. You know, we talked ad nauseam here today about a lot of them.

The reality is that, until positioning gets back on sides, it’s hard for markets to go down. It doesn’t mean the weighing machine won’t take over. The weighing machine will take over. This is a very important point. So, let’s go directly to kind of timing and issues. The end of the year is a bit of a magnifier to whatever’s happening going into the end of the year.

So, as we get to October or November, early November, if markets are still up, the end of the year will see more vol compression, a little bit more of the summer type action, with an accelerated kind of rebalancing, re-leveraging effect that comes at the end of the year.

So, if this market does not start a decline in the next month and a half or so, and it doesn’t need to be, actually. The best outcome is a slow, ‘boil the frog’ kind of ‘heat-up the water’ without any vol. Again, I don’t expect anything like last year at all.

So, people automatically think, oh, a decline’s coming, we’ve got to get short/long puts, like the vol… No, I want to be clear. And if by the way, if that happens, that’s not good for a bigger decline to actually play out for several reasons I can get into.

But the most likely outcome is when, whether this is soon here, because we’re now getting to expiration tomorrow, or August cycle. Some type of small down would be most likely. And if it happens… Which is hard, by the way, because if vol is compressed it’s going to be very hard for the market to go down. But that would be ideal as well because it’ll allow… And again, it’ll be muted because all the short interest from hedge funds and whatnot will have to be bought back.

But all the internals are showing that there is underlying weakness and that the vanna charm flows that run into this expiration are likely, as they go away, to allow markets, these jaws, to kind of come back in line, these divergences. So, if we see that, which we think is likely, it’s likely to be a small one month decline. I think 2.5% to 5%. Like a nothing burger, really, given how much we rallied.

The interesting part comes a month from then, starting in August expiration, as I mentioned, because of the Sep. OPEX. And, under the hood, if you look at skew, and the S&P, and a couple other places, there is a big dislocation between August skew and September skew. And that’s kind of a clue that there’s a lot of pain sitting out there in that quarterly – potential pain.

As we know, these quarterly option expirations are always an issue. But there’s a breakdown there. And so, that could activate a grind lower, with vol compression, calendar expansion, skew continuing to stay high in the back but the puts in the front just disappear. This could force a chase that could even make that worse. It could build on itself and then eventually lead to a bigger decline in August to Sep.

Now, I don’t think that August to Sep. decline, either will be a big one, but it could force more of that action. And instead of a 2.5% to 5% decline in a month, you know, you could go to a 5% to 7.5% decline the next month. And then you start looking back, you’re like, wow, this is a 10% to a 15% decline. And by the way, that would take us right back to 5,700, where we were at the beginning in May – not that long ago. And so that would make a ton of sense. And I think that’s probably the most likely outcome – market down, vol down, calendar expansion.

And I think, in that process, the pain will probably still continue momentum versus value you until about the middle of August, sorry, late August or so. And then you’ll probably see a bit of a turn in that factor as vol finally releases, probably at the end of that – towards the end of that move a little bit. It won’t be a big increase in vol but like some type of taking it from completely pinned to the floor, out of bit.

And as that happens, I think you’re probably going to get some type of relief rally, from 10% to 15%, probably around Sep. OPEX, after some resolution there. And if that happens, if this all plays out as I’m saying here, the big question will be how does that relief resolve? And that’s still ‘we will have to see’. That’ll depend on some of these macros outcomes. And we’re going to get a lot of data between now and Sep. OPEX, and a lot of very important data. The next two months are, basically… All the things we’ve been waiting for are coming now.

It’s earnings. It’s inflation, It’s employment, and all the things. And never mind that we’ll see how this Powell/Trump stuff resolves and what their reaction is. I’m guessing if the market does decline there, they’re going to try and kind of support it along the way as well, which will also help create compression, again, controlled demolition, which I think they probably wouldn’t mind. So, all these things kind of point to that kind of an outcome.

Now the question is, let’s say Sep. into October, the first couple weeks of September we get a bit of a rally back, and we’ll have to see, by the way, how does institutional positioning look? How does retail positioning look? How’s sentiment at that point?

But I have a feeling that retail has had such a positive experience here, I think 2021, that once 2022 comes, which again I feel like this is more of a 2022 type decline…

[01:23:00] Niels

It sounds like it, for sure.

[01:23:01] Cem

Yeah, they’re more likely.

This is why the ‘boiling the pot’ is effective for a decline because if hedges don’t work for institutions, that’s painful, and that makes it worse. If you don’t get a vol expansion, you can’t get a V bottom because they’ll up the vol. And then, also retail, who’s been the primary entity supporting things, will continue to try and buy all the way down. If there’s a big vol event, they get kind of pushed out. But if it’s not scary and they keep hoping, then, and that’s what happened in’ 22. You can get a real just painful grind lower. I could see that being like that.

So, if we can’t get the resolution in October, some type of momentum, and then it starts to roll back over, that’s when it could get interesting. Because, again, the end of the year is this very kind of magnifier. And usually, the end of the year is positive, and people know because the markets tend to be up, and even if it’s neutral, it’s positive because, again, 5% interest companies make money – they reinvest. But if we’re down 10%, 15% come October, and then we start to roll over, then you can get a magnifier into the end of the year.

And we saw this in ’18, Oct. to Dec. We had this, this 20% decline in 2018, which, again, people were kind of scratching their head, but that’s how it can play out. So, I don’t want to say we’re getting… you know, but this is how it would play out. I will say, as a caveat, that if it does not happen in the next month and a half and really get some of this weakness. Again, it’s ideally about ‘boiling the pot’ type weakness, like a nothing burger to most people, like a 2 1/2% decline. It would be nothing.

But unless we start to see that, or even more, if we start to see a rally that continues to next month, it’s going to get really hard, into the end of the year, to get a decline in that case. And actually, in that case, you start to see more of a ‘98 kind of blow-off top scenario coming in.

Because then there’s this, this, I kind of describe it as a dance. The pattern, the beat matters, where and when the steps happen. Because then you have a midterm coming next year. And then you have them taking on the Fed chairmanship in June next year. So, unless we start getting a decline now, soon… And again, nothing big, , like the price action now really matters. I don’t want to put too much weight on it, but the next month and a half, two months is kind of critical.

And again, if we don’t get the decline, then there’s all the supportive flows in the end of the year, and then we start getting it early next year. You’re running out of time. It’s a midterm. They want a positive outcome. They’re also going to try and bring monetary stimulus in and get things moving again. And then you see a year and change of a continuation here, which would be a squeeze in a situation where institutions are short. And this thing could just kind of really blow off. It will resolve poorly, directly after the midterms, in my opinion, if that’s the case. And again, the dance steps will be… they would prefer for that to happen as soon as the midterms are done, so then they have time to resolve it and come to the rescue by the end of the year, or if they’re unable to create a bigger crisis that then they can use to accomplish their outcomes.

But these are kind of the two scenarios, and we’re at a pivotal point here to take advantage of it. But I will say, knowing that those are your more most likely paths itself is incredibly valuable because you can bet on both paths at the same time.

[01:26:41] Niels

Well, first of all, thanks so much for that, for sharing that. I know our audience loves hearing these thoughts. Not a lot of people are brave enough to venture into that. But a couple of things.

First of all, the best way to make sure that you see how Cem continues to evolve his views is, of course, to always tune in to the podcast. But also, I have a suggestion for you, Cem, because you have such a strong and large social media following, and that is you should record yourself with doing two different dances, because you love memes. And then you can just play the dance that you think we’re in, and then if you change your mind, you just play the other meme.

[01:27:28] Cem

Yeah, I try and be subtle… Just to tune into these conversations to get the clip. But I’m with you, I’m all about more memes – more memes on social media. Maybe I’ll record a dance.

[01:27:48] Niels

Sure. Well, first of all, an amazing conversation. I really appreciate that. We had not a lot of things planned, as I said in the beginning, but we have in fact probably recorded our longest edition of our Systematic Investor conversation. So, I hope that everyone listening will appreciate everything that goes into Cem coming on and doing these incredibly detailed conversations. And if so, please go and leave a rating and review on your favorite podcast platform to say a big thanks to all of the efforts that goes in from his side.

Next week I’m back with Andrew and Tom, so that’ll be an interesting, fun conversation. We’re going to dig into a new paper that’s come out and actually a special edition of that paper that we got from the source directly. So, tune in for that.

Make sure you watch all the four episodes of U Got Options with Cem directly from the Cboe floor. Their incredible conversations. And of course, not least, from Cem and me, thanks ever so much for listening today. We look forward to being back with you next week. And until next time, take care of yourself and take care of each other.

[01:29:03] 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.

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