Market Outlook for the Rest of 2024 & EOY S&P500 level ft. Cem Karsan

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor series.

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor. Cem, it’s great to be back with you this week. I can’t believe we’re heading into May in a few days. How are you doing? Is summer already with you?

[00:00:41] Cem

Doing well. Spring in Chicago, so everything’s in bloom. Good time to be here.

[00:00:46] Niels

Good stuff. Now, we’ve got some very interesting topics and forecasts from your side that we’re going to be tackling today. We got a few questions that came in, which we appreciate. But before we dive into all of that, besides what we’re going to be talking about mainly, what else has been on your radar? Anything interesting that you’ve noticed recently?

[00:01:13] Cem

Yeah. We just had GDP come out weaker now than expected and we have a hot CPI at the same time. So, it’s that stagflationary environment that you and I have been talking about. A lot of people have been whistling by the graveyard on it, but I think it’s starting to be pretty clear that’s the new timeframe we’re going into, and I think markets haven’t necessarily caught up with that. So, I think that’s the bigger picture that I’d love to talk about.

[00:01:45] Niels

Okay. Yeah, we’re definitely going to do that. It’s interesting though, as you were mentioning that, and of course, you and I have been talking about for a while that we thought that interest rates would go higher and they over the next few years will continue to move higher at some stage. I couldn’t help noticing this morning that the China 10-year government bond yield decreased to an all-time low of 2.22%.

Now, of course, I’m not sure if that’s a freely traded bond, but it sure does indicate that things are maybe not as good as they may seem in the Chinese economy for sure. Now, before we dive into the topics also, I wanted to ask you one thing. In my side of the industry, the trend following world, there’s been one thing that has dominated the conversations for a while now, and that’s cocoa.

I was just curious whether there was one thing in your world that everyone seems to be focused on at the moment.

[00:02:43] Cem

Honestly, in my world, it’s skew. It’s how flat skew has gotten in the vol complex. It started out very low and into the most recent decline has gotten even lower. We’re at near historic lows, and that’s without a significant decline. We’ve seen these levels, but only at higher vols into a controlled decline before. So, I think that’s the biggest most interesting thing going on in vol world.

[00:03:10] Niels

Okay, cool. Now, we have a pretty tight and firm deadline today in our conversation so I’m going to quickly run through the trend following update, not to leave it out completely. We still have a few more trading days left of April. So far, it looks like a solid month for the industry, with the usual suspects, so to speak, helping to drive performance.

As of Thursday evening, coffee, cocoa, both up about 16% for the month. That’s going to be helping trend followers. Fixed income markets are down again so far in April. So, depending on the speed of the models, there should be some positive contribution especially for the slower models who may have stayed short in the last few months.
Copper is hitting a two-year high. Of course, the yen, that has been a good source of returns with an incredibly weak level this morning, hitting a 34-year low with the BOJ holding interest rates. Maybe, by the way, there might still be more in that trend to come. Of course, equities so far in April, not fared that great. So that’s going to be hurting long positions for trend followers. But let’s see, there might still be a little bit of a late-month rally that will resolve some of that.

Anyways, from a performance point of view, my own trend barometer finished at 52 last night. So that’s confirming the good environment for trend followers. CTA indices also doing well. BTOP 50 up 1.42% for the month, up 10.89% for the year. SocGen CTA up 1.5% for the month, up 11.3% for the year. SocGen Trend up another percent in April, up 13.4% for the year. And the Short-Term Traders Index, the best of all of them in April, up 2.15%, up 3.48% so far this year.

As of last night, the MSCI World Index was down 3.8% in April, but still up 4.34% for the year. World Government Bonds down almost 2% in April, down 2.5% for the year. And the S&P 500 Total Return index down 3.85% so far in April, up 6.3% so far this year.

All right, Cem, let’s jump into a couple of questions that came in. It goes like this. “I would be interested in Cem’s view on the impact of call speculation on the VIX. It seems like there were extended periods this year where investors were notably active on the call side (a behavior that we already have seen in 2021). So, it would be interesting to get his view on the following: whether he agrees with the observation, how that has impacted the behavior of the VIX, and whether we can expect more of that going forward.”

There’s a little bit of a follow-up question but I won’t overload you with more than three at a time.

[00:06:06] Cem

What a perfect question after that skew comment before. Yes, absolutely. I agree. Call speculation has been fairly rampant until a little more recently. Positioning, I often talk about this, is very much correlated to trend. You and I should do an episode just about that honestly. But what do I mean by that?

The more you get trend, the more something is working, the more people pile into it. The more people pile into it, then it eventually reflexively has some feedback loops that then prevent the trend, in the short term, maybe from continuing. That doesn’t mean it won’t continue for longer, but that’s what causes pullbacks, that’s what causes little gyrations in a trend. So that is 100% what’s been happening.

The trend in November, December, January, February, March, it’s a pretty long, strong positive trend in equity markets. When that stuff starts to get going, people start speculating. How does this affect things? At first, that type of positioning tends to exacerbate the move. It tends to push leverage into the move. People aren’t positioned too heavily that way. It’s good positive push.

By the way, it’s happening for a reason. Like I said, there’s a positive trend. There’s a lot of reasons why there’s a positive trend. There’s been the Fed, the Treasury, there a lot of entities out there giving the green light to markets. We’ve talked about the election year stuff and why these years tend to be positive and what we’re looking at. But that positioning first exacerbates and you get a lot of these gamma effects.

But particularly when you are buying VIX calls, those VIX calls can start to increase vol on the way up and really unpin volatility broadly, which again cannot just create upside volatility but can create downside volatility eventually as well. We’ve talked about the dynamics of a blow-off top. So, we have seen call speculation on the index side, on equities and options, but we’ve also seen it on the VIX call tail as well as we go higher.

That market up/vol up is the dynamic that has been working into rallies and likely will continue to work. Late stages of rallies, when I say late stages, I mean the last year or two of a big trend rally, this is what we tend to see. This is what we saw in ’98, ’99, 2000, for years. We’ve seen it again in other periods similarly. ’07 towards the end, we definitely started to see market up/vol up as well.

So, it doesn’t mean that the end is nigh in terms of months or quarters, but it does tend to mean that things are getting frothy and the last moves tend to be bigger because they’re squeezes. So, I would expect that this speculative action will continue to increase vol into the rally and create more volatility into the coming rally. That’s kind of what we see. But again, expect squeezes to the upside based on it, but also broadly more volatility. Vol of vol itself should really start to increase.

[00:09:47] Niels

Interesting. Now, there was a little bit of a follow-up question. I don’t know whether you know this, but there was an added question of this behavior, “upside speculation” could lead to a similar scenario as in Japan in the early 2010s as Abe announced massive quantitative easing leading to upside volatility. I don’t know if you recall that period, specifically around Japan, and whether you see some similarities.

[00:10:17] Cem

Instead of giving specific similarities, I will say that the more concentrated and leveraged positioning is short in the vol market, the more risk there is for markets. We’ve seen this again, and again, and again. So, if you have a specific set of buyers, think of 50 cent in the VIX call wing that buy massive amounts and get concentrated positioning in the market against others.

If there are big groups absorbing that liquidity, at some point, you can get a very dangerous kind of mix that can create liquidity issues. We’ve seen them win before and cause stress. It wasn’t just them, but the COVID crash, to a great extent, had others along with them buying March OpEx, quarterly OpEx options that eventually created massive gamma and leverage into an OpEx cycle. So, it’s kindling. It’s something that can make things dramatically worse.

Just more recently, in China, we’ve seen all the autocallable snowball options have a significant effect on the decline there and the way it looked. These things have to be accounted for. The more you see them, the more likely there are bigger structural declines that are much steeper than people could expect. I think that will eventually come. We’ve been talking about that for some time.

We’re in that part of the cycle where that is the next move. The question is, how much higher, how much more does vol have to become unpinned? But if you’re looking at speculating over the course of a year or two, four, this would be the time to start actively managing a long vol portfolio?

[00:12:15] Niels

That is interesting. Okay, good. Well, let’s dive into your topics. The first thing you wanted to dive into and talk about was really how you see things right now. So, I’m just going to keep my mouth shut and listen to you talk about that.

[00:12:36] Cem

Sure, yeah. Happy to jump in. It’s an interesting time not just because of the recent pullback and the move in rates and what’s happening in Israel and Iran, but really in the context of a year that’s otherwise looking pretty positive. So, it’s an interesting and important time to look at not just what’s happening, but speak broadly about how to look at these things. I think this is a good time to educate about how to judge how things happen.

I think everybody gets caught up in deterministic thinking. You and I talk a bit about this. “Oh, things are good, so we’re going up,” or “The inflation number is bad so we’re going down,” or “There’s a war in the Middle East, so we’re going down.” I think that could not be more wrong. I think people really need to understand how seemingly random some of the market movements can be.

But when you begin to understand the reaction functions of supply and demand, how rational the paths can be, I often say it’s very hard to predict direction. It’s very easy- well, not easy, but it’s easier to predict distribution and to isolate certain paths as high probability versus other paths as low probability.

I think that if you can really, really focus on what paths, some may be up and some may be down at the same time, but what paths, up and down, are highly likely and why and what needs to happen for them to happen and then isolating those away from the ones maybe very close and surrounding them, down and up, that are highly unlikely. That type of prediction is easier and just as profitable, if not more.

You have the ability to bet not in two dimensions anymore. We have the ability to bet in time and space, in moneyness, in very specific ways on path. That is where the real opportunity lies in markets in my opinion for market timing. This is a perfect example. Talking about speculation, there’s incredibly long positioning in the market.

We had already talked about in November, December, January, February, March, a very positive run in markets. Not surprising, that created very positive positioning in the market and pushed everybody in. Most people think that is a very negative indicator. You would think, “Oh, if everybody’s long, then there’s more people to sell and there’s less people to buy into a decline.” It’s not that simple.

Yes, it is kindling. It is potential energy. And that creates a reaction function. If hedge funds are levered, if the world is long and, those entities we know have to react in a given circumstance, if that circumstance happens, then yes, they will have to sell. So, it is kindling. However, if the market continues to rally, these same positions can create gamma. They can create a positive momentum in the market.

Think ’97, ’98, ’99, 2000. Remember irrational exuberance? Do you think people were long in ’97, ’98, ’99 and 2000? Heck, yeah, they were long. That’s why the valuations got there. And did it stop? No, it went to absurd, ridiculous heights and accelerated into the end. So long positioning, particularly if it’s for a reason. Structurally, there’s demand reasons that are imbalanced in the market like there are now, etc.

These are very positive things and can create squeezes and really create a supply and demand push where those animal spirits are overwhelming anybody who could ever be short. That said, you will notice if you go look at ’97, ’98, ’99 and 2000, that each year, there were an average of two declines of greater than 10% in those years. Yes, we were getting 30% type years, 40%, 50% type years, but they were volatile.

Because guess what? If people are long, that is potential energy. At some point, you get these reaction functions where the market does sell off 3%, 4%, or 5%, and these entities, some weak hands are forced to delever. So that volatility, that positioning is exacerbated by this type of positioning. That means up and down, to be clear. That means both directions.

If it’s a very positive underlying push, the bigger moves actually end up being up. You get volatility on both sides. This is part of why we’ve been really pounding the table long long-dated calls and short stock. That vol to the upside is too cheap. The right tail, in particular, is too cheap. But guess what? If you have hedged it with stock, you also get the benefit into declines, and that’s what we’ve seen in the recent move as well.

So, it’s important to understand that and think about the world in this way. Recently, what has happened recently? Let’s paint an example of how that’s worked recently. People were very long. We knew CTAs had a rebalancing point underneath the market and lots of other entities as well. But the market continued to rally for five months.

The market was very long in January. By late December, it was already long. January was very long, February was very long. March continued to rally. Going into expiration last Friday, or two Fridays ago (I apologize), going into the week of expiration, we saw a random thing that I believe, by the way, has very little to do with market long-term performance, Iran versus Israel. Iran attacking Israel, Israel then responding.

All of this I think has very little to do with markets in the long term. But what it does is it creates, going into a Friday, Fridays are not the same as every other day, a circumstance where entities are not willing to buy because there was a long weekend.

There’s a weekend coming ahead. There’s all kinds of potential responses and illiquidity. On a Friday, what that’s going to do is create sellers in a very short period and no buyers.

That pushed the market down to certain levels, which if continued for a day or two or three trigger deleveraging across the market. We got there. Next, we come in Monday and now it’s about a response from Israel. Again, now uncertainty. You’re in expiration week and there’s volatility and all that vanna and charm is now past coming out of that weekend, and the market is unable to then respond.

You get below technical levels, and guess what? You start to get deleveraging right as you’re going into our well-documented window of weakness. You get several days in a decline like that, deleveraging has to start. That’s what you saw. If you look at the market action, so two reasons we know this. One, if you look at hedge fund positioning, what performed or what didn’t perform into that decline? Hedge fund longs got decimated, hedge fund shorts…

If there’s any area of the market that you can look at to tell you what was happening and to tell you it was deleveraging, you could just look at hedge fund names. It was as clear as day that this was a deleveraging event. So as soon as that gets started, now you can also see in the price action these rallies every morning, which are these vanna and charm flows, the positive buyback, the machine of the market doing its thing, and every morning, what happened? No matter how big that rally, it was sold. We had significant rally and reversals.

That’s, again, deleveraging. That’s entities when the market opens saying, okay, now we’ve got to start taking this down. So, what we saw is a week and a half now of deleveraging. It’s been decreasing. It was heavy at first and then has come down since then. But again, path. Once you get that rebalancing you know that, okay, now there’s this forced selling that’s coming every morning, now you have a supply side on your end.

We may not rally, we may not go down, but we’re not going to rally. The rallies are likely to be sold. That is exactly what we’ve seen. This is the if-then function and the type of thinking on path that you need to really think about and understand when you’re modeling and thinking about prediction. To be clear, it is my opinion that if Iran had not attacked Israel on that weekend and we had not had this whole issue that the market would have continued about its merry way to the upside.

Now, it may have hit a roadblock a month later, or at another point, but that might have started from another 3%, 4%, 5% higher. So, it is not as equivalent to, “Oh, this happened and this is important news so we’re going down,” or “Oh, the market is in a bullish year so it’s going up.” The path is much more important.

Importantly, they are now after this period, let’s think forward, of deleveraging, which has now been two weeks. Again, we believe there’s another two, three days left here of muted upside, even with the positive earnings, now until May 1st. That’s coming up quick. Why is May 1st such an important date? Why are these events so important? Now, let’s talk about this. Again, in the context of path, why are they so important? It lies on the other side of what is end of month and beginning of month flows.

So, we’ve had a down month. This has been a significant drawdown market. Guess what happens at the end of the month in these months? Significantly less positive or negative flows come out at the end of the month, beginning of the month. This is that deleveraging effect. All the levered entities at the end of the month now have to take their risk constant to where it was last month.

So that is likely to happen here end of month, beginning of month. Again, it doesn’t mean we’re going down. It just means there’s negative flow that’s going to resist any significant rally back. There is event vol. This is a Fed meeting coming. If you have an event vol, we’ve talked about this again, that means there’s lots of puts in the market in this expiration relative to the puts around it, that dealers are short, and they’re short stock again.

When that event comes off the table, regardless of what the Fed says, I don’t care what the Fed says, there’s stock to be bought. Now, that doesn’t mean again that we’re not going down in that window. But that’s potential energy. Until that happens, that doesn’t come off the table. So that potential energy is locked up until May 1st. There’s a perceived risk to the Fed, understandably. That’s why the market is long put, short call.

But that also means that deleveraging, to the extent it needs to happen, needs to happen before that event. That’s exactly why that period is important. You’re likely to continue to see selling and deleveraging as these algos and functions are basically saying, okay, by May 1st, Fed, we need to be back to X risk level. So that deleveraging continues essentially till that point. A lot of it’s done, but that is still on the market.

And then you have a natural opportunity for policymakers to try and support markets in that window. But until we know that can’t go. So, there’s this sitting potential positive on the other side of this with deleveraging that needs to happen up until that window. But the good news is, again, this is likely a positive period coming on May 1st. I think those that get it, the more sophisticated traders out there, are trying to speculate long and there have been buyers underneath this market.

This is part of why the market hasn’t also declined dramatically. It keeps dropping and rallying, dropping then rallying. We’re getting this natural action. After this event vol passes and presumably, and the Fed doesn’t say anything too nasty now that we’ve gotten a pullback, and by the way, there’s QRE there too. So, it’s not just the Fed. We know what the Treasury’s going to say. The Treasury is going to try and be as accommodating as possible. Then you get the positive flows coming from May OpEx and all the vanna and charm flows we talked about for the next two weeks because we get into that very positive part of the options cycle.

So, it’s a very positive period coming with deleveraging behind it. These are the things that determined path. This is why time is also not linear. You have events. There are minutes and hours that matter more than other minutes and hours, and dramatically so.

Anyway, this is why the pullback we got and the deleveraging, once it started, was likely to last to May 1st, and why selling calls in that window was such a positive trade. Going forward in this window, there’s a likely resumption of that positive trend.

Now, the key here though, and again this is path, if we can continue in this window where we know positive flows exist, we know there’s potential positive energy here in this May 1st to May 15th, call it, two week window after this pullback. We need to now see (now that the deleveraging has happened) some strength. This is, again, an if/then statement. We need to get above technical levels to start getting momentum going and trend going in the right direction again.

If we see that in this window, we can look at levels, but more importantly, we can look at momentum as a function of time. This has to be a function of time. If we can start to see certain momentum, then this rally will take off again. You don’t want to be short. You want to be buying the dips again. We’re going right back to where we were.

But, and this is an important but, again, reaction functions as a path. If we cannot, and it starts to look… Again, you don’t have to wait till May 15th for this. If you start to see, like a week goes by here, we’re not getting the momentum you would expect, things are still floundering, we’re still seeing some weakness, there is significant risk and potential energy (I really want to highlight this) in the June OpEx.

We talk about quarterly OpExes and the importance of them all the time. But there is a ton of, and more than usual, open interest in the June OpEx partially because there has been a lot of (going back to the VIX call speculation and other things), there has been a significant amount of vol buying in the longer end of the curve and there has already been a bit of weakness that’s been building for several months on the long end of the curve.

We’ve seen a lot of expansion in vol. The front continues to decay and the back continues to get bought. As that’s happened, June, in particular, has been a point of short vol. Why? Not just because it’s a quarterly and there’s lots of structured products. Yes, every quarter, they are big. That’s one. But two, it’s another Fed meeting. We have a Fed meeting right before that June OpEx. So that’s been an important driver, and an important one.

There’s been speculation as far as the Fed cut starting then and up until more recently. So, there’s a lot of still uncertainty. Some of that will come out with the May OpEx here. But importantly, there is some other added vol in there because of that On top of that, third of all, it is a five-week options cycle. Again, it seems like a random unimportant thing, but it’s not. Why?

Because the week or two, it’s usually about a week and a half, of weakness before vanna and charm – these structural flows come back into the market, is that first week into an option cycle. When you go to five weeks, you go from one to one and a half weeks without positive flows, potential risk in the market, to two and a half. That is a significant 75% or so percent increase in the amount of time where things can go bad.

So that week and a half to two and a half weeks, call it two and a half weeks, in this cycle of the last half of the May cycle into the first two weeks of the June cycle, are particularly dangerous. And if things were to continue to break down here, and we went into that cycle, it could create a deleveraging a significant increase and even more deleveraging and you could bring the vol complex into this decline. So, there is a tail sitting out there and the time window is very clear in which that tail exists. You need to hedge for that.

Now, that said, I am of the utmost confidence, maybe that’s too confident, that whatever this decline is, and it could be significantly more, will come to an end sometime not far after June OpEx at the worst case. Again, it could be as early as May 1st. So, you have a window that is a potentially dangerous window. It’s not the full five, six weeks that you need to be worried about. You’re going to get support here in this window.

If weakness comes back here, then you need to be very cautious in that first two weeks of the June cycle. That decline in the June cycle, if it gets going, could be ugly. But provided it doesn’t happen the last two weeks, and the momentum doesn’t come down, and vol doesn’t respond and vol is still pinned in that window, you better get back on long in this market at that point because this will all be a digestion that will be bought up, and again, we will be at all-time highs before too long.

It still should be a positive year for all the reasons we’ve expected primarily because the Fed and the Treasury are telling you there’s a put on this market, that there’s only so much that this thing could decline before they react with more stimulus. Even in the context of none of that stimulus because inflation is hot or whatever, there’s going to be no calls being written on this market in the sense that they’re going to be withdrawing liquidity. I think that’s the critical point to make here. Anyway, long-winded, but hopefully people got something out of that.

[00:31:40] Niels

Okay. A number of questions came along in my head as you were talking. So, I’m going to go back a little bit to some of the things you said. But before I do, I want to stay with some of the things you just said. What springs to mind here is that given these scenarios, and given the fact that the outcome can be significantly different depending on which outcome it’s going to be, and I don’t want you to give you a secret sauce away, but how do people who are not invested with you, how would they even go about trying to make some profit out of this scenario?

[00:32:23] Cem

The key here, and I think this will be a theme that you, Niels, and I and will tease this a little bit. We’ll end up doing a lot more conversations in the future as we talk more and more about volatility going forward, but the key is to use options. Options are a superior way to express dimensionality. When I say superior, stocks, bonds, any asset is two-dimensional. You can only bet up and down. You cannot bet on path.

But options allow you to bet on the full distribution of outcomes. It is a superior technology in a sense. It is a superior product. It has, much like any technology (and you and I have talked about this, I don’t want to dive too deep into it again), but it needs certain network effects to gain volume, to gain customers, and those network effects we have been seeing now for decades, and they have increased dramatically.

We used to have quarterly options like every 1% in the market basically and just in certain products like the SPX. Every product has options on it. Every day, you have it every five strikes to one strike depending on the product. You have not just full size and mini size, you have micros and you have nanos. This is full accessibility at this point.

You have TD Ameritrade, you have Schwab, you have Robinhood, you have all kinds of access now. You have all kinds of education. You and I are talking about it. Everybody else is educating. And importantly now, dimensionality matters more, much like we’ve been talking about on all these macro pods. This is not a world of two dimensions as much anymore. There’s a lot more relative value.

We are in a regime change. Things are changing. There’s a need for that dimensionality. So that is creating massive increases in volume and the importance of options. This is why the CBOE stock is at all-time highs. This is why their volume is at all-time highs. It is not about hedging. Everybody thinks options are for hedging. Options are the market.

Options are the ability to express any form, any bet, any information that you have with dimensionality. It is the ability to bet on path. That is such an advantage in a world where we’re looking to predict on path. So, the key is starting with the products that help you actually express that dimensionality. It takes education, it takes time, but these things are available out there.

I can’t recommend enough that people start understanding not just speculating with options, but really starting to think about what are they betting on, what’s the path, and betting on the path that they believe is likely based on the reaction functions.

[00:35:16] Niels

We’re definitely going to be talking more about that in the future. But I will also just add a caveat because it’s also what I see in the trend following world. Although there are all these wonderful possibilities, they are wonderful in the hands of the professional, not always in the hands of everyone. So, I do think it is important to work with people like yourself or other people who really know what they do because these instruments of course they work both ways, let’s put it that way.

Now, I want to go back a little bit and just understand something. You obviously talked about the importance of flow and how they perpetuate the trends that we’ve seen and so on so forth. That’s also something that we see in the trend following space of course. But I wanted to ask you whether you see a difference from your vantage point when we talk about let’s call it trends, just a word that I’m familiar with, to the upside and trends to the downside.

Because my observation is, and I think that’s kind of also what you’re saying, is that these things take longer and often move much further than people can even imagine. That’s to the upside. I’ve always found that upside trends or long trends are very hard to turn. It takes a really long time. They have this, I guess you could call it, kind of a distribution where the top takes a long time.

It’s either like a parabolic move, but it comes after a long up move, or it’s just a long positive move that takes time before it really turns. However, on the short side, it seems to me quite different. I don’t know if it’s the flows that makes them different, but they seem to turn much quicker like we saw in March of 2020 and many other times where the trend has been down for a while and people are panicking, but then suddenly it happens.

Even though you said, and I agree with that, that the Iran-Israel situation is something the market might react to but it’s not a long-term effect. But sometimes on the short side, and maybe it’s because it’s usually central banks coming in and putting in some kind of put, then things really do change and can change dramatically in a day or two. Have you thought about this or am I completely wrong in my observation here?

[00:37:53] Cem

No, absolutely. This is market structure. The flows are synonymous with market structure. The reality is that we can go back two years, one of the first things you and I talked about is if you eat, you asleep, you work a job, you own a home, you are long. I don’t care how much stock you have in the market. Everybody is long. You’re long assets, you live in a home, the story goes on and on.

If that’s true, you may speculate, but you don’t buy insurance to protect yourself on the upside, you do it on the downside. This is why skew exists. This is why insurance exists. But that also means that there is an opportunity. There’s a risk premium on the downside. It’s better, by the way, than being long stock to be short an out of the money put, and long an out of the money call.

You have an embedded risk premia that you’re benefiting from in being long. There are all kinds of ways to benefit from this in the market. But as a whole, the market is short put structurally, always. You can talk about relative, how much different. You can talk about specific corners of the market where it’s not true. But as a whole, the market is long put, which means net short. Somebody has to warehouse that risk, and entities are warehousing that risk.

So that naturally leads to a reflexive nature. There is a hedging and, day to day, 95% of the time that means that buyback flow is there. That perpetuates the upcycle. That means that in order for this market to really go down, it has to go down big.

By definition, a small down move is profitable for all these entities, and that means it’s going to be bought up, and bought up, and bought up. This is just on the options side. There are all kinds of other things that perpetuate the long side. It’s the Fed, it’s Treasury, its buybacks. The world is making money. Markets go up over time. There’s a vested interest for markets to go up for everybody.

I could go on and on about all the structural reasons why the difference between supply and demand is not even. It is way, way, way tilted in the buyer’s hand. But the way it works, in terms of distribution, is fat left tail, right distributed. It is that way because there is bankruptcy risk, liquidity risk, tail risk to everybody, particularly the leveraged entities, but everybody, every business, every person to the downside.

If you trigger gamma or structural risk to the downside, that perpetuates selling not just because of the derivatives but in general because the world is long. Particularly those warehousing the risk are all correlated to the downside. You may be countercorrelated if you’re selling those puts to the buyers of the puts and selling stock to those entities because you’ve hedged it to the downside up until a point.

But at some point, everybody is short the tail, even the dealers. And if the person who owns the put is not, they’re hedging a long portfolio. They still are not doing well to the downside. The world is short, and that creates convexity to the downside. Again, the corollary is that, in the absence of convexity, it creates even more positive flows. So that reflexivity underpins market structure and creates a market that is very hard to take down.

Actually, the way it has to almost decline, not has to, but the overwhelming majority of time is a blow-off top. This is what you and I have talked about. That happens structurally when vol becomes unpinned, when the vol just gets lifted off the ground so far that the potential energy is so much that the tail becomes significantly easier to surpass and then the liquidation can come.

So, it’s very much again about distribution. It’s not about up/down. These two things are not created equal. There’s a natural structural difference in the way supply and demand functions in the market as a function of that market structure.

[00:42:25] Niels

I want to broaden out the conversation in the last 15 minutes or so we have together today. It would be weird for us to have a conversation without a little bit of global macro stuff in it. But actually, I want to tie it maybe more to the Fed and US politics a little bit. But I also mentioned that only a few days ago, I released an episode where you and I spoke with Marko Papic, which was super interesting.

I think some of the things from that conversation might be what you want to mention towards the end of our conversation. But also, I want to mention that on Wednesday next week, I’m releasing an episode where you and I speak to our friend from Goldman Sachs, Mueller-Glissmann, the chief of the asset allocation, or Christian Mueller-Glissmann, I should say his full name, the head of asset allocation at Goldman Sachs. Also, it’s a fascinating conversation on how one should think about setting up their portfolio for the second half.

But as you and I speak today, as you mentioned earlier, we just had some data coming in today from the US where certainly inflation doesn’t seem to be doing what the Fed wants it to do. In fact, it’s coming in above expectation and certainly way above the targets that they have. However, it feels like equities have been somewhat immune to interest rate levels. But as you said, you are bullish towards the end of the year.

So, I was just thinking, does that mean that you think that we will, despite the inflation data coming, do you think we might actually get some rate cuts later in the year?

[00:44:07] Cem

We don’t have to get rate cuts ultimately for this market to go higher. Remember, the market creates its own stimulus. If the market goes up, guess what? The economy does better. Inflation is hotter, yes, but the economy does better. There are significant wealth effects to asset appreciation.

Ultimately, that is not just, by the way, in the core indexes. There’s lots of undocumented wealth effects that I’ve been looking into a bit more, whether it’s through crypto and other speculative assets that are kind of off market, that people aren’t even measuring, but dramatic, dramatic benefits to the whole market in terms of wealth creation. So, if the market continues to go up, there will be stimulus. If it doesn’t come from the Fed, it will come from the markets themselves.

Treasury, by the way, will stimulate no matter what. That actually may be bigger than the Fed’s impact, particularly in short-term. I really want to emphasize that. I think everybody thinks of liquidity as one thing. There are different kinds of liquidity. Yes, interest rates matter. But how do they matter? They act with a significant lag and they don’t affect a lot of entities upfront.

Now, to be clear, if interest rates dropped suddenly right now and everybody could go refinance and move, that would create a significant stimulus to the markets. But on the way up, people are just sitting still. It doesn’t dramatically reduce, all of a sudden, liquidity. It kind of just sequesters it. So, the interest rate part is important over a medium to longer term. But in the short term, it doesn’t have dramatic effects.

Now, QT, QE, that’s a different story. These have direct impact on markets. QRA has significant direct impacts on the market. If we’re doing a fiscal stimulus, guess what? That $100 billion we just passed again for military aid, that’s not just going to another country by the way. That’s going to US contractors for military investment. These things are direct.

Tomorrow, those guys are getting checks and new contracts and they’re hiring and that’s going to people’s pockets. So, these things are much more direct, much more impactful. I would argue, and the numbers bear this out, that liquidity is actually not weak. Liquidity is very stimulative and has been despite interest rates going higher. So, the interest rates matter. Yes. And they are reason for concern when we look over a multi-year period.

That’s part of why we are warning people that, hey, we’re getting to a point here. Again, it’s been a couple of years since they’ve gone higher. So, we’re already working through a timeline that things don’t look great. As a function of that, down the road this will have significant negative impacts eventually. But in the short term, this can go on for quite some time.

Liquidity is actually, in this window, very, very stimulative. We have talked about this in election years before. We said ’68 to ’82, I don’t want to hammer on this. You and I talked about it last time. But in that context of 14 years, market went nowhere. The average return during election years during that 14-year period was 21%. So, you can do the math on what happened nominally, not to mention real terms in all the other years.

It is bad structurally. But does that mean it’s bad for this year? No. No, it doesn’t. Actually, what matters this year is who’s buying and who’s selling now, and that is geared on the side of the buyers right now. I think that’s kind of the way we need to think about these things. Again, an election year matters, the reaction function of the Fed because of that, and the Treasury as a function of that matters. But again, we have to think about path, not just direction.

[00:48:13] Niels

You mentioned the election. Of course, we’re all fully aware that in about six months, it’s going to be very interesting to see what happens on your side of the pond. I know you talked about narrative relating to one of the candidates, namely, Trump. But I also saw a headline today, I’m looking at it right now on the Wall Street Journal’s front page on their website that “Trump allies draw a plan to blunt Fed’s independence.”

Any thoughts about what something like that would do to confidence in the markets? We talk about that things are bad, and after this massive run-up in equity prices over the past many, many decades, with a few crises along the way of course, if something should really change, perhaps changes to the Fed’s independence could be the source. I don’t know, pure speculation, of course.

But what are your thoughts when you hear that and what are the narratives that you think will change into the election in the next six months’ time?

[00:49:22] Cem

A ton of changes. This is part of, much like we were talking about May 1st and the Fed meeting, how it affects path. An election effects path. Certain entities don’t want to move. They want to delever or they want to do certain things into a risk. Think of China. China is not going to move and do something dramatic, we’ve talked about this, before the election. They want to see what happens. They may have a better window afterwards.

They know the state now, but there may be a more positive situation going forward. These are examples of things that are just not going to change until the election. The stimulus into the election, we’ve talked about this, we know that that is coming into this window. We don’t know what’s coming next. Now, that path from there can be multiple directions based on multiple different things. But there are certain paths that are more likely.

What is more likely? It’s more likely that to your point, and again, we may be hearing this, but you and I’ve been talking about it for a while. The trend towards the politicization of the Fed and its likelihood to continue to support growth over inflation is structural and more likely to be a problem under a Trump than a Biden. But under both, it is something that is being used.

Again, I said back in December, the Fed choosing of growth over inflation is not a coincidence. It is political. It’s always been political. They’ve never really been fully independent, because at the end of the day, guess what? They need to work together because they do have common interests. The Fed and the US government have common interests and they work together in a sense. They have to.

If they didn’t coordinate, there would be dramatic problems to how that works broadly for the US interest. So, it is political and it’s likely to become even more political if we tear down the relatively little independence that the Fed ultimately does have. What would that mean? I think we all know what that means. Worse inflation, more upside right tail to the market.

Imagine you give Trump, who’s now president if that happens, the power of the Federal Reserve. What does that mean? Do you think he’s going to use that responsibly or do you think that he’s going to use that for short-term political benefit? Now, long-term, that’s a problem. But in the short term, they probably don’t want to get in the way of that. And so, again, it’s the path. You’ve got to think about those.

Yes, regardless if he’s actually able to do that or not, he will likely be able to wrest some control and affect policy in some way. At the end of the day, he can choose who the Fed chairman is. That’s an important distinction. I’ve argued this for some time, but I think Powell is very aware of this.

The Fed essentially have three objectives. One, to control the balance between price control and maximum output. We know that. But it’s other two responsibilities are, one, to control volatility. So, make sure there’s no tail in the market, smooth the business cycle essentially. But lastly, it’s to preserve the independence of itself. It’s to create a belief in the Fed and its independence. So, you can kind of understand why Powell is doing what he’s doing. There is a structural reason. If there is a fear at the Fed, you can call it political or not, but the loss of independence or the structural risk that exists for itself, that it would be doing what it’s doing as well.

So again, it’s not a conspiracy, but there are structural incentives. People always, and entities always follow incentives. That’s for sure. So yeah, this is an important trajectory. I agree with you, that is a potential risk. But it’s an upside risk, if you ask me, in the short term, and a bigger structural problem longer term for the markets.

I think there are other issues, if you want to dive into those too, with the Trump presidency outside of that, problems or opportunities depending on how you look at it. China has been an awful place to be in the last several years. Markets have, if you look at that relative to everywhere else obviously, been a problem. A lot of people have lost a lot of money trying to catch that falling knife.

The narrative has now turned dramatically. Imagine where the narrative was two years ago on China – turned dramatically. And now it’s hard to find a bull on China, really hard. Everything you hear is basically what you and I were talking about several years ago when we had all kinds of other macro analysts coming out and talking about the structural problems in China.

That said, and this is teasing what we talked about with Marko Papic, only Nixon could go to China. Only Nixon could open up China. I think that’s a critical point that Marko made. I think a Trump presidency will be initially seen as bad for China, that tariffs can increase, and that protectionism can accelerate. I want to alert people that when narrative gets so far, in that people are so convinced of impending doom, that sometimes we miss some very important things.

I think Trump could be very, very good ultimately, after some increased volatility, for an actual deal with China happening if Trump gets elected. Ironically, when people are so negative on China and things look so bad, I would caution people to start looking for silver linings and things that can potentially go the other way.

Another one, this is less tied to Trump specifically, but Europe has been left for dead. Everybody says long-term possibilities in Europe are not looking great. Well, guess what? The biggest problems that they had, which is the war on their footsteps, the energy issues that are tied to a lot of that, are being reversed. Commodity pricing is coming down partially because of lack of lack of growth, but also because LNG is coming up.

Again, Marko talks about this. I think it’s very important. I think we are getting to a point where things have been so stretched and there are now potential narratives and potential reasons for structural rebalancing. I do think the next rally that we’re going to see in markets, after this relatively short pullback that we’re looking at potentially here, will be more broad-based.

I do think into the end of this year, it’s going to be kind of an everything rally. And that when things do eventually decline, I don’t know if that’s next year, I do think some of those other things like Europe and China will actually hang in a bit better than people might expect due to some of these trends, and I think there will be structural weakness in the US. So, I think there’s an opportunity here, starting now, to start speculating in some of those names on a relative basis.

[00:56:50] Niels

Good stuff, Cem. I think we did it exactly in one hour, more or less. So well done for packing so much information into the conversation. I really appreciate that, Cem. If, of course, everyone listening out there also likes these conversation and the views from Cem, please go and leave a rating and review because it does help make these episodes more visible to other people.

Next week, I’m not entirely sure who is co-hosting with me, but whoever it is, it’s going to be fun and insightful, but probably difficult to send questions in since I don’t know if Nick Baltas, who was meant to be here will be my co-host or not. Otherwise, someone else will for sure.

Thanks again, Cem. From me and Cem, thanks so much for listening. We look forward to being back with you next week. In the meantime, take care of yourself and each other.

[00:57:47] Ending

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