The Unpinning of Volatility & How to Prepare for What is Coming 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 or welcome back to this week’s edition of the Systematic Investor Series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor.

Cem, it is wonderful to be back with you this week, I can’t believe we’re in August already. How are you doing and how’s the summer been in Chicago?

Have you had any time to watch the Olympics or are you saving it up for some live action maybe?

[00:00:49] Cem

Yeah, it’s been a good summer and right as it’s heating up, of course, this seems to always happen, when I go out of town, the world blows up. So yeah, actually heading out to see the Olympics live for several days and then off to the motherland for a bit with family.

So, but yes, this August is going to probably be more interesting than most.

[00:01:12] Niels

Yeah, actually I think there is a history a little bit of August throwing in a few surprises. I seem to be there were always some dead ceiling debates and risk of default in the US which never comes to pass.

[00:01:24] Cem

For sure, August kind of can front run September sometimes and I think that’s what’s happening here.

[00:01:29] Niels

Yeah, okay, cool. Well, we have a really good lineup of topics, not because all of them are positive, but because the world really is kind of blowing up as we speak. And we’ll be tackling those.

We have a couple of questions we’ll be dealing with, but as you always know, I’d love to hear kind of what’s been on your radar just the last few weeks. Not related to all the topics we’re talking about, it could be something completely outside of that, just something you find maybe interesting, something we don’t talk much about, whatever.

[00:02:04] Cem

Yeah, I mean, I think we do talk about this a decent amount, but I don’t think the rest of the world does. And I think this rotation and what’s happening under the surface is incredibly interesting from a market structure perspective in particular. So that’s something I definitely am excited to dive into.

The other thing is the election’s gotten really interesting here in the US, like things are really changing quickly and it’s a short timeline. So, you know, buckle up, it’s going to be a pretty wild several months, I think.

[00:02:34] Niels

Yeah, and I agree with you on all of that. For myself, actually, you know, the last week or so obviously has been incredibly dramatic in so many ways, especially, of course, what’s happening in the Middle East. You know, it’s very troublesome to hear how it continues to escalate.

And, you know, I do worry about more countries like Iran being drawn much deeper into this war. And I kind of still think, even though there has been some pretty interesting action the last few weeks in the markets, I still wonder whether we are seeing still way too calm a reaction in the financial markets to what’s really going on. And then on the flip side, a little bit of a positive sign yesterday, of course, when a few countries came together and made a big, exchange of hostages, bringing them back.

So at least it was nice to see that they can agree on a few things, even though we’re kind of at each other’s throat in so many other ways. But I do have a little bit of surprise question for you, Cem. And it’s completely unfair to do it.

But I did the same with Mark last week. And it was kind of funny, because you mentioned you’re going to the Olympics. And, you know, I’m curious to know, if volatility trading was an Olympic sport, which sport would you say it is?

And I’ll, after you tell me what your guess is (and you can also say I have no idea, that’s fine), because I did go and ask ChatGPT. And so, I will give you an answer, at least from that side.

[00:04:15] Cem

What, if it was an Olympic sport, what would I be doing? Is that the question?

[00:04:21] Niels

No, so I’ll give you a little bit of background. So last week, I asked Mark, if trend following was an Olympic sport, what would it be? And he said, long distance running.

And that’s kind of pretty good, because ChatGPT came back and said, yeah, it’s like a marathon, you know, and it came up with all these reasons why it kind of fits into that mold. And then I said, well, it could be interesting to ask if volatility trading, you know, would be a sport, what would it be? So, I wonder if you think there is any analogy that you can point that way?

[00:04:49] Cem

So yeah, well, it’d have to be something, you know, incredibly convex and with a lot of potential for energy in it. Like, if it was the Winter Olympics to be like the giant slalom or something, if it was the Summer Olympics, let’s see, what would it be? It’d be some type of, like skateboarding event or something where it’s like very high flying, lots of risk, can go any number of ways, can be incredibly beautiful and clean if done right, but can also be catastrophic if done poorly.

[00:05:22] Niels

Okay, okay, cool. So, here’s what ChatGPT said. It said that if long volatility or volatility trading were an Olympic sport, it would be likely akin to fencing.

And here’s why. Precision and timing, agility and quick reactions, defense, risk and defense, strategic thinking, focus and discipline. Essentially, the qualities that make a successful fencer, precision, agility, quick reactions, risk management, strategic thinking and discipline are also crucial for successful long volatility and volatility trading in financial markets.

[00:05:58] Cem

I think that’s a great answer. I think the point of view there, though, is from the participant, like a volatility trader would be a fencer. I think that’s a good analogy in that regard.

[00:06:09] Niels

I think it did well on both, actually. Both strategies came back with some…

[00:06:13] Cem

We should get ChatGPT on the podcast.

[00:06:16] Niels

Maybe we will.

I think there’s a new release out there where you can just speak to it and it’ll reply.

[00:06:22] Cem

We should definitely try that.

[00:06:23] Niels

I do think, though, people prefer to hear your voice, Cem.

So anyways. Now, a quick trend following update. Since it is very early in August, it’s only the 2nd of August, I will talk about July, as a whole, instead of just what’s happened in the last few days.

July turned out to really be a month in three acts. We had Act 1, which was a very strong start for trend followers, making up a lot of the ground in terms of performance during the first 10 days of the month. And that really changed as economic data and narratives dramatically shifted, leading to this big rotation that we’re going to talk about later.

And so, a lot of the trends that had started out in July really took a big turn. Then we had Act 2, and that lasted roughly from the 10th of July to the 25th. And that was super challenging with large correction across most markets, in particular US, Japanese equities, energies (although they had been trading lower for a few weeks), metals, grains; they all changed direction, as did the currencies.

And then you had Act 3, which was the shortest of the three, lasted only for a few days at the end of July, but where, with the exception of the Japanese yen, we saw a significant reversal (which we may also touch on later on today), and we actually did see some of the longer-term trends resume. That provided a strong finish at least for trend followers, but not enough to bring it into positive territory. To say the least, it was quite a rollercoaster month, frankly.

My own trend barometer finished the month at 48, so that does suggest kind of a neutral flat plus/minus a couple of percent month for the industry. The initial numbers we see right now are that the BTOP50 index finished at down 1.58%, up 5.36% for the year. SocGen CTA index down 2.36% for July, up 4.73% for the year. SocGen Trend down 2.46% and still up 6% for the year. And the SocGen Short-Term Traders index down a percent and flat for the year.

In the traditional world, MSCI World was up 1.7% in July, up 12.7% for the year. The World Government Bond index was up 1.78%, so clearly benefited from this shift in narratives, and the S&P 500 Total Return index up about 1.25%, up 16.7% so far this year.

Now, we talk a lot about trend following and how it’s been doing, but maybe it would be a good opportunity if you can share, Cem, just a little bit of insight with the audience how volatility strategies in general are doing in 2024.

Now, I don’t mean your specific products because, of course, for compliance reasons, we’re not going to go down that route, but maybe describe kind of industry performance, but also maybe even talk about what indices can you even follow in the vol space. We have a few in the trend following space, but I’m not even sure how that is. And, of course, July was an interesting month because one of the things that happened was that the S&P 500 left its streak that had lasted for 356 days without a 2% decline. That happened on 24th of July. And the last streak we had of a magnitude like that occurred in 2017 and 2018, leading into Volmageddon when the streak was 351 days. So not trying to scare anyone here, but curious to know how your world so far is dealing with this weird year.

[00:10:17] Cem

Yeah, so it’s not as weird as it may seem to the outside observer. This is kind of how vol markets work these days. There’s so much reflexivity to the system that when vol is offered and well-supplied, we get these periods of immense, unconscionable, unimaginable placidity at the index.

And we’ve been talking about this for some time. This summer, we went in, we said, look, while this is offered, it’s going to be very, very well-supplied. And for sure enough, for two months, we just saw literally paint dry. We did not see a single decline of greater than 50 basis points. So go with the market for two months. That was a function of vol-supplied markets.

Now, the other side of that coin is that much like in Volmageddon, when we came out of 2017, which the whole year, we didn’t have a decline greater than 3% lowest realized volatility in history, in 2017, for an entire year. What happened?

Well, the impact, once it did break, was even greater. And so, these are the things that you need to be very watchful for. So once that vol becomes unpinned, then it reflexively now accelerates volatility.

And with all the zero DTE things that we’re seeing, and when there’s selling in that area, it compresses vol; when there’s buying, it exacerbates vol. And so, it really is a tail that just flips around much greater than it used to. So, the vol can really be dramatic.

And again, that reflexivity just adds an extra, another factor of dimension of convexity to the whole system. Now, once that starts and the unpinning kind of happens, that is actually the time to be very, very careful. And reading the tea leaves on when that might happen is incredibly valuable to a portfolio.

People don’t think about these things. These things seem like so minute, unimportant things, but the strength and positioning in that vol supply, especially as we go out in time, is so critical to the system. And that’s part of what we started talking about here on the expiration, August expiration, when that window kind of opened, we had some bad news.

The positioning was weak in September, October, November, in terms of vol supply. And if you saw that there, you saw the potential risk and the tinder box was really packed. And so, all it took was a little unpinning and now, oh no, we don’t have that vol supply.

So, it all fits into what you would kind of broadly expect if you’re in the vol market, if you see what’s going on under the hood: the dispersion, the vol pinning, the unpinning now. But for those that aren’t in the vol complex, this seems odd or strange.

So accordingly, for practitioners of long vol who know what they’re doing, kind of see that performance has been good. Obviously long vol has not done well into a 20% rally in the market, but there have been many ways to offset the costs and the burn in preparation, not to mention deal and improve with the timing of when to lever up and when to lever down.

And that real alpha, right, from being a participant in the vol space, that can really pay off. So, you know, again, there’s wide performance in long vol strategies. If you’re just out there buying puts the whole year, you’re down way more than you are making in these last couple of days.

But if you are able to manage both the timing element, as we focus on, as well as look at the relative value opportunities, both in dispersion, cross index, even within each index, there’s really a lot of opportunity under the hood to capitalize. And I think there is a wide, again, no pun intended, dispersion of performance. And that’s because there are a lot of different ways to capitalize.

But yeah, vol is central. I think that’s the thing that people have to understand. These vol markets are central to the broad market performance. And it is not an asset class as people like to call it. You know, it is really the underlying distribution across all asset classes. And so, it’s critical to really understand the dynamics at play there.

I think that’s, it’s been a very interesting year for people in that space. And there has been lots of opportunity.

[00:15:01] Niels

No, that’s great. And we’re so grateful for having you to explain all of this.

I did a little bit of research into our conversation today, because I did want to try and see if I could find an index of vol, like a benchmark, that I could find.

The only one I found was something called the Barclay Hedge Volatility Trading Index, which as far as I understand, is comprised of 23 funds. And that was up about 3% at the end of June. I have not seen any July numbers.

Is that an index that you know, follow? Do you have better suggestions to where people should keep an eye on it?

[00:15:35] Cem

Yeah, I tend to like the Cboe’s indexes, vol indexes. They have a whole host. They’re more specific than just a broad vol manager. Because you have dispersion trading, you have short vol, you have long vol. If you lump everybody into vol, you know, what does that really mean? And the Cboe really does a relatively good job of saying, okay, here’s a buy right index. Here’s an emerging market buy right, put right index, financial select sector, half buy right technology. You know, they go through each subsector. And I really like that’s about as good a more specialized focused approach.

[00:16:18] Niels

Sounds like it’s a bit nerdy for me, but there we are. I’m not a vol trader.

[00:16:22] Cem

So yeah, vol trading, I think, is by definition nerdy. Again, if we’re calling fencing, you know, the Olympic sport, you know, there you go.

[00:16:33] Niels

At least it didn’t say chess player or something like that.

Okay, cool. All right. So, we have a couple of questions. Let’s tackle them right now.

Zach wrote in a question where he had been listening to the episode 301 where the question came up about systematic buying of put options as a tail risk strategy.

He writes, like Steve, I recently read Chaos Kings by Scott Patterson and Safe Haven by Mark Spitzlynager. These two books got me thinking about how someone might use a systematic trading system to purchase and sell put options. I’m currently reading The Second Leg Down by Hari, which obviously Hari is well known to the podcast, to learn more about options and different available strategies.

Do you have a few words just on sort of the systematic part of that and why it may be a good idea or a bad idea?

[00:17:32] Cem

So look, over the long run, options are an insurance contract. If you blindly just go buy the same put every day, for 50 years or longer, you will lose money. But the argument for doing it in just a basic systematic way would be the benefit of geometric returns.

And what do we mean by that? Well, when the market’s down convexly, and you make a bunch of money, it’s counter-correlated to everything else. And so, you can monetize it and put that money to work in the market.

And so, if you use rebalancing logic with this, then all of a sudden that negative performance all of a sudden makes sense for a portfolio approach. Now that said, systematic put buying, there are better ways to do it than just going and buying a put every week or every month. As I mentioned, everybody has a different way of approaching it.

Our focus, and the edge that I think is most valuable, is understanding positioning in the market and using that as a timing mechanism and a sizing mechanism to leverage on and leverage off and to find the right part of the distribution where there’s the most risk. That paired with just a broad relative value, looking at what’s cheap and what’s expensive on a relative value basis. So, I think using those two tools can provide you enough edge to offset the expense and not just offset the expense, but then still get that massive convexity and get those geometric returns.

And that is something that people really, again, people, your average investor is used to looking at each investment on its own. And if you look at a vol investment, tremendous volatility to it, returns are not incredibly high, but they dramatically up your geometric returns and are one of the most important things to a portfolio, broadly, in order to outperform on a risk adjusted basis over the long run. So, it’s something that people need to dive more into.

And again, times like this week, all of a sudden people get interested, but it’s unfortunate that people don’t make it a more systematic part of their portfolio. So, I strongly recommend it being a systematic part of the portfolio, but there are ways to optimally get performance.

But just like anything I say, the big caveat, last thing I’ll say here is, you hire a cardiologist for heart surgery, you hire a lawyer to defend you in court. You don’t try and do these things. Everybody thinks they can be an expert in everything financial markets related. It takes deep expertise, and it takes time to get those tools.

So, I think there’s also an argument to be made that you should look into hiring professionals.

[00:20:12] Niels

Couldn’t agree more. Great stuff. Now, there’s also a short question from Rick.

Rick sent over a few questions, but I don’t think that we could answer many of them. So I’ve kind of just stuck with one of them, which again, we probably can’t say much about, but it is actually a topic that we have touched on at least a little while ago in some of our conversations, in particular with Dave Dredge, and I suggest Rick might want to go back and revisit the last conversation we had with Dave in the beginning of this year. But anyways, Rick wrote in, with all the talk about US dollar and rates, does anyone have a view on how a possible unwind of the dollar/yen carry trade could impact markets?

Do you know the size of this? And of course, this has been a week where there’s definitely been some change in the dollar/yen carry trade. So, and I know this is not any of our specialty, but do you have any thoughts on how this might impact the financial system? Because we know, obviously, it’s been used as a major funding trade.

[00:21:16] Cem

Yeah, we should get David Dredge back on here. It’s been a while, especially now, given everything’s going on. But that said, and I won’t dive too much into this, this is not our core, deep expertise, but clearly we watch these things.

Carry trades, by definition, are convex when they break. And there’s an argument to be made that the majority of the market is a carry trade. You know, a skew trade in the volatility is one of the biggest carry trades. How does that work? Again, you sell put, you buy call, and you sell stock.

Yes, that has edge over the long run because puts are more expensive than calls. There is a relative value trade there that you can make money nine times out of 10 and make a lot of good money on a relatively low risk. But the tail on it is dramatic, right?

And that is market structure at work. There are opportunities to borrow cheaply and lend expensively and get the edge, but you have to offset that in things that are not a perfect hedge, right? That are generally linear hedges to that convex outcome.

And they are very, very crowded trades as well. Part of the reason for the pricing the other way, by definition, is because everybody has it the other way. And so, at the end of the day, the yen carry trade is incredibly convex and it works, and it works, and it works.

And so many people make so much money on it for so long, but the problem is if you’re still in it when it goes bad, you can lose everything in days, in weeks. And that’s the reality. That’s one of the biggest carry trades.

Now, another reason that people do this is it’s, yes, you have a tail, but the argument is always, well, if things really start to break, the government will be there to kind of try and bail people out, whether it’s Japan or the US. They don’t want the system in the tail, the convexity to exist. The same with puts versus calls, the whole thing. The Fed is on your side, right? And there’s some truth to that.

And that’s part of also why carry trades over the long run, even with the tail, will make money. Much like the put conversation we just had. But it is not a linear trade. And it is very, very leveraged. And whenever you have a tail with leverage, you better have some other convexity out there somewhere.

[00:23:52] Niels

Perfectly said. One thing I will advise you to do, Rick, is to go and follow Dave Dredge on LinkedIn because he posts a really, really great newsletter every month on LinkedIn. And I can’t wait to read the July version.

I’m pretty sure this must be a topic that comes up. Of course, I can’t speak for him, but I have a feeling that there might be some interesting information regarding what has happened in the last week or so over there.

Anyways, we’re going to jump to something also very macro-like, namely a number of topics that you’ve brought along, Cem. They’re great. And I’m going to kind of more prompt you because I’m not entirely sure where you want to go as it’s relatively shorthand that I get from you, which is perfect. So, let’s just jump into it.

And of course, I would say following on from our conversation with Alfonso Macroalf, better known as MacroAlf, some of these things, people should maybe go back and also listen to that conversation. We released it a couple of weeks ago to get even more color on. But let’s just dive into it.

You have a topic here, Trump 2.0, harder, better, faster, stronger. Where do you want to go with this?

[00:25:07] Cem

Yeah, so multiple things to talk about today. You know, we usually like to talk about two major areas. Macro, what’s happening that can drive bigger structural changes on a multi-year basis. You know, what are the bigger distributions kind of telling us and the incentives in the system? The other one is flows. You know, what’s happening in market microstructure under the hood.

And the key is to kind of put those two together, to put short and medium and the term together. For the big picture, let’s start with the big picture and the election. You know, the reality of the election that people need to broadly understand is it is first and foremost, the electoral college math is very hard for Kamala.

It’s not that she can’t win, and things have changed very quickly, right? But the electoral college is very, very difficult. That’s one.

Two, if Trump wins, it is almost impossible. I use that word generally very carefully. It’s almost impossible for the Democrats, based on the seats that are up for grabs. And the tie voting in the Senate by the vice president for the Democrats to win the Senate. So, if Trump wins, he’s going to win the Senate. They already hold the house.

Turning the house has never happened in a year that the presidential candidate has not won the election. For the Democrats to turn the house to positive is also highly unlikely. So, we have a situation, in terms of the election, where if Trump wins, he’s going to have a broad mandate.

Pair with that, the incredibly important, I can’t believe sometimes how little things are talked about, but the Supreme Court decision last month about presidential powers, here in the US, and the general immunity given to a president under carte blanche under pretty much every scenario, makes a president like Trump, who is willing to push the envelope and get any crack he can to push a different agenda, makes it much more possible than the last time Trump was president. So that’s incredibly important. And then add the last element of the assassination attempt.

It seems like forever ago. It was not a long ago on Trump. That has created a greater groundswell of sympathy for him broadly, in some circles, and among his base, an increased fervor and support as well.

And so, you take all of these things, potentially a mandate across Congress, more potential executive action powers to also influence other parties. And then a broad support, a stronger fervor of support. And we have a very volatile potential input to the system.

If he is to win, it’s far from guaranteed, but I would say still very likely. We’re dealing with a three-legged stool, I would call it three major things that he clearly holds high in his agenda and is looking to broadly institute.

One, he’s looking for protectionism, right? Broadly increasing tariffs and protectionism broadly across the system. Two, he’s looking at, at the same time, hemming immigration. The big release valve on this whole system, in terms of inflation in the US, has been twofold. One, it’s the ability to manage the dollar and export inflation here in the US. But two, it’s been the ability to bring immigration to the US. Open borders and allow that to release some of the pressure on labor. That has played an enormous role here in the United States. And closing the border, we believe will dramatically accelerate labor inflation here.

Lastly, the third part of that stool, is Federal Reserve activism. A hallmark of the Trump administration is to try and influence Federal Reserve policy and bring the power of the Federal Reserve under his own dominion. And I think you better believe that will happen, maybe not immediately, but definitely that is his intent. And he would like nothing more than to run a hot economy and to really particularly favor US over global, obviously make America great again.

So, I think those three things, protectionism, immigration policy, activist Fed, are all not only inflationary, but they are very bullish together based on the federal reserve piece as well of gold, Bitcoin and things that are really diversifications to the dollar and to inflation.

[00:30:38] Niels

Okay, great overview. Let me try and dive in with just a few questions to clarify a few things. Obviously, I don’t follow US politics as closely as you do, but I am aware that Biden wants to overhaul the Supreme Court. Can you just explain, briefly, what it is he wants to do and who would decide on this? And if they could do it before January of next year, wouldn’t a Trump clean sweep just undo it, so to speak?

[00:31:12] Cem

So, to be clear, the Supreme Court decision recently, which was arguably a function of Trump in his last administration, putting in several new Supreme Court justices, has already been kind of revamped in the image of Trump. It’s all well on its way, right? It is an activist Supreme Court at this point, it is trying to remake policy. And we’ve seen that, and this is not a political anti-Trump comment, it just is.

We’ve already seen it with abortion pro-life policy. We’ve already seen it with several other major decisions, which are very much against precedent, right? And so that’s already well on its way.

Now this is a hallmark of strong dictator kind of types that Trump himself would say he aspires to kind of be. Just look at my home country of Turkey, right? Erdogan, one of his first principles was to go try and overhaul the judiciary, and that’s what he did.

He cleaned out the judiciary and made it much more favorable and less of a check on his powers. Then he went in and did it to the military, and then piece by piece kind of tried to break down checks and balances in the system. And that’s, I think, you know, the model that you can expect in different ways.

It won’t be the first or the last time in history. This is a well-played textbook, you know? So, I think that’s the broad thing.

The Democrats, on the other end, are trying to circumvent that in any way they can. They have very little ability to do that, in my opinion, unless they win the presidency.

[00:33:03] Niels

Right. But my particular question is, my understanding from just what I’ve seen in the news is that they want to limit the term, for example. It can’t be a lifetime term anymore.

There’s a limit to the term, and so on and so forth. But what I’m trying to understand is, yeah, but even if they manage to do things like that, which obviously won’t have an immediate effect, but it will have an effect over time, couldn’t another regime just turn that around? I mean, isn’t it just whoever has the majority…

[00:33:30] Cem

That’s the US system. That’s the US system, and it’s both its benefits and flaws. I mean, go back to Plato, right?

All these systems are innately flawed. The reality is humankind is flawed, and we’re trying to create a less bad system and protect us from ourselves over the long run. But yeah, the democracy will last longer, but we tend to get kind of non-optimal outcomes in the meantime, is the thought, or it can last a lot longer.

So anyway, but not to spend too much time on the topic, but the reality is there’s very little, realistically, for the Biden administration to do here until the election. They don’t have both houses of Congress. They don’t have enough of a mandate. It’s a lame duck period, and anything that they did, yes, would be overturned by the next administration as well.

[00:34:32] Niels

Okay, you mentioned the Federal Reserve and what might happen to this if we get a clean sweep at the election in favor of Trump, and you mentioned the fact that he likes to make things very accommodative. He’s, after all, a borrower. He’s in real estate, so lower interest rates are better than high interest rates, I guess.

But the thing, I guess, is how effective are the policies, and economic policies, in addressing some of the major economic challenges that the US face? And I was listening to Jim Grant the other day talking about the Federal Reserve Bank of Chicago Financial Conditions Index. It sounded like, from memory, that that’s an index that he thinks might actually give a pretty good idea of, among all sorts of indicators, but, you know, how tight conditions are, how easy they are, and so on and so forth.

And again, from memory, I think he said, and this also, by the way, includes things like credit spreads and all sorts of indications. And according to him, I think, it actually, at the moment, is pretty loose. It’s very accommodative when you look at this index.

So, I guess the question is, I mean, it should really be, I mean, for someone to take control of the central bank in the US and drive a certain, you know, agenda through, I mean, it’s really, it’s unfathomable, really, if that was to happen.

[00:36:10] Cem

Well, look, I’ll say the following. In the short term, it is in the US’s best interest, again, I want to reiterate, in the short term, it is in the US’s best interest to tax the world, and use its power for better outcomes for itself relative to the rest of the world. The reason, though, the core reason that the US has power at all is because the rest of the world sees it as a, at least the least bad of other options in terms of providing kind of support and a system that holds everything together. Again, you can argue that, but, you know, again, least bad relative to the other options.

In the second, long term you start to use your power seemingly unjustly relative to what the rest of the world thinks, then you start to degrade the core reason. So, I think a Trump administration could, in the short term, you know, it’s very short-sighted, could drive, and I think we’re seeing the markets kind of pricing that in the last eight years, right, increasingly better outcomes for the US relative to the rest of the world.

It’s a power game at the end of the day. It’s like, you know, you can tax your dominions, and, you know, again, I hate to talk about it that way as an American national, right, you know, but that’s the reality. But in the long run, that’s not good for the United States.

That is very bad for all kinds of things and creates convex outcomes. Again, another tail convex outcome with positive short-term, you know, outcomes. You have to take the middle route, right?

It’s okay to benefit from your power to some extent, but let’s think of it as a tax for providing services. What any leader or anything else would do. And so, pulling away from the world stage, make America great again, that whole idea is a very short-term focused idea.

And I think, you know, Donald Trump, with an activist Fed, would just do more. He would degrade the long-term trust in the system, but could very well make for a very good four years for it. And I think that’s something to be thoughtful of.

[00:38:39] Niels

Yeah. Okay, cool. Final point I wanted to mention, not least because we’re recording just after the latest unemployment numbers came out, a rise to 4.3%, which is interesting for a slightly different reason. And that’s because a couple of weeks ago we had a guest on, Claudia Sahm, who has something called the Sahm rule. And the Sahm rule is, for those who don’t know, and I didn’t know, frankly, is triggered if there is a rise of 50 basis points or more in the three months average compared to the low of the last 12 months in the unemployment rate. And when it is triggered, it forecasts a recession.

Now, I think, I haven’t read up on this, but I think she’s been out saying that maybe it’s actually not going to trigger it this time. And I haven’t looked into why that may be, but I saw a tweet about this from an observer. So, I’m not using this as a prediction.

It’s just that it’s interesting because I actually think it may have been triggered this time without having done the calculation since the number just came out. So, there may be different signs that the US economy is slowing down. And of course, we’ve seen expectations of rate cuts change dramatically in the last hour or so to about 100 basis points now before the end of the year.

So that number has really swung around a few times already this year. Any thoughts on that? I’m not entirely sure whether I had a question there or not.

[00:40:16] Cem

I have a ton of thoughts on this actually.

The important piece here, in terms of market structure, that people don’t understand… I mean, if there’s one thing that amazes me is that wealth advisors, people that are in financial markets day in, day out, these people don’t understand one of the most basic important principles of financial markets. And that markets, by definition, are providing liquidity to the whole system. So they are, there’s a wealth effect which people call it, which I cannot emphasize this enough, that is way bigger and way more important to the outcomes of the macro picture than more or less anything other than the Federal Reserve. Even the Federal Reserve, I would say it’s 50/50. The markets themselves (and I’m not talking about the bond market, even like just the broad equity markets) that effect is dramatic.

We’ve talked about this before, but real quick, $200 trillion on average, I can tell you how we get to that number of a hundred trillion in equities, at least another a hundred trillion tied to equities, $200 trillion. You drop 10%, that’s $20 trillion of collateral taken out of the system. And what did Powell say at this last meeting?

People were like, that was a really ‘if then’ kind of commentary. Like his commentary was just ‘if then’, he’s like, we’re not going to say we’re data dependent. If the market does something weird, then we will act. Why is that? It’s because the whole thing is reflexive to the market itself.

The whole policy engine is a focus of offsetting and trying to manage the market, the whole thing. It is managing money supply and a $20 trillion of change in money supply necessitates a move by the Federal Reserve.

And everybody says, well, come on, the Fed’s not managing the market, but they’re managing money supply, right? So, I think I cannot emphasize that enough. People do not understand the size and scale and importance of that.

And again, I hate the word wealth effect, but people at least know what I’m talking about. So, I think that is critical. And sure enough, guess what? Fed came out, they didn’t proactively get ahead of the curve with things. Now the market’s down, guess what? Those numbers are all going to start coming up.

And we saw that in December, right? We saw the opposite in December. In December, they said, okay, we’re going to cut, we’re going to do six cuts and market repriced, market went up 20%. And guess what? Economic outcomes were way better than people expected. Well, okay.

Now what happens when the opposite happens, right? Now we’re into a rotation. So, there is a reflexive nature to markets and it’s so critical, especially given how much leverage there is in the system, the whole system.

Banking, by definition, is leverage. Money, I think it’s like 95% of money is are loans, are leverage. And so, you have to understand that the collateral that underpins all those loans, when that changes, the leverage effect is dramatic, right?

And so, I think that’s the most critical thing to understand and why the Fed was like, oh, we’ll see. We’re not sure, but let’s see what happens. And all of a sudden now, by the way, we’re going to get Jackson Hole in not too long, right?

I’m guessing that tone is going to change pretty dramatically if markets are still there. And we’ve seen situations where the Fed has to go from, hey, we’re cutting 25 basis points, think late 2018, to the exact opposite, right? Or vice versa.

So, the Fed has to be very nimble and quick to react as a function of market action. I think the other important thing to now, this is a bit different point, but I think it’s very important. Another thought bubble that’s very critical is I don’t think people understand that interest rates as they move are not always the same, right?

If they go up 50 basis points versus down 50 basis points, it’s not a linear effect always on economic outcomes. So, we’ve raised interest rates, right, 5.5%. Oddly, that didn’t seem to have a big effect. Well, part of that’s lag, the lag we’ve talked about, because everybody had already locked in interest rates, right?

What that means is that actually, taking that there has had a very slow negative effect because it’s meant that people who want to go buy homes, who had already bought homes, are now unable to and that sequesters demand, right? But if you sequester that demand and increase that demand and it builds up because now it’s been some time, the good news for the Fed is there’s more asymmetry now to lowering interest rates.

If you lower interest rates 100 basis points in this environment, especially given that we’re running a demand/push economy and we’re pushing money into people, millennials and those who are looking to build homes or to buy homes, you’re going to release an economic engine to offset these things.

And it’s going to be bigger than it normally is. And I think that’s this thing that now ties into this inflationary vein we’ve been talking about. We ran a really demand/push economy in the ‘70s and people kind of scratch their head and say, well, why did inflation keep coming back?

We got these recessions and sure enough, when we got a recession, inflation came down, right? But almost instantaneous to the move into lowering interest rates and the Fed funds rate in those periods, inflation spiked back. That’s very different than other periods.

And the reason is because when you’re running a demand/push economy, you’re packing in potential demand. And the second you lower interest rates, now you release that demand and it can really accelerate demand. And that’s why I’ve been pushing on, we’re really in this stagflationary environment.

The inputs to the system are very different. We’re not pushing money to corporations, we’re pushing money to individuals going forward. And if we don’t offset that with the cyclical measures, at some point those cyclical measures have to come back down.

And when they do, then you just release all this demand that’s been building in terms of goods demand, housing demand, et cetera. So, the Fed does have a more powerful interest rate tool than it has in the past in terms of being able to support demand. But what it can’t really do well is manage inflation in the context. And that’s the big problem here in the long run.

[00:47:15] Niels

And I think also one thing just to mention from my memory, and I’m sure I haven’t studied it nearly as much as you have, but back in that period,’ 60s, early ‘70s and so on and so forth, where we had these three shocks to inflation and obviously interest rates accordingly, kind of the joker in all of this that we don’t control, but where I can see the same thing could potentially happen. And that really makes things difficult. That is, of course, we had, as far as I recall, three energy shocks happening more or less at the same time.

And we have a situation right now where the Middle East is blowing up. And so, who’s not to say that that something similar could happen and Federal Reserve can do nothing about it.

[00:47:59] Cem

We’ve talked about this before, right? It is not an independent event that in the 1970s that we had oil shocks. Again, people look at the ‘70s, they say, well, for me, things drove the inflation fiscal policy, great society program. We had a war in Vietnam. And lastly, oil shocks. They’re all the same thing.

The oil shocks, the geopolitical conflict are a function of protectionism and going from a cooperative, business first environment, sending money to corporations, to pulling it to our people and saying, hey, we are taking care of ourselves, America first. Well, guess what? That leads to global conflict, that leads to oil shocks, that leads to more fiscal policy, which means more inflation from fiscal.

So yes, we are likely to continue to get more oil shocks. We’ve talked about that now for a year. So, if people are surprised, you’re missing the big picture.

The big picture is we are going to see more conflict. We are going to see more people taking whatever sources of power they have, whether it’s oil or copper or anything else, right, and trying to control the price and control the supply for their own benefit. So, between those two elements, this is a big supporting factor.

[00:49:24] Niels

Yeah. And luckily, we’re actually in the process, you and I, of locking in one of our favorite commodity guests to join us when you’re back from your travels in early September. So that’s going to be a fascinating conversation to hear his thoughts about this.

And speaking about the wealth effect, by the way, I don’t know if you’d noticed, but actually the topics in Japan after what’s happened in the last week or so actually is in the midst of a two-day decline that is the biggest since 2011, the tsunami in 2011. So, talk about a wealth effect on Japanese equity investors. And of course, at the same time, we’re seeing a flight to safety into bonds and treasuries.

[00:50:07] Cem

Yeah. I mean, interestingly, the Japanese have been on this road a lot longer than we have, and they will go buy stocks like the federal, you know, the government isn’t even mincing words anymore. They know the wealth effect is real and they know that if they have to jump in and manage it directly, they will.

And so that’s another thing to be mindful of, something we haven’t talked about, but something that, you know, a spectrum throughout there that maybe people aren’t thinking about, that could very well play in as we move forward.

[00:50:38] Niels

We’re going to jump, in the last few minutes we have together, we’re going to jump over to flows. But before that, I mean, you and I have just touched the, you know, kind of scratched the surface in terms of what’s been going on. We haven’t even talked about the fact that there’s been, at least from a European perspective, quite an interesting and surprise outcome in the very end of the French elections.

We have had elections in the UK, where the two main parties, I think people might be missing that, the two main parties, so Labor and the Conservatives, won just over 57% of the vote. That’s the lowest combined share of a century, showing perhaps something I didn’t even mention when we talked about the US election, the fact that when I hear someone like a Pippa Malmgren, my previous guest on the show, talk about the election and who better to ask than her, in the bigger poll, and I forget the name of that poll, but it has something like 26,000 people, they’re asking, Robert F. Kennedy is polling incredibly well in those polls.

We never hear about it really on mainstream media, maybe because he wants to ban vaccine advertising on those channels, I have no idea, just a guess, but there’s so many things in that. And of course, only yesterday, Bank of England came with its first interest rate cut since early 2020, so there are lots of things to talk about when you return, that’s for sure.

Okay, flows. Talk me through the flows, because I think there’s some very interesting topics, specific topics you wanted to bring up here.

[00:52:15] Cem

Yeah, I think this is one of the most important kind of things, what has happened here, in terms of why did this decline start? Why did it start the way it started? Again, I mentioned at the top of the show, if you’re in the vol markets, a lot of what’s been happening here has, at least in terms of market structure, has been really tied to vol markets structure.

We have seen dramatic, and we’ve talked about this for so long, the vol supply and the index level being the Dutch boy with his thumb in the dike, right? The reality is that, that index holds together what’s otherwise been a lot of idiosyncratic risk. And we saw that this summer, again, to the consternation and confusion to all, how could we have such low volatility in the context of all these other things happening, right?

Well, that vol supply was the key, but the key to that is you don’t mute idiosyncratic risk. So, we’ve been getting all of this dispersion, right? Something goes up, and the index has been something has to go down.

We’ve talked about this concept a lot here. That dispersion drove to such an extreme over those two months. Yes, the market wasn’t moving, but under the hood, you kept seeing an increasing, increasing divergence.

And that divergence, when it gets to this extreme, can itself cause underlying volatility. It can force stress to the middle if it’s violent enough back the other way. And so, what we started seeing in about a week and a half, two weeks, call it, before the rotation really started moving, was a couple of important things.

I really want to highlight this. One, in terms of market structure, momentum in NVIDIA specifically and broadly in those tech names started to slow. You started to see brief declines.

That was based on some idiosyncratic news from NVIDIA and some other names in particular. But when that starts to slow, and it’s a short gamma center, right? The index has been long vol to the dealers, but customers have been buying calls and speculating on calls in these names and getting lots of convexity in the AI names.

When that started to slow, those calls started to decay. Those dealers, who are short those calls and long stock, now have to start selling that stock back out. And we started to see a slow decline.

You can see every day that selling come in the morning, in the evening. So, the structure all of a sudden started to change a bit. At that time, at that same time, you had Druckenmiller buy a massive amount of upside calls in Russell’s.

The amount of call open interest skyrocketed in the week or two weeks before the Russell took off. It’s not just Druckenmiller. There’s the cascade of when somebody like him does something like that where the majority set up in terms of other things where other people start buying.

And so, what we started to do is get a move from the call short gamma area going from AI to Russell, right as NVIDIA was changing its personality in terms of that, right? You started to see losses on call buyers as well, which stops some of that call buying in the squeeze.

It’s a momentum game, right? When that starts to move like that, the market is now set for, again, remember the index of vol is pinned, right? So, if one of the moves in one way, that money has got to go somewhere else, right?

And so, it’s not just the setup on each. It’s the fact that the index itself is now going to enforce a greater volatility once a move happens. And all it took was one comment.

It was already in play. We already saw play, and then a brief narrative change. And that’s all it is, is a narrative change. Because it’s something we’ve known, something we’ve talked about on here. We actually said it, I go back last month. I think I highlighted it was last month or the month before.

I was like, NVIDIA is one of the core risks to the market. Why? Because the reason it was left for dead in ‘22 is because people saw it as an existential, uninvestable, despite its positive outcomes, because of the risk of China invading Taiwan. That was the reason that NVIDIA was dramatically underperforming during that period. And there were all kinds of speculation that that would happen.

Well, it didn’t happen in ‘22. The narrative change, AI took off. Their earnings were great. It went on a 150%, 200% run, right? Well, but guess what? We’re getting to the election. And all it took was those fears and those concerns. And to be clear, there is not a single company in the United States that has more to lose if China invades Taiwan, and that’s the United States and the world, than NVIDIA.

And NVIDIA would have to shutter, I think it’s 80% of its production the next day. So that existential risk, and by the way, the odds of that happening are increasing as we get into the election if a Trump type gets in office.

He came out and said one important thing that Wednesday of expiration. He said, hey, Taiwan, we’re not paying for your defense. If you want us to defend you, you better pay us a lot of money.

We know, he says stuff, but that comment, which normally would just, nobody would think much about it, set off a narrative change and a realization that this run has been devoid of thinking about the other risks that exist. And more importantly, it was in the context of an already turning market structure.

So, what have we seen? We saw, almost immediately, a four standard deviation move in the Russell relative to other things, relative to the S&P. And we’ve only seen that move continue.

Now though, as I mentioned, if this rotation is powerful enough, what it does is it can unpin volatility. Why? Because of true volatility events happening. I mean, this is zero sum market, right? So, somebody wins and somebody loses at the end of the day. There’s a buyer and seller at all times. What creates volatility and stress is when risk gets concentrated and leveraged into a part of the system.

And sure enough, when you get a massive rotation and then you’re taking these big winners and all of a sudden you’re reversing them, that dramatically increases the probability of the concentration of risk being in a few hands that can get really hurt. And now you have entities that are, having major losses and major problems and that causes stress in the system. And that’s what we’re starting to see now.

And so, we’ve been very vocal for almost three weeks now, that if you’re, A, you better be hedged going into this as this starts to happen. But B, because of set volatility supply being very poor because it’s a quarterly expiration and there’s a Fed meeting there, there’s a lot of uncertainty. Two, because you have an election which is increasingly more volatile and uncertain and a November election vol, which historically has been very high and is high again.

And then a next year with a new president with all kinds of risks and other volatilities. That the vol supply, which has been very strong here, is fragile. It’s fragile. This vol that’s here now will not necessarily be there later. And if we get moving faster, it can really happen.

This is what we said. We were very vocal. And when asked, what do you hedge it with? The answer was NVIDIA puts.

Intel is down 29% this morning, 29%. That’s not healthy action. The relative move up in the S&P just two days ago, a 2% plus move is classic short squeeze trying to shake out people who realize what’s going on.

This is what we see. So, you have to be very cautious in this window until at least September and arguably October November. Vol is incredibly, in my opinion, undervalued in this environment as we speak. And more importantly, skew and convexity are undervalued.

Skew is very, very low here, FYI. It is, and historically the way market structure works is you decline and skew comes down. People start selling more puts as opposed to buying stock or they are selling far away units to buy closer ones for smaller. But if you start getting a more convex move, skew can explode. That’s what we saw during Volmageddon and we’ve seen it during other similar periods as well.

So just be mindful. There’s still hedges. Yes, the VIX has gone up, but fixed rate vol relative has not gone up that much yet. And there are, given the risk and the likely staying nature of this, at least for several months, this is not something that is now that vol is unpinned going to get back to a pinned nature likely quickly, and particularly in those rotation names, that rotation is likely to continue now for some time.

[01:01:52] Niels

So as everybody knows, I’m not a vol expert in any shape or form, but I want to bring up one point at the very end here that we discussed a couple of months ago, where you mentioned this thing about, well, if the June OpEx goes well and there’s not a lot of pullback in the markets, you could see kind of a parabolic move to the upside before it all falls apart early next year. I sense from what you’re just saying now, and again, I could be wrong, and by the way, this is not investment advice. I sense you may have changed your view on that.

Is that correct or not?

[01:02:32] Cem

You have to remember that this is a distribution outcomes and path changes as we go. And that is not a cop-out. That is just the reality of the system.

It takes sometimes incredibly small, seemingly small things to make a dramatic change in path. The Federal Reserve has tools at its disposal, as I mentioned, and the Federal Reserve’s response to this, its reaction function is important. If they choose to go 50 basis points in September, or better yet, they choose to get ahead of it and all of a sudden use very strong language at Jackson Hole.

You could see a reversal, and again, post-September expiration, right? My personal view is that a lot of the stress diminishes dramatically. So, the view has broadly been, and I want to be clear, that this summer was going to be placid.

We have to be careful in our windows of weakness, and that we had said most likely outcome in terms of path, most likely path would have been August of expiration. We started to see things before that showed potential risk there. We got it to the day in the July of expiration, that kind of front run and saw the risks and is now pushing. Now vol is unpinned, and now there’s stress until kind of that September OpEx.

So, to me, it makes a ton of sense, again, the current path, but let me rewind. We said we were likely to get some wobble in the fall, and we’ve been very vocal about that. The point I’m making to you is this is the wobble.

It’s happening. It started a month earlier, but we got the two months of dramatic dispersion in vol supply. It unpinned earlier based on the rotation kind of starting.

Very clear when it started, this is it, get hedged, right? You have to be dynamic. But the view has been that after that decline happens, that we’re likely to see another run into it. I still believe that. I don’t think this is the cataclysmic end. Now, to be clear, that could change, right?

If this thing gets bigger and worse and China and invades Taiwan or something happens, the view changes, right? The reality is there’s a reaction function here that’s dramatic. And the biggest reaction is the Fed, right? The second one is policy in terms of election and who’s likely to be in and what they’re likely to do. My view, to be clear, has always been slow summer, wobble in the fall, rally back, likely sometime early next year, the real fireworks begin. And I still think that’s true.

[01:05:27] Niels

Okay. Very interesting.

This was awesome. This was perfect. And as always, people really should go and follow you on all the social channels, mostly Twitter, I would say, because there is so much value in what you share and for people to stay up to date, because it is a very dynamic situation we’re working in and therefore even our fairly regular conversations, there’s not enough of those.

Next week, I’ll be joined by Nick. So, if you have questions for him, as people often do, please send me an email, info@toptradersunplugged.com, and I’ll try and get them in front of him. And if you love these conversations, which we hope you do, please don’t hesitate and jump over to your favorite podcast platform, leave a rating and review. It really does help.

The conversation we had with MacroAlf, by the way, I did see on social, that people called it the most important macro conversation they had heard, which of course we’re incredibly grateful for those comments. So, by all means, share those as well.

From Cem and me, thank you ever so much for listening. We look forward to being back with you next week. And until next time, take care of yourself and take care of each other.

[01:06:42] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review, and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com and we’ll try to get it on the show.

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