The Unstoppable Volpocalypse ft. Cem Karsan & Alan Dunne

[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] Alan

Welcome back to Top Traders Unplugged, where each week we take the pulse of the markets from the perspective of a rules-based investor. It’s Alan Dunne here again this week sitting in for Niels for the second week while he’s traveling. Niels will be back next week. But today, I’m delighted to be joined by Cem. Cem, how are you?

[00:00:39] Cem

Great. Good to be here. I love that we get a little mashup this time. Two guests as hosts should be a lot of fun.

[00:00:47] Alan

Exactly. Looking forward to it. We have a lot to get through. I know a lot of very interesting macro topics and there’s a lot of elections going on around the world at the moment, so we’re going to touch on that as well. But maybe before I get into what’s on your radar, we might just do a quick update on trend following performance just to get that in there.

Obviously, it’s been an early start of the week and it’s been a shortened week already with the holidays. But based on the most recent data, SocGen Trend with a positive start to the month. SocGen Trend up 0.66% on the month and up 9.4% on the year. The SocGen CTA Index up 0.54% on the month and year to date up 7.81%. Obviously, early in the month, I think from a trend following perspective, ongoing weakness in the yen certainly one of the key drivers there, and also obviously the equity market rally continuing, bonds quite choppy.

From your perspective, Cem, early in the month, are you seeing anything interesting from a performance perspective? What are your thoughts?

[00:01:54] Cem

On my end, the story this summer near and dear to my heart is dispersion. You don’t hear a lot about it, but we’re seeing record dispersion. What do I mean by record dispersion? You’re seeing four times the volatility of the constituents, relative to the indexes themselves. This is something we called for several months ago into the summer.

We’ve continued to go off the chart in terms of 150 years of history in terms of those happenings. That’s really broken down the breadth signal for people, causing a lot of consternation, scratching their heads. I think we can dive into that later.

I think the Nvidia story and the breakdown relative to everything else is super interesting as well. And then as you mentioned, it’s election season. So that’s the big macro story, and everything and how it relates to that election has got to be the laser focus outside of just the market structure questions.

[00:02:58] Alan

Good stuff. Well, as you say, market structure and breadth has been a big focus. We’ve had a very narrow and increasingly narrow rally in the equity markets. As you say, dispersion has been a popular trade in the markets. It obviously worked very well in 2022 on being long the constituent vol versus short index vol. But talk to us about why is your sense being that that would particularly come back to the fore during the summer and what’s the implications of that at the moment.

[00:03:29] Cem

What most people don’t realize, the natural instinct for market participants is to start with the asset first. An index is just a measure of a combined calculation of all the constituents, and it doesn’t work that way. Actually, more than ever, it’s the opposite that the constituents follow the path of the index, and the index is driving a significant amount of the flows. Obviously, it’s two ways.

The part that’s causing the dispersion here is the index. The amount of structured product issuance and the amount of vol supply, at the index level, is so high that it is pinning the index itself. The counterintuitive part, and I’ve talked about this a decent amount, is that actually increases the volatility of the constituents. So again, very counterintuitive. If there’s vol supply and the index is pinned, you’re actually forced by arbitrage constraints to increase the volatility of the constituents. Why is that?

Well, because idiosyncratic risk still exists. So Nvidia comes out with earnings, it goes up 10%, or salesforce misses, and it goes down 10%. If the index is pinned, by definition, things have to move the opposite way away from Nvidia because you have to balance the index. So the actual total volatility that’s happening underneath the hood actually increases. Correlations have to break down.

We are seeing record lows in correlation. We’re seeing record highs in dispersion. Again, as I mentioned, four times the volatility of the constituents relative to the index. That mechanical effect is really confusing to people. Because again, we’re getting off the charts on this stuff. So many indicators, so many models are built on these assumptions of breadth and other things.

Again, I think there’s still truth to some of the breadth issues instead of a shorter or medium term on a more long-term timeframe, because I think these breakdowns of relationships between things create a significant fragility, particularly if some of these items are speculative like I believe some of the Nvidia and AI names can be. Not that I don’t believe in AI, I believed in the internet in ’99 as well. But that can cause significant fragility in a more medium to long-term perspective.

But that breadth breakdown, that breadth signal is broken. It’s broken because of structural effects in the market. That doesn’t necessarily mean the market is going to crash tomorrow. Quite the contrary, index vol supply means the market is going to have a very hard time breaking down anytime quickly. Think 2017. We have now not had a pullback in the market of greater than 50 basis points in almost two months. It sounds very similar to 2017, and the reason is because it’s the same effects causing the same outcomes.

[00:06:32] Alan

A couple of things on that. Obviously, you’re pointing to the vol supply and you’re pointing to structured product issuance, which are things we’ve heard about in this regard for a long time. So are you seeing something new coming in in terms of that vol supply and structured product issuance? Who would you say are the key players? Where is that supply primarily coming from?

[00:06:52] Cem

A couple things. One, the structured product issuance is continuing to increase at the bank level, and it’s been multiple couple of years, two and a half years I’d say since we really started seeing dramatically higher issuance there. Why? Because in ’22, the market was weak, and broadly, people look at these valuations and how high interest rates are in valuations and say, “Hey, do I want to be betting on a 10% per annum outcome from here in stocks when I can do that easily with interest rates higher with structured products?” So the value proposition is significantly better. So that’s been driving that.

On top of that, we have the increase of 0DTE option L trading. That is not on its own a vol supply. It can be the opposite. It can also unpin markets. But what it is a magnifier. So when the structured products come in as vol supply, and market makers and banks are laden with all of this gamma in vol, the pinning action that happens – people realize that’s an edge, and all the speculators come in.

So the most profitable way to take advantage of that in a very short period, which is to sell 0DTE, which then reflexively causes more gamma and then causes more pinning. It is from a structural perspective it can be fragile. If it breaks, you can get a big break like we saw at the end of 2017 with XIV’s implosion. Eventually, it won’t end well. But it took a year and a half of record low realized volatility, record correlation breakdowns, and incredible profits in vol selling mind you for quite some time before it broke down.

When it broke down, it didn’t just kind of break. It’s just the vol-apocalypse. That’s how this is going to work. Can this go on for another six months? Sure. Does it end well? No. But in the meantime, some of the most profitable periods are if you could hedge that tail. So that just leads to reflexive pinning in markets.

[00:09:02] Alan

As you said, it’s a reflexive process. The vol supply causes the pinning from dealers on gama. So they have to sell when the index goes up, they buy when it goes down. That pins it. That encourages more volitility selling and it feeds on itself. Looking at templates of maybe like 2018 or other episodes, do you need a catalyst or is it just you run out of vol sellers? How does this type of dynamic typically end?

[00:09:31] Cem

So you get a sharp move. What unleashes that sharp move? A concentrated positioning somewhere in the market generally that’s illiquid. XIV would be a perfect example. XIV was very concentrated. It concentrated into a few names and it concentrated part of the market that once it broke, there was not enough liquidity to absorb it. You have my word that the next break will have a 0DTE element to it.

Could we find a situation where things start to go sideways at some fund (unknown fund at this point) where then all of a sudden somebody says, or that entity says, “Okay, I need to hedge this with the most concentrated hedge possible, which is to go buy 5,000-10,000 0DTE options on the offer, and now you have a cascade that just all of a sudden breaks. Yeah, that can happen. But it needs a reason where somebody has to have an existential risk in some way to concentrate entity.

I’m not talking about macro here. It’s really where the rubber meets the road. Where’s that supply and demand? You’d have to have a concentrated entity big enough to move the market to have some issues. Think Long-Term Capital Management, think XIV, we could go through the history books of entities. None of the entities or the size of the whole market are that big, but they were concentrated, and they were concentrated in certain vehicles that just became too big relative to the liquidity in that space in a short interval of time.

So my guess is that is what’s likely to happen. I think this rhymes. I think I’ll just put this out there. Much like in 1997, the Asian crisis and the dollar relationship to what was happening in China caused a break that eventually caused stress on Long-Term Capital Management happened, you need a macro there to kind of lead, but that would cause stress, And the key is that causing enough stress in some concentrated entity.

[00:11:48] Alan

Just from left field completely, as you mentioned, the Asian financial crisis and really a moment where dollar/yen is breaking above 160, euro/yen up to multi-year highs. Obviously, Japan’s benefit to TOPIX is at an all-time high. It wasn’t one of your prepared topics, so I put you on the spot. But the yen, are you seeing any possible spillover effect there? It is something I think about. Is there a possible loop there where we get either an exaggerated move or a reversal?

[00:12:21] Cem

This is a very important topic. Again, there’s a reason I brought up ’97. We’re starting to see that history rhymes. We’re starting to see clues that that might be the spark. I think there’s so much leverage in FX and these carry trades in particular. That can be a concentrated enough trade. In some entity, that can break things. I wish I was at the epicenter of trading that stuff, because that’s not as much our focus there in Asia. But David Dredge, we’ve talked to on this platform several times, that’s what he does.

I’ve talked to him a decent amount about this, and that’s his biggest position, for example. Not to speak for him, but an area that he believes is one of the most likely areas to break. I tend to agree. On the radar, it’s got to be on the top of the list. But again, those things will break. It’s like everything goes really slowly and then breaks all at once. That’s kind of how we’re likely to see this.

In the meantime, vol supply at the center causes everything to stick together. I do think that we are building towards, early next year, a potential issue but we can talk about that and how that may or may not play out.

[00:13:53] Alan

Just coming back to what you’re saying then around vol supply and breadth. So basically, the normal interpretation of low breadth is not a good sign for the market. So, are you saying, okay, disregard that this time around because it’s being driven by different factors so the rally continues?

[00:14:12] Cem

It used to be more so. I mean, it’s related. The market hasn’t completely changed. This has always been somewhat of the case. But breath used to be a good signal in a much more shorter interval of technical structural flows relative to fundamental good-quality flows. when the structural technical flows push things out of line, that was a good sign that hey, look, the underlying health long term of the market is not good. That still applies.

It’s just the flow piece has gotten so much bigger and so much more dominant that it no longer is relevant over a one-week, one-month, one-quarter period, it could be relevant over a one-year, two-year period. So I just think that it’s not that the breadth indicator is broken, I just think the reliability of it as a trading signal over any shorter period of time is really, really not great.

Again, still not good for the market I want to be clear to have this type of breakdown. But the vol flows in particular are so dominant and they’re structural, they’re not concentrated. That’s the important part other than the 0DTE piece I talked about. Structured product issuance is like, this is not levered, and it’s distributed across all kinds of institutions, not in a big way. If and when things break, that won’t be the cause.

Will that cause a lot of pain across the market as part of it, as we saw in China recently with all these snowball contracts? Yes. But in the meantime, it is not going to be the cause because it is not a levered reality. So the breadth issue is not a good trading signal, but it is an increasing indicator of more medium to longer-term fragility. I think we can dive into that a little bit here. I think in particular, I give a little bit of lip service to this, but I think it’s really interesting.

Nvidia’s dramatic performance people all attribute to the narrative of AI. And yes, they’ve had good earnings. I’m not talking about Nvidia is not a good stock or anything. Please don’t come at me with your AI further. But what it is, is I think super interesting that just two years ago (we have very short memories), Nvidia still had great earnings. It was still a great story. The AI story was already issuant at that point. But people had left Nvidia for dead. People were shorting it partially.

Part of the narrative then was that there was a big fear in ’22 of China invading Taiwan. The fear of who would be at the epicenter and how bad that would potentially be for stocks was focused on Nvidia. By the way, nothing has changed with that potential outcome. We don’t talk about it as much because we’ve forgotten about what’s happening in Russia-Ukraine. We get bored of some of these macro stories.

But the reality is the percentage probability of that still happening are significant. They’re not only nonzero. I think if you go talk to people in the US government and other people who are in the know, this is a coin flip that something’s going to happen here in the next two, three years. So if we’re dealing with a coin flip, this epicenter of the negative outcome for that coin flip is Nvidia. It’s now the biggest company in the world. That is a weapon of mass destruction for the Western economies and Western markets.

You want a potential fragility based on a single event that’s on a 50/50 coin flip that can lead to a 30% downturn in the market, there you have it. That’s the way that breadth matters. Breadth matters in that way. It causes this type of fragility for the broad market, but it needs an impetus, a catalyst to break things. In the meantime, it can just keep going. Structurally, it will keep going because you have negative gamma in those names, you have positive gamma in the index.

In the meantime, you have short interest in those names and all kinds of other things that are just squeezing it higher, and the natural state of flows will be to push that. Also through passive investment, all the momentum effects that happen, there’s a natural market machinery that will just continue to push that in line or push that out of line until the impetus comes.

[00:18:49] Alan

So for a single stock, the negative gamma comes from- is that from the-

[00:18:54] Cem

Call speculation.

[00:18:55] Alan

Call speculation. Okay.

[00:18:56] Cem

So the reality is, we saw this in Tesla for years, we saw this until it stopped. The easiest example is the story that everybody knows, the meme names. It has nothing to do with rationality. I think we can all look at GME and other things and just say, hey, that has nothing to do with reality. But the power of the market machinery is that if overwhelming entities are buying calls and betting on leveraged outcomes, that leaves dealers short gamma in those names.

In the meantime, you’re getting structured products and other things which are completely unrelated, which are providing vol supply at the index level. So there’s a trade there, which is a dispersion trade where you have to offlay risk on the short gamma in some way. At some point, you would think the biggest stock in the world has a gamma connection to the index if you run a dispersion model. But as we saw it, ironically, on the Nvidia earnings, Nvidia beat earnings. It was up 10% and the index went nowhere because that’s what supply and demand dictates.

[00:19:58] Alan

It’s a classic trend, from that perspective. In terms of psychology, obviously, rising prices attracts new buyers. But you’re talking about even other dimensions to how a trend evolves, and it gets reinforced by call buying and then dealer behavior. The obvious question is, when does it all end? Obviously, if we had a terrible earnings result for Nvidia, that would stop things pretty quickly.

But outside of that, when you’re looking at an opportunity like that from both an options trading perspective, how do you think about managing risk in something like that where it can go on as you say for a long time?

[00:20:39] Cem

So ironically, it’s all about reflexivity. You and I briefly talked about this before, but it’s not just a wealth effect, it’s a liquidity effect. A market break necessitates a further market break. So the question is, when will it break? Now you’re asking the very detailed question of, what will stop that momentum? It can be anything. ironically, it could be things that are completely unrelated to the core movement itself. I’ll give you an example.

Let’s just say all of the earnings start to absolutely, for small caps, let’s just say this is a made up thing, I don’t expect this to happen. But imagine they all start to do very well. All of a sudden, those stocks now are starting to really get momentum, yet the index is still pinned. Well, something has to go down now. So what if that itself trims Nvidia’s or other things momentum enough so that the calls stop working, people start losing money on all the call speculation?

Now the volume starts turning towards okay, we’re not going to buy as many of these things, we’re going to sell them. And then you start to get a situation where Nvidia starts to underperform for a little bit, which can then lead to a downside. Ironically, sometimes, good news creates bad outcomes. So market structure is not necessarily as linear as, oh, we need some bad piece of news to cause the market to go down. And then the market goes down and reflexively, that’s bad.

So the reality is often the market ends with some type of market strength, some type of counterintuitive move that then changes the positioning, the underlying positioning, and then that underlying positioning then leads to a break in the total process. I think it’s really counterintuitive that markets going down will lead to a worse outcome. Markets going down don’t necessarily happen as a function of bad news. They happen as a function of a change in underlying positioning.

Underlying positioning can be a function of just some underlying realities happening under the hood of the market that have little to do with the total economic outlook. Again, this is I know very counterintuitive for people, but we need to change personality. It’s also about timing, which seems completely silly. People are like, why would us moving through a calendar matter? Why would just some basic things that have nothing to do with up-down outcomes for the market matter?

Well, because guess what? You get out of the summer, you get more liquidity. You get away from holidays and the pinning that’s at the index level which accelerates with all these flows based on time now is relieved a bit. You get closer to events like the election and other things along those lines, the vol is not as well supplied in those periods because people need to hedge and are worried about those periods, and that can lead to a vol expansion.

There are things that happen just based on broad events that just exist. It’s not because the election is per se a bad thing for markets. It’s because the amount of vol supply during those periods is more dangerous, and as you approach them, the vol supply dissipates. As you get away from liquidity and the placidity of the summer and the lack of liquidity, the risks increase. You get away from three holidays in June essentially. We had Memorial Day, we had Juneteenth now, which is a new thing, and now Fourth of July, that really contracts time, etc. So there are calendar effects there.

People think seasonality is crazy, that it’s just a magical construct. It’s not. It actually has to do with structural effects tied to the calendar, tied to liquidity in the markets, tied to contracts of options and holidays and things that reinforce certain outcomes. So sometimes it’s just a movement of the calendar.

[00:24:41] Alan

Exactly. You touched on the wealth effect there, which has been something that a lot of economic commentators have pointed to. It is arguably becoming a more dominant force. On the one hand, economists point to excess savings being depleted in the US economy post-COVID. But at the same time, asset values have ratcheted higher, and there has been this extraordinary boost to alts via rising stock prices in particular, obviously, real estate more mixed.

That points to the market being a more important leading indicator for the economy than the economy being a leading indicator for the market. So it makes it difficult as a strategist or as a trader or a risk manager in terms of what do you monitor then.

[00:25:29] Cem

But it re-emphasizes the importance of looking at these flows. These flows are short-term indicators. But if the short-term indicators lead to path that then leads the actual long-term outcomes based on these wealth effects on the macro realities of liquidity. If you’re not paying attention to the short-term flows, you’re missing the big picture too. Just to put your wealth effect comment in context, in rough terms, about $100 trillion in equities globally, $100 trillion.

There’s about $400 trillion of other assets, real estate, commodities, hedge fund assets, with bonds, we can go on and on, which a lot of these other assets are tied in some form or another to the equity markets. Let’s say half of those, let’s just say half of them have exposure to equity market outcomes, $300 trillion of assets, they go up, or 25%, this year, $300 trillion, up 25%. This year, we have $75 trillion of new asset value. People are like, “Why does that matter?”

Because that’s what collateral is, those are collateral. you’ve just increased the amount of actual dollars. The whole system, people don’t understand, is built on leverage. The whole system. Banking by definition is leverage. You increase money supply by $75 trillion, that is a massive stimulus. That’s simply the value of the increase of the US equity market and the global equity market for the last year. So what happens now when that goes the other way?

So people completely diminish the understanding of value of the wealth effect. We’re not even talking about the liquidity effects. You start to pull back and these banks which are leveraged entities, now they have to get out and they’re overleveraged and malinvestment. That leads to other risks. I’m not here to scare people but it’s just the reflexive nature of markets. A market goes up, economy does better than expected. Weird. That’s because liquidity and money supply matters.

[00:27:50] Alan

Taking all of that together, obviously, we’re saying it’s not about necessarily what we’re reading in the economic news flow, but market flows, timing, seasonals. If you’re looking ahead between now and the rest of the year, obviously, we’ve got some key events, and into next year. What are you thinking in terms of particular calendar periods where there is maybe elevated risk?

[00:28:14] Cem

So we were pretty adamant that coming out of February of this year if we didn’t see a little wobble in February this year, it was risk on for the year. Why was that? Because, again, seasonal effects, March, OpEx is a quarterly OpEx, a lot of vol supply. And then you get into the summer periods with very strong vol supply. It’s an election year.

The powers that be are going to continue to increase liquidity, which they’ve done, to provide underlying liquidity to the market, whether it’s the Federal Reserve, the US Treasury, and policymakers. They’re adding fiscal and monetary liquidity to the market. That combined with that vol supply and those market structure elements, the passive investment piece, will keep things moving in a certain direction.

Once we entered the summer, I was very clear that it would be a very slow grind. The personality of the move would change, and we would get more dispersion and the lack of pullbacks, and that’s what we’ve seen as well. So these are the countereffects a play. There’s a reason we can talk about these things and pinpoint them. So given that though, to be clear, as we get to mid-August, the summer flows really, really start to change a bit.

You have a brief August 14th, the Wednesday VIX OpEx, I’ll be very precise here, into the next week and a half of that period. You have this risk sitting out in September quarterly important expiration options. If you can get an impetus like Japanese yen, something blowing out during that time, vol supply is worse, it’s a short window of potential risk in the vol. Especially because we’re also entering where we have that Nov election OpEx where vol supply is not as good sitting on the other side of the summer, you can start to see a wobble. You can start to see a period where things are less secure.

Usually that first wobble, especially if people are expecting it or talking about it, it’s going to be hard for it to really break things. But I think what we will start to see going into that period, and I actually think starting in a couple of weeks (everybody put this on your market) you’re going to start seeing vol in the back end of the curve. The VIX like 30 to 60 days out, even 90 days out, you’ll start to see the longer-dated vol start to rise. That’ll show up in the VIX and some of the other term structure.

I think soon, the best trade, maybe just starting now, the best trade going forward here is actually not just selling vol but buying calendars, going out and buying longer-dated vol to sell shorter-dated vol because the vol will still be placid for the next call it month or so, very well supplied here on the index level. But I think eventually we’re going to start to see here a vol increase. I think that you get the best of both worlds in that play.

Now, it’s priced very steeply, so you’re going to have to sell a low vol to buy high vol. Still, supply and demand matters more than any of the theoretical realities there. So I think that’s the play you want to prepare for. Until then, and ironically, when that vol starts to unpin, I think it’s going to happen on the upside. So just because I’m saying, hey, vol will start to go higher in that period, it does not mean that the market will go down yet.

What that means is that vol itself will start to increase, and eventually, you’ll get a faster move up. Instead of the steady move up with all the dispersion we’re talking about, you start to get a different character, a different distribution, and that’s a faster set of moves into the end, squeezes into the end. I think you’re likely to see something that looks a little bit more like a mini blow-off top. What that will be, the first time will be a warning shot. This is what usually happens.

What I mean by a warning shot, it’ll be something that will increase the vol of the market, will not lead to a cataclysmic decline in September or whatever. What it will do is it’ll increase the broad vol of the market, we’ll get a real pullback of some kind, maybe it’s 10%. But ironically, I personally (we’ll see when we get there) think that that decline will still be a viable dip, and it will actually lead to a very big end of year rally, and that very big end of year rally will probably be the ultimate blow-off top.

That rally will be met with a market up, vol up personality, something similar to what we saw late last year, early this year, that market up, vol up will lead to vol increasing, becoming more and more unpinned, more and more unstable, vol itself increasing in the market, and then I think early next year, we could see some real second move fireworks. We’ll see.

Again, we’re giving a full path here. We’ve done it before, move 1, 2, 3, 4, 5. It’s hard, but we also have to measure as we go and see how the characteristics change and what that means for the path of outcomes based on supply and outcomes. But that right now is the most likely path in our view.

[00:33:12] Alan

That initial increase in vol you’re talking about mid-late September is driven by just an easing of that vol supply, is it?

[00:33:22] Cem

Structurally already sitting out in November, very low vol supply dynamics because you have the election and you have issues out there. On top of that, you have a big quarterly OpEx in September which has potential tail on a put positioning out there. Once you get past August where vol is very well supplied and on forward, there’s already structural risks. That’s how we’re looking at the future, but on top of that, you have dynamics where people come back in August, people start trading again.

The lack of liquidity dries up, people back away from selling vol maybe because summer was an easy time to do that. You also have less holidays. All these holidays in the summer, that starts to wane. I’m not saying that the market is going to blow up in September. What I’m saying is we’re likely to get in August, September, and I think it maybe on the earlier end right because people are going to try and get ahead of it. Again, August 14th is a date I circled.

I think we can start to see a wobble in there. I characterize it as a wobble and a warning shot that increases vol. Before we get any big decline, unless there’s something very acute that happens out of left field from somewhere else in the market, you generally see an unpinning of that index vol, an increase that broadly allows then for movement in the market into something bigger to come down the road. That’s 25 years of market experience of how this stuff tends to play out, saying, okay, these are the higher probability ways that this path will likely play out based on supply and demand.

[00:35:13] Alan

Obviously, in the midst of all of that, we’ve got an election coming up in the US. We’ve had a lot of new dynamics to think about in the last week around this since the first presidential debate. Normally, it would be what’s the impact of Candidate A versus Candidate B. Now we don’t even know who’s going to be in the mix and the potential replacement, etc. So I’m curious to get your thoughts on that.

Also, certainly for a few days at the start of this week, there was much more talk of a Trump trade in the immediate aftermath of the debate and a couple of days of weakness in bonds. People were pointing to that. Are you seeing that being actively priced in markets as you look at it from volatility and an options market participant’s perspective?

[00:36:03] Cem

Yes. So a couple of things. One, not just the US election here in the US but global. What’s happening in France, what’s happening in the UK, these are all connected. This is what we’ve been talking about for years. The millennial generation on down who’s becoming increasingly dominant in politics are populist. Why? Because they are at the bottom part of the distribution, living at home with mom and dad unable to afford a home, all the things we’ve talked about as a function of Fed policy and money going to the top and creating asset inflation and money not going to labor.

Well, we’ve changed that in the last couple years, and that’s being driven by this populist rhetoric. The problem with that is that drove inflation, which is a flat tax, which is also bad for that dynamic. So it’s a reflexive thing that once it gets started is very hard to stop. Importantly, time matters because every year, millennials become more and more dominant in politics. Every four years, you have a big change. A lot of baby boomers die off and a lot of millennials get older. They are up from 40% of wealth creation and household formation to 45% in the last year, but it gives you a sense of the timeline.

We have a long way to go still, and that populism is going nowhere. That populism means people are still unhappy. It’s not necessarily specific to the policies in place, although there’s a general tendency towards populist and protectionist policies, but it’s more about change. Think back to ’64 to ’82, the last time we saw a really populist push. Great Society Program here in the US, protectionism, all the things that people know happened in the 70s and the inflation that came with it.

During that period, there was only one president that was reelected, and they were kicked out of office, or officially had to resign. Nixon, right? So this is a time where it’s bad to be an incumbent, and that’s what we’re seeing everywhere. It’s hard to stay in power because you can’t do enough to make these millennials happy. There’s not enough. You can’t do this for 40 years and then solve it in 4. It’s incremental differences, but the demand for change there is dramatic. People are going to vote people out in dramatic ways as we saw with Labor in the UK. It’s a pretty dramatic outcome.

What you’re seeing in France is pretty dramatic to how people felt about LePen 10, 20 years ago. If Trump is not a dramatic outcome, I don’t know what is. So that’s what we’re up against and that’s what we’re going to continue to see again and again and again. Trump is here and he’s going to be, he’ll probably be the new President of the United States. Is it too late to bet on that? No, but I do think that what people are trying to bet on there are maybe the right outcomes.

Again, often these things are very counterintuitive. Let’s talk about this as it relates to China, for example. Most people would consider Trump to be incredibly protectionist. All his rhetoric is we’re going to put 80% tariffs on the rest of the world and then take US taxes down to zero. That was his recent policy proposal. Obviously, it’s him being bombastic. He’s never going to go to that extreme. But that is the zeitgeist, full protectionism, nationalism, all that fun stuff.

The reality is though, we talked about Nixon briefly, much like the last time we had this trend, it took somebody like Nixon to go open up China because people saw him as hardline anti-protectionist. Trump might be the only person to be able to politically go make a deal with China, and to kind of be more strong and harsh upfront. We can argue whether that’s a good thing or whether we should be doing that or whatever. That’s not my point. But in terms of outcomes, often is very counterintuitive as to what this trade might be to take advantage of a Trump presidency. The trade might be one thing at first, but then another thing the second.

[00:40:27] Alan

The narrative at the moment is around the tariffs, and it’ll be inflationary, etc. So that’s part of the bond negative.

[00:40:33] Cem

Totally, Alan. I think we can depend on the fact that he’s going to be brash and talk up tariffs and scare people about the extent of those. He’s going to push the envelope on how big these things are. So the trade probably is right at first, but I would caution people to get too out and over their skis on that trade as it happened. So right now, yeah, that’d be a really good time to bet and buy the rumor, sell the news into an election that actually happens on that effect.

I think there’s enough doubt as to whether he will still be president that it’s not too late to make some of those trades. But it’s also sell a little bit out-of-the-money puts in a sense. But if it doesn’t happen… But I do think that’s the highly probable outcome. I hear a lot of the rhetoric about a replacement to Biden. It’s just getting too late. There are several structural things that people don’t realize. Biden has raised basically $100 million for his campaign.

The only person that he can hand that to legally in a transfer would be his vice president Kamala Harris, and she is incredibly unpopular, more unpopular than he is. So they have to be sitting at the Democratic party saying, “Well, this is our option. Is that a better option? Probably not.” Not to mention, the only person in my opinion that they could replace her with is somebody like Michelle Obama, a black woman. the reason is that the base of the Democratic Party is both women and African Americans.

You can’t make that commitment in terms of vice president and skip her over for a white male or something similar. Internal to the core of the party, it would be a big problem. Now, that presents that question of Michelle Obama which has been raised. But I think there’s some structural problems with that. She has been pretty clear again and again that that’s not something that she wants. So my point is, it’s a very narrow window to make that happen.

I think that the people who are getting out of their skis saying, hey, this is a real probability. Could Kamala Harris become a candidate? Potentially. Is she likely to win? No. That means we’re still likely to get the same outcome.

[00:42:51] Alan

From a market pricing perspective, how does volatility look? Presumably, the dates around the election are elevated from that price action risk, but any other observation from the options market as to what’s being priced?

[00:43:08] Cem

People have gotten very burned. The collective memory over the last two elections is that vol was high and it was a buy. It’s to such a point that people are not willing to sell that election. The contested nature, potential nature of the election, and not just relative to the one day of the election, even around it, you’re seeing people bidding that up, leaning in, leaning out, because of what happened last time.

My gut says it’s a little bit more cut and dry this time. It will unpin markets and create a volatile market outcome, but I do think that it will be volatile but mean reverting. Much like a lot of times when vol is very high, it will be hard for vol sellers to make money and it’ll be hard for vol buyers to make money, and that outcome usually means very volatile in between.

If you step away and look down over some medium-term week, month, some period, the market actually goes more or less before. So I think that might be the case during that period. And then I think we could see, like I was saying, something going into the election that’s volatile pullback, vol increasing. This kind of ties into the flows I was talking about earlier. But they ultimately get us to the seasonality into Thanksgiving and Christmas.

That could cause the final push end of year higher in markets. I think that might be the last push into the end of the year. Again, important to note that one thing I did note, end of year flows in a year that the market is up 25% are very positive. If a market is still up 25% post elections or even 15% and then starts to go higher, they’re going to start front running the end of year flows, which again, $100 trillion US equities, $300 trillion more tied to equities, you have a rebalancing of that reinvestment that happens not just monthly and quarterly, but importantly, a lot of those are annual.

If 10% of that $75 trillion we just mentioned before, $7.5 trillion gets concentrated into reinvestment at the beginning of the year, look out, don’t get in front of that. That’s why flow-wise, the beginning next year starts to get really, really interesting.

[00:45:38] Alan

A couple of the other possible reactions to Trump. Obviously, we’ve seen yields spike up a little bit for a few days and payrolls have been a little bit better than expected. But unemployment rates ticked up, so bonds haven’t really gone anywhere dramatically. But that might be one way to play it. Another way, obviously, there has been talk of a weak dollar policy under Trump. If that was to become a theme, that could undermine confidence in US assets as well.

Are they themes on your radar? Can you play those themes at the moment, or do you have to wait and see what a Trump administration actually looks like?

[00:46:19] Cem

I think you can. I do think the last rally here in markets, the more Trump looks increasingly likely to get elected, that you can play it proactively. It is not just market continuing to rally after a wobble, but volatility starting to go up, gold starting to increase in value, and as you mentioned, yields, a yield steepener which you’ve already started to see from the markets. I’ve been pretty adamant. I think we’re going to hit 5% again in the 10-year before the end of the year. So a market up, yields higher outcome. Why?

Again, that’s somewhat counterintuitive. I think we will start talking about, I think the Trump general zeitgeist is to run the economy hot. Run the economy hot means he’s going to do that through activist monetary policy. I don’t think Powell is long for this world once Trump is a candidate, and I think much like Nixon put in Burns, I think Trump will put in who knows.

I think that outcome is a higher probability that the markets are pricing, and that steepener is the perfect trade there. That means short-term interest rates are going lower, and long-term interest rates are going higher, and inflation is going higher. That trade I think is one of the better trades you can get out in front of right now. Particularly because people aren’t talking about it as much.

There’s not a ton of positioning out in that trade right now. I would say maybe six months ago, there was more of it. That is a good trade in my opinion to be going in that could really, really outperform going into the end of the year.

[00:48:00] Alan

As you touched on, we’ve had elections in the UK. Yesterday, results out overnight and we’ve got the second round coming up in France at the weekend. As you say, we’ve had this general shift. We have the European elections here of late, which was the impetus for Macron to call these parliamentary elections. It is all part of the narrative as you touched on of this rising populism, ships to rise, etc.

In terms of the French elections, is that something you’re looking to from any particular angle from a trade perspective or more from just a broad macro theme?

[00:48:45] Cem

Yeah, I think France is an interesting very short-term trade. One thing we haven’t touched on is the Olympics, which seems like, oh, why does that matter? Well, you talked about how holidays matter. Guess what? Historically, if you go look at election years, election years that are Olympic years, that three-week period is one of the least volatile. If you look at all other data sets, it’s an incredibly low volatility time.

Why? Because people are just, they’re tuned in to other things. It’s the middle of summer, it’s late summer, and liquidity dries up during that period, and it’s just very low volatile. So it accelerates time. Volume-weighted time is a measure I like to look at that very few people look at. Volume-weighted time is very low during those periods. So I just think we’re going to have a very low volatile time.

I also think people will be looking at Paris and much more positive on some of these outcomes than the market is pricing in France. So I think given the vol supply, given the placidity that’s here, and the low probability of some stressful event coming out of there. I also think Europe, broadly, people have been talking about how weak Europe is relative to the US and trying to call for mean reversion for some time. I think that time is coming. I really do.

Going into the end of the year, I think Europe could play a little bit of a catch-up trade. I think structurally, economically, the energy issue in Europe has been resolved. I think LNG and how cheap energy is becoming in Europe is a huge, huge benefit for Germany, among other things. If you’re somebody who’s trying to create a manufacturing facility right now, Germany’s got to be at the top of your list, particularly in terms of broad nearshoring-onshoring that’s happening in the West broadly.

So I think there’s a real interesting trade in Europe broadly. I think a dip in French equities. I was out there publicly talking about buying BNP with two hands into this recent pullback at this top-tier bank in the world, and actually, some of its best business lines are in positive trending derivatives, other positionings that I think are broad secular trends here. So there are real opportunities I think to buy in France at this moment.

Again, I think you could see some real quick mean reversion there. We’ve already seen a little bit, but I think that could really outperform. The counterintuitive trades are the best. The reason those work so well (to be a contrarian) is because of supply and demand. Reflexively, people get positioned on one side, and that likely means that the other outcome is more likely.

[00:51:32] Alan

Yeah. Well, you do have that added reflexivity I guess with respect to European sovereign debt markets as well, because obviously, the banks tend to hold sovereign debt. So if you get a wobble like this, they tend to get hit on the double. Obviously, the French stocks getting ahead on possibility of changes in taxes. But also then, if the sovereign debt say gets hit, that side of the asset balance sheet is a hit too. So that’s an additional reflexive opportunity.

Obviously, the ECB does have the tools within its arsenal now to directly intervene in this type of situation if it came to that, but it seems like all the noises from them at the moment are no, let markets play out. But I guess that is something that in the extreme we could see.

[00:52:25] Cem

I just think that there are the trades like China which you don’t want to get out in front of. You don’t play mean reversion in all markets. That would get you into trouble. But when the rhetoric is so negative, it has been negative for a while, people have abandoned the trade for some time, you get this real negative tail outcome which seems honestly relative to the realities of what can and cannot happen overdone.

It represents a real nice inflection point, which could then ironically lead to a much bigger bull move in the longer term. So I think that feels like the case in France right now for me. Again, I’ve been looking for an entry point across Europe. That’s a nice one there in France.

[00:53:10] Alan

In terms of the vol supply dynamics that you identified and spoke about with respect to the US, do you see similar dynamics with the European market? Obviously, we haven’t had 0DTEs in the European market, but I guess the structured product issuance is as big a theme in Europe as it is in the US. Are the dynamics fairly similar or are there distinct features would you say?

[00:53:39] Cem

Actually, there are similar structured product issuance realities. I think, in terms of demand by markets, it’s actually quite strong in Europe. The difference though is increasingly these products are tied to the S&P 500. So even if they’re buying them in Europe, the effects are happening in the US. So the US is the epicenter, I would say, currently of those dynamics. Ironically, that’s more supportive for the US as things go up.

But into a wobble or something where those things can go sideways or be hurt a bit, I think entities away from the US will, into a decline, outperform. Once they start to outperform, there are momentum and other reflexive effects that can lead from there. So yeah, I think a wobble in August-September if it happens with the vol going higher ironically could hit the US worse than somewhere like Europe and you could start to see Europe outperform, which could then lead to a change in trend as we talked about.

So I think there’s an interesting moment here to start. Again, you don’t have to pile in. But again, you get a discount like you did in France. That’s a good entry point into what I think is coming in the next month or two.

[00:54:55] Alan

Okay. You touched on gold starting to move up. I know you’ve talked about this before. Obviously, there’s that structural argument in terms of multiple dimensions in terms of the role of the dollar and fragmentation of the global system, etc., and obviously the changes we’re seeing in international reserve managers and their holdings of dollars and treasuries and shifting more into gold. We’ve had a run-up in gold, it’s come back a bit. From a long-dated options perspective, any changes there? What are you seeing in that market?

[00:55:32] Cem

The trade, I have been very adamant about this from the lows in gold about a year and a half ago. The trade in gold, in the next decade, is long long-dated calls. Now, we called that from the bottom, almost the exact bottom, when the opportunity arose. Why? It’s not just that I’m bullish on gold, which is one thing. I’m bullish on volatility. Implied volatilities in gold, particularly on the call side, were very low. They’re still not that high.

If you look at historically, again, let’s go use that last period we had, ’68 to ’82. The realized volatility increases dramatically in certain products in structural inflationary and protectionist populist times. The entities that increase dramatically in volatility are bonds, FX, gold, dollar. Now, this shouldn’t be a surprise. You see massive flows. It’s not one world connected. It’s a bunch of different areas competing against each other both in economic warfare as well as others, and the biggest beneficiary in that time is gold.

To be clear, this is also a time when we last took ourselves off the gold standard. That may seem like a completely different thing. In my view, it is obviously different, but it’s going to rhyme. The US debt is to a point where it’s unsustainable. I don’t think there’s anybody out there who can say we can continue to go down this path. Again, I’m not saying that the debt itself is too high.

I’m saying that it’s unsustainable unless we do one thing, which means we’re highly likely to get to one thing, which is we can do that in several different ways. We can hit a button and say, that’s it, we’re not doing it, which essentially is the Federal Reserve going out and buying all the debt. Now, is that inflationary? Yes. Not dramatically. I think the initial thought is that’s really bad for the dollar.

The initial move when that happened, when we untied ourselves from gold, was dollar weakness. But relative to the unpinning, the actual strength of the dollar ultimately was better, because guess what? We saw the debt fall and things look a lot better in the US. But the primary beneficiary of that is gold. At the end of the day, you’ll see a very volatile outcome in maybe 2, 4, 5, 7, 8, 10 years, whatever it is, as we come down this path where we have to contend with this, and the Federal Reserve starts to make these actions.

You can see some real volatility in gold. But again, the move is long-dated calls. Now, that doesn’t mean you don’t trade around that position. That means you hold that long-dated call position. After you get a dramatic volatile move, you may want to sell some short-dated strangles against it to fund it or whatever, because you get periods where it consolidates and goes sideways like this. That was the move after the big move takes profit. These are dramatic outcomes, so there’s still decay on these things. That was the move.

I think we have defined a very clear channel in gold. We’ve just bounced off the bottom end of it. We’re going into the end of the year and a very interesting set of election outcomes as we talked about. This could be an inflection point politically. Again, the long-dated trade is still the same. So now would be a time we’ve been talking about for the last several months to buy calendar call spreads, similar to what we said in the S&P. But this is I think even the better outcome because I think gold has a longer-term bull trend that will not be hit by a wobble per se in US equities.

The increase in vol in US equities, which I think will likely come, will likely also benefit gold vol. So yes, the answer is buy long-dated calls, continue to own them for 10 years, not just six months or a year but trade around them and lean from that side.

[00:59:43] Alan

Good stuff. Well, we’ve covered a lot of ground. A quick tour of the global elections and some very specific times to put in the calendar as well for the coming few months. So thanks very much for that, Cem.

Next week, Niels is back. So any questions send them through. From Cem and I, stay tuned to Top Traders Unplugged and we’ll be back soon with new content. All the best.

[01:00:11] Ending

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