#974 - Sell the Stock Rally? with Cem Karsan

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0:55Should you sell the stock rally? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Jem Corsone, founder of Kai Volatility. Hey, Jem, it's great to have you back on. Always great to be here. We were joking. He's so busy that he literally is running from appointment to appointment and client to client. So we appreciate it. We're all coming and hot because there's a ton to sort of keep track of. I want to just start out by reminding everybody that the last time you were on, you warned that things around mid-February, in fact, you said around February 14th, things could get a little dangerous.

1:33There's a lot going on behind the scenes, as well as, of course, the data, which we know the latest inflation reading kind of roiled the market. And sure enough, it's been a volatile, brutal week. We had that inflation number yesterday, which has everyone rethinking the Fed with a big sell-off, stocks down, bond yields up. Today, as we close the US session, we've seen US stocks recover, rebound a bit. Treasury yields are down a touch, but the 10-year is still sitting at 4.26. It's been a big move from what we saw end of last year. So how are you thinking about all this market action? Yeah, I mean, we've been talking about for several years, right, that inflation, despite the narrative that you will hear, is sticky and will continue to be sticky and that there's a structural element to that.

2:30And it's not just the core inflation, which has clearly been sticky, right? It's also the things that people assume that are non-correlated to that core, which are things like the price of oil, geopolitical conflict, the deglobalization. We're seeing all of these things also affect the headline number. And those trends are solid and not going away. If anything, they're getting worse under the hood. And people are overlooking that under this soft landing kind of narrative. And they're missing a much bigger, more important picture, which is in the short term, we can get declines, much like in the 70s, significant declines in headline numbers.

3:12But if you look at what's happening on the surface, that's being accomplished under cyclical pressures, duress from cyclical and monetary policy. And the second that recession comes to play and the things, the malinvestment that exists before, which has a lag to it, kind of comes to the head, you know, comes to the head, then we're going to have to re-stimulate, which we've already started to talk about this year. And what that means in the context of a structural inflation is very troubling. Last time on the show, I think you asked me about the soft landing, and I said soft landing, stagflation is more like it.

3:51So I think we're starting, that's what we're beginning to see. And again, we're the only ones saying that word right now. Look forward to six months and that's going to be the word du jour. But again, that's what that CPI number tells you. In the context of that, there is real risk and weakness. At the same time, we're seeing those sticky CPI numbers. We're seeing a commercial real estate market that has 65%, 65%, two-thirds of commercial real estate is underwater and in risk of foreclosure currently in the whole country. Yeah, that's so scary. So is that we have this wobble? It's interesting because before we were sort of focused on inflation, we had this wobble again with the banks.

4:36And every time we see that, everyone's like, oh, don't worry about it. You know, the federal ring fence, they're going to pop up like whack-a-mole. We know it's there. The Fed will ring-fence it, create some facility, and they'll be able to kind of contain it. And then we kind of forget about commercial real estate. Is that just too complacent of a view? Are we missing something with that? So late 70s, really early 80s, we had something called a savings and loan crisis. Yes, we did. A lot of people forgot about that. How long does that take to resolve? Do you have any recollection? I mean, I - About 20 years.

5:12Yeah, I was going to say. 15, 20 years. This is not a known thing. It is something that the regulators are going to continually backstop and try and not make an existential threat. By definition, banks are, you call it a Ponzi scheme, put whatever you want, but it's a leveraged entity with a tail. They don't have enough assets to their liabilities. It's structured that way. That's not, That's just the way what banks are. And so anytime something like this happens, there's a structural tail. And the only way to stop a run on a bank is to backstop it for the government to backstop it for a bigger entity to come in and say, we'll make sure all these things are good.

5:59So this will continue to be a recurring issue. The government will continue to backstop this issue, but it's not going away in a year or two, or it's not a temporary crisis. This is a rolling crisis that we will continue to deal with. And again, not a coincidence that things rhyme with the 1970s, right? The back end of when you keep rates artificially low and then have to raise them, malinvestment eventually comes to a head and things become less affordable. The investments that people made, we've seen this before, this is not a new story, eventually go underwater. And given the amount of leverage in the system, it's not something that you can just make go away.

6:40You have to nationalize it, you have to somehow digest it and move on. And it's so big, that's not easy to do. So is that in your mind a drag on growth? Is that where, you know, because you're talking about stagflation, right? So does that create this kind of, yeah. That's one of the issues. It's more of like a canary in the coal mine, right? It is one of the things that's very important, but it speaks to the amount of malinvestment And that with time, the eventual risks of having to reset those marks and what that means to liquidity. In financial markets, people probably don't understand the momentum effect that exists.

7:26We've talked about this quite a bit in the context of the end of last year. We talked about how when the market's up 25%, that's 25 % of new money. And if the assets of the world are$400 trillion, that's$100 trillion more of money. People don't think about it that way because people don't think about leverage, but the whole system is built on leverage. Money, when we create money, when the Federal Reserve creates money, they create leverage. That's how they do it. That leverage is money. They're the same thing. And the whole system is built on leverage. So, you know, again, most people think about, well, I own, you know, this cup.

8:02And this cup increases in value. I own just more. But that's not how it works. How it works is you own 25 % of a cup, and much like real estate, right? And if it doubles, right? If the value of the property doubles, it goes from a million to 2 million, and you had 250 down, you make a 400 % return. But now you have a million and a quarter in equity, and the leverage has to be reset. There's new dry powder to put to work. And that collateral reinvestment is the momentum effect that exists in markets. But just like it works on the way up and creates more and more money and more and more growth and more and more reinvestment, it works on the way down.

8:42And that liquidity, that leverage kind of factor is what will eventually come in and kind of force leverage up, leverage down. And we always see this at the end. So it sounds like you're pretty bearish about the coming months. Or is that? I want to be clear. I started in the business in 1998. Right. And I started investing in 1995. So my early experiences were a market that from 95 to 2000 that exploded higher, way bigger than anything we've seen in any recent history. And then lost 92 % of its value. The NASDAQ lost over 90 % of its value. and so if you're asking me to tell you what's going to happen in the next month or two I can look at flows and give you some context and probability but what you have to understand is that this market and the path that it takes on its way down has way less to do with was what's actually happening and valuations and realities in the short term and has more to do with supply demand and balance and flows.

9:56And so we can have that conversation, which is a separate one. But if we're talking in the context of macro and the bigger picture, yeah, this isn't going to end well. I am broadly bearish years out, right? Given the macro realities of the world we are living in. But that does not mean that in the next couple of months, this market has to crash or decline in value. Those two things are, you know, we're talking weighing machine versus voting machine. The two things eventually will reconnect, but it could diverge for years at a time. Hey, everyone, we're going to take a quick break right now to hear a word from our partners.

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12:52Which I think is hard for people to hold both of those things. You know, we tend to sort of grab onto that longer-term macro narrative. and then it's hard because you'll see the market moving and it doesn't fit into what you're expecting from that. And a lot of people in the chat already talking about commercial real estate, because it was really something people were so worried about. And then I don't want to say suddenly we weren't, but it was everyone collectively extending and pretending and just sort of trying to manage it. It's a problem, but it's kind of in a slow-moving, slow-motion crash.

13:28So how are you thinking about things shorter term? Because you always watch these structural flows that you've been so great about shining a light on for us, as opposed to just that, you know, we know that there's data. We know that earnings are coming in. You know, all those things that we're looking at in the headlines. But I know there's options expiration, which you watch closely. So what are you seeing in the short term that has your attention? So we've talked about this before, but I can't emphasize it enough. these quarterly OpExes, which we are about to impart on. When I say the OpExes, it's not the actual March OpEx stuff, it's the cycle, right?

14:08It's the, that starts post-OpEx into March OpEx, are very important. The options themselves, there's more open interest tied to both structured products and trading tied to those quarters. And because of that, that leads to a change during these periods of distribution. So what happens during these cycles is you have a very fat left tail with more right distribution. And as you move through that cycle, the tail drops off and the right distribution, the flows start really accelerating. Why is that? Because again, all this, the street, the dealers, the banks, the market makers are short puts, long calls, short stock in those expirations.

15:10And that's just structural, right? The world is long and the world has to hedge. So the options markets have the opposite. and as a function of that, as time passes, they have to buy back that stock or as the probabilities change of that decline happening, they have to buy that stock. So it's kind of a, again, it's constantly moving. It's a function of time and risk and those flows enter accordingly. But at the same time, if a decline happens, then they have to sell into it. Those are the gamma effects, which are the counter effects here. And those create, we've seen this many times from mid-February.

15:48Again, this is one of those things where people call it seasonality and it's an almanac. And people, you know, look at the stars and say, you know, but the reality is there's reasons for these things. And so if you look at that, those tendencies, the tendencies are to have some big tail events. Think COVID, right? Day after FebOpex to the day after March Eplex. Literally, you know, the exact days of the cycle. we had a 30 % decline. And then as soon as it was done, a V bottom and it was over. Not a coincidence. We knew about COVID in late December, early January, right? We've talked about this.

16:24So those periods can be very dangerous, big fat left tail. But it doesn't mean, again, to be clear, it doesn't mean the market needs to decline here. And if anything, if we get through this short period at the beginning of that cycle, and we don't get the wobble or the risk that we need, then the vol kind of compresses, the risk of downside decelerates, and then the flows start coming back. It can be very positive, and we can get an extension in this period. But it is a period after, particularly after a big run, particularly when there's structural fundamental reasons under the hood to be bearish, as we've seen from CPI, and we've seen the commercial real estate issues we've seen, that people are kind of just whistling by the graveyard on that there's risk here.

17:07And And you need to price that probability and the tail and the leverage that exists in those products during this period. Yeah, so it's vulnerable. Do you see presently anything on your radar that would be that kind of risk that hits the market in this dangerous time? Is there anything you worry about? Well, to be clear, I'm worried about the structured products and the actual volatility exposure that exists, the short vol that exists on the tail in that quarterly expiration. given how far we've run and the potential energy. So these blow off tops, which are essentially these big fast moves that go further than anybody could possibly imagine.

17:48As vol starts to become unpinned, so fixed strike vol starts to increase. We've talked about this and we're seeing, right, it's harder to be short vol in this environment when you're getting 100 point decline and then a 75 point rally. And meanwhile, the longer end of the curve vol keeps kind of hanging in, And it just doesn't pay to be short vol. So what do people do? People start selling less and buying more vol. And you start to get a squeeze up in vol. And then the thing becomes a bit unpinned, right? And not to mention, as you rally, you're sliding to a lower vol anyway. And it becomes more appealing relative.

18:23So there's this whole process that we're watching. And that's unfolding kind of as we've talked about for months now that you would want to see transpire to unpin some of this vol. And we're starting to see that. So that's a reason for concern, right? It makes the probabilities higher that something can transpire because there's less ball hitting in the short term and there's more tail risk. So we're reading the tea leaves. And when I say the tea leaves, it's not just qualitatively like putting our fingers to air and saying, OK, macro is bad or whatever. It really is saying measuring, OK, how much supply demand potential risk is there?

18:57How much leverage is there in this potential voting machine that can cause problems? Where do we need to get to for that to start to transpire? And we're measuring that and time passing as a function of that is kind of how you play this. Yeah. It's so interesting, you know, again, to think about it that way. We talk all the time. I want to play, you were just talking about the long end, sort of not moving. I want to play, Harry Malandri had a chance to sit down with Bob Elliott today. I know you know Bob, you know each other well. You speak often as well. And they talked about the outlook for the bond market and some of the things that Bob's watching when it comes to treasuries.

19:35Let's have a listen to that, and then we'll talk on the other side. Well, I think in a lot of ways what we see on the short end is – I sort of describe it as the easy money has been made. You know in these trades, you've got to think carefully about sort of where do you have the highest confidence, and then when does that confidence start to erode. And so, you know, and it's not a linear thing. So, you know, we had in December as much as intraday seven cuts for 24 priced in. And now we're down to, you know, three and change cuts priced in for 24. And that really is that big shift is reflective of the fact that, you know, it's pretty extreme in terms of the cuts relative to the strength of the economy.

20:21You know, at three and change cuts, you know, does that look like on the short end? You know, does that look like about right? You know, it's probably in the ballpark of right on the margin. I think there'll probably be less cuts than that, but it's a lot less interesting a trade. The thing that really, to me, is an interesting focus is how little of the move in the long end has been around the expansion of the term premium. So you've had actually, through the course of all of this short-term cut, all these short-term cuts getting priced out, essentially the yield curve in aggregate has shifted up.

21:00And you really haven't had much change in the term structure of interest rates. And that's the place where the pricing of sort of stronger for longer here seems a little underdone. And that full interview, who's better than Harry and Bob? That full interview is available on our platform. If you're not a member, head over to our website and join us. We have an, I just found out, an amazing Valentine's Day. It's Valentine's Day. Amazing Valentine's Day promotion. A price massacre, they're calling it. For the Plus membership, you'll get interviews like the one you just watched, as well as the Real Investing Course and the Crypto Academy.

21:39So there's a lot in there. So go check that out. And hilariously, while we were talking, someone's running a poll. I think it's Paul on who spent what on Valentine's Day, which I love. So fill us in on that, the results of that. We're going to find out if you're generous, if you're all a little stingy. But to get back to bonds, it is an interesting point from Bob. What are you thinking about? Especially, I think he's talking about that feeling like that long end may be mispriced. What's your reaction? Yeah, so Bob and I do a Twitter spaces almost once a month before the Fed meetings in particular.

22:16and for almost a year, we've kind of agreed, we come out about things in quite a different perspective, but we have really agreed on this fact and that the more the Fed eventually pivots, what will likely happen down the road to the yield curve, and we've been correct on this, which is, by the way, counterintuitive to most bond traders because this is not what's happened for the last 40 years, is that the front end of the curve will likely come down, obviously, because the Fed is lowering rates, but unlike other periods where the whole curve kind of shifts down, our view has been that actually given that we're in a very structurally inflationary period, what that'll tell the long end of the curve is that Powell's actually not Volcker, that he's more Arthur Burns, and that ultimately the risk there increases of higher long-term rates, right?

23:08This lack of willingness to kind of combat inflation instead to favor growth over inflation, an unwillingness to kind of create a meaningful recession, right? What that means, the yield curve is more inflation down the road. And so you're likely to get a steepener as ironically, the Fed is lowering rates. And that's exactly what we're going to see here. I think that's a real risk. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

23:46and and then so and of course the other side of the equation is fiscal and again we don't see any fiscal constraint any balanced budget efforts there's not to say that we're going to get a ton more spending or not but but there's lots of indications that very unlikely we see cuts or frugality in washington no the the appetite on both sides of the aisle for spending is higher than it's ever been. And that's the populist rhetoric and the populist kind of reaction, impulse that we've been talking about for years now. It's only getting stronger and we are likely to see more. But there's already so much in the tank, to be clear.

24:28It's not like we spent it. We passed it, but we are spending it as we go. And there will be more. You can count on that. That's what people want. And politicians give people what they want. Right. And there was a time in Washington where maybe, I mean, I don't know if any of you can remember, but there was that famous story. And I don't know if it's lore or if it's accurate. Someone can go down that rabbit hole where Bob Rubin, when he was the Treasury Secretary, convinced Bill Clinton to pay attention to the bond market and get a handle on a balanced budget and that the bond market would reward them with lower rates because they were being serious about inflation.

25:09But that whole idea that you can do anything on a bipartisan, you know, platform is completely impossible, at least for the moment. We shall see. It's a crazy world and we do have an election, but it's hard to see that right now. It's an interesting point on that, Tim. And this comes up that people say, oh, well, that the Treasury can't afford to let rates go up. So, you know, Yellen will push them because they've got to roll over this debt, which is true. but that doesn't mean that bonds won't go up anyway, unless you buy into the, I guess this is where you and Bob either don't agree, or you may not think this will actually happen.

25:49Sort of some form of yield curve control, right? Like they forced someone, the banks to buy more treasury, something like that happens. That's the only way that Steepner wouldn't run out of control, right? So I have a different view than pretty much everyone on this. and that is that, and it sounds Pollyannish, this is not a moral belief, this is just the reality, is to the extent there's no alternative to the US dollar, which we can debate all day long, but at the end of the day, I don't know where you're putting your money, but you can believe that you're going to get it back with the confidence that you can in the United States.

26:29You're doing a million different reasons. As long as that's the case, I don't believe that higher interest rates and not being able to balance the budget matters. At the end of the day, much like Japan, which was backed by the US, that allowed it to essentially monetize all its debt, just internalized. We talk about GDP ratios to debt in China, I mean, in Japan, but they're irrelevant because the Japanese central bank owns all that debt. It doesn't matter. It's one hand shaking with the other hand. So if we're paying absurd, as a percentage of the budget, it may look high, but if the money is just going to the Fed and then the Fed is just passing the money back to the US government, it doesn't matter.