Cem Karsan on The Economy's Path Forward (2024)

26:49And those dramatic changes are very hard to hedge with the underlying index. In fact, at RMC, which is the SIBO's risk management conference last year that attended, they had market makers on stage and we're all talking, asking questions. And those market makers said what I've known all along, both of them, which is they don't hedge these zero DTE options with futures or underlying because they can't. The gamma is just too much. They have to hedge zero DTE with zero DTE, which creates a reflexive loop, right? That works well as long as there's two-sided supply. But if a big enough order comes in where everybody in zero DTE gets totally swept out of their gamma and becomes short gamma, now you have a cascade, where everybody is trying to get back that same hedge with the same trade.

27:42And that's why I think zero and T ultimately will be a significant force in the next decline or increase of volatility that does happen. So this is really interesting. And I want to talk a little bit about how everything you just said bears on the current dynamics of this market. Look, Jim, I know just enough to be dangerous here, but it's pretty clear to me that we've seen this pattern, obviously, of when you look at the chart of U.S. equity markets, you look at the historical rate of return on these indices. You look at where we are today, roughly halfway through the year, obviously blowing through the historic rate of returns, significantly outperforming.

28:28You do have to wonder at what point this might be getting a little bit off sides. Let's talk about what some of those risks might look like going forward. So we mentioned long-term capital management, right? And I think that's the one that rhymes the best here in this current circumstance. Yes, times are different. We have a structural vol supply, which didn't exist back then. So you have to think about how 2017 into 2018, that environment with vol supply dovetails into the macro picture of 97. But it rhymes to me because we had a similar situation where essentially the Fed was increasing interest rates.

29:16The value of the dollar was very strong and causing all kinds of problems from a macro perspective from emerging market economy. We're seeing that same thing right now. And I think that itself, macro, in my view, will eventually, especially some corner of macro, maybe it's the yen. There's a lot of talk about what's happening in Japan right now. Maybe it's China and the yuan. And there are lots of places that they're feeling a lot of pain and seeing a lot of outflows as a function of higher interest rates in the U.S. relative to the risk. And that dollar strength and weakness in those currencies is a big potential issue.

30:05It's creating a lot of stress in little corners of the world. Now, again, that created, you know, there's a different time than 97. I get it. It's not going to be the same exact thing, but those rules still apply. And if we continue to go down this path of dollar strength, I think that could be something that really eventually creates emerging market problems, problems in other holdings and banks that eventually could cause a ripple effect and increase volatility in a part of the market that creates a wobble, right? Something that unpins this vol. And when you do unpin the vol from, you know, it's like dropping something from a higher altitude.

30:51There's just more room to fall. There's just more potential realized volatility. With vol, implied vol this low, if there's a concentrated bet, if something blows up, eventually the tail is just going to be fat. And that's what we're in. We're in a very tight distribution in terms of the actual volatility and the odds of something happening. But if something happens, it is going to be a fat, big left tail. And so that distribution of outcomes is very different. That said, I don't think we're there yet. And there are structural effects in place that make that pin in volatility so strong right now that into the end of the year, there's also reflexive effects.

31:32especially as we start to get closer and closer to the end of the year, that reiterate this momentum, that reiterate the vol supply, that keep this thing going in the same direction. That said, seasonality breaks, vol supply weakens, all of a sudden something wobbles, and you can get a real big impact out of nowhere sometimes. So let's talk about what that wobble might look like. Listen, if there's one thing I can assure you of, it's a hell of a lot easier to ask these questions than to answer them. But I have to say, when I asked you about the current market dynamics, the first eight words out of your mouth was, so we talked about long-term capital management.

32:13Boy, that is a sobering way to begin anything when we talk about where markets are today. I should say, just for a little bit of context here, dollar yen right now trading at 161 on my screen. It hasn't been at that level since I could run a mile without wheezing. It's been a long time, 1990s, I think, since we were at these levels. When you look at these markets, when you think about where these fragilities might lie, what are you looking for? What are the gauges on your screen that you're looking at to see if one of these wobbles starts to begin? Because, boy, if you can find that wobble before it becomes a full out spin, it's really obviously a significant advantage for investors.

32:58Yeah, I think the key when you're looking at these things is I think everybody's looking for, well, what level are you looking at? Because people are very directional, right? And what asset? And that's not what I'm going to tell you. What you're looking for is speed. It's about the volatility and acceleration of certain different factors. The way things break is things don't break slowly. Things break when the acceleration starts. when you start to see an impact of an event that is too big and too fast for an entity to manage. And so the speed and acceleration, the acceleration, the gamma, if you will, the second derivative of the move is ultimately the thing that you really, really want to be paying attention to.

33:53And you want to do that. You want to look at that as you see flows in emerging markets. right? What's happening to outflows in these countries? You want to see it in currency and FX pairs. You want to look at interest rates, particularly short-dated interest rates and what's happening at different points. We in the volatility markets look for, I've told people this before, but in terms of high-frequency data, that's very important. The ultimate, isn't the only way you can hedge the fattest tail is by looking at VIX calls, which is the most convex moment or really, really close, you know, two, three, four, five days out, really small units, nickels, dimes, 15s.

34:43That's the way to get the biggest leverage. When those things start to break, you have probably hours, if not a day, right? So, So these are things to look at. On the macro side, really looking at, again, FX pairs, as I was saying, fundamental outflows and problems on the governmental level. When derivatives contracts and volatility of those contracts start to break is a very good sign that you really want to dive in. And then, again, across indexes in the most liquid markets, those fat tails, when those start no longer being available, for hedging, that's usually a sign that the convex moment is happening and can accelerate very quickly from there.

35:32I guess the flip side of that question, it's an important point to make it by way of disclosure, is that to borrow from Keynes, markets can stay irrational for very long periods of time. And so there's no implication here that something is imminent. So let's talk about that. Quite the contrary. I want to be clear. I didn't come on here to kind of scare people, right? This is talking about distribution. And as I mentioned, this distribution is very tight. And this is a highly profitable time to sell volatility. Historically, low volatility like this begets more volatility. And the risk-adjusted returns of that realized versus implied is actually wider during these times, despite the implied volatility being quite low.

36:16and that's for a reason. The structural effects are in place. People realize it in the short term and they're going out and they're making those bets, which is reflexively making those bets more likely. So I'm not telling you to go out and buy hedges right now. What I am saying is that when the tail event happens, it's a low probability, high impact event. It'll be much higher impact than anything we've seen other than let's say the biggest ones like XIV or long-term capital management or something along those lines. But, you know, what's interesting to me is fleshing out this idea of XIV affected a very small group of people who were speculating in that.

36:58What is the risk to broader markets if you do see this snapback moment? Because, I mean, we're talking here about things that are implicit in the broader market structure that are extremely widely owned. We're talking about We're talking about a handful of stocks, half a dozen or thereabout, that have seen tremendous increases, dramatic increases in market capitalization relative to the equal weight on the index. What's the risk if this scenario begins to unfold? Yeah, again, not to put all this bear porn out there, but I think the reality is that we live in a very dangerous structural time. I've called this a sumo market before, right?

37:42What do I mean by that? If you have two things pushing on each other, right? And it's, let's say, two skinny little wrestlers, there's not a lot of potential energy there. But next to them, on the mat next to them, there's another wrestling match going on with two sumo wrestlers. They may not be moving either. They may be pushing. But there's much more potential energy. There's much more likely to be something very volatile that happens. Once those guys slip on the sumo mat, you're going to see bodies flowing in dramatically different directions. We are at a balance here because of structural flows, but the underlying pressure in the system is dramatically higher than we were, let's say, in 2017.

38:25And the reason is because we have a situation where structurally we're having political changes globally. We're having deglobalization. We're having global conflict. We're getting higher interest rates. Right. We're getting commodity scarcity. All of these are a function of a bigger macro picture, which we've talked about on this show and other shows at length that are driven by structural effects, generational divides, inequality and a lot of other big picture things. Those structurally higher interest rates, those that structural inflation and those the protectionism and populism that's driving it ultimately create a much higher potential energy environment.

39:08when things break here, the odds, the probability of them breaking big are much higher. Yeah. And I think that's the thing that people aren't appreciating that the realities and the fundamentals, they matter. They always matter. They may not matter the six months. They may not matter this year. They may not matter for two years, but in the long run, they always matter. We knew, for example, that the housing crisis was coming. Everybody knew that we were talking about in 05 and 06. It just took way longer than people expected. And then it eventually loaded, right? We knew that NASDAQ was overvalued and that the spec was a bubble.

39:46Everybody knew that. We're talking about it in 98. And then it doubled. It didn't change the fundamentals and the realities of underneath the market. We know the risks here and the problems underlying. Most people do. We talk about this all the time. That doesn't mean in the next six months or the next nine months that it's going to implode. But when it does, the risks are significant. We are in a sumo market. There's a ton of potential energy, right? And that's reiterating, by the way, this dispersion. The dispersion, we talked about it from a structural perspective, right? What's driving this dispersion.

40:17But part of what's driving it is also these underlying volatile dynamics that are really pushing idiosyncratic risk across the market in different directions. It's just being held together by all of these flows. And so, again, fat tail always, as we talked about at the beginning, as volatility goes so far one way, eventually it undoes itself. But this time when it undoes itself, all the structural volatility, all the structural flows, I mean, of lower interest rates, of all the growth that's coming from globalization and technological development, and all the things that we were seeing before are no longer there now to underpin things.

40:57And I think we could have a much bigger structural issue. The Federal Reserve, not to shift to macro all of a sudden, but the Federal Reserve is in a bit of a box. And that wasn't the case five years ago, 10 years ago. And I think that, which is the ultimate source of the biggest flows in a tale of that, right, is a recipe for a much bigger structural problem. You know, Jim, here's the fascinating thing. I'm not a deep thinker about markets, right? But I can read the headlines. I can see what's happening in elections in Europe. We could talk about structural causes of inflation. We could talk about all of the geopolitical risks.

41:36We could talk about the risks to commodities on a supply side shock. We talk about the risks of a potential demand decrease when you have increased AI, increased technological innovation that drives out folks in the labor markets. Here's the really fascinating thing about everything we've just discussed. If I were to pull up a chart of the S &P 500 from, say, Halloween of last year and say, show me where you see those risks being priced in to asset market prices, it's just not on the chart. It's not there. And that's the whole point, right? At the end of the day, all that matters in the short term is the voting machine.

42:18It's supply and demand. And if there's structural effects that can put people to sleep, that'll just kind of create the machine going on about its own path, right, for some time, it will. We confuse the short term for the bigger picture. To be clear, the NASDAQ was overvalued in 97, in 98. We knew that. And then it doubled. And then it dropped 90%, right? and this is how the machine works. The natural state of things is for things to march higher, for volatility to become more and more compressed, for things to go to this final terminus where things are ultimately, again, that consumer market is so pressured that eventually the smallest thing, right, butterfly flaps its wings somewhere, it drives that final straw and that final piece of sand to move, and then things start to change.

43:17And then the cycle goes the other way, much like I was expressing. Vol supply begets vol compression, begets vol support, buying support, which begets more vol supply, which is a full circle. But the exact opposite also holds true, which is once these things start moving the other way and volatility becomes unpinned, now the stress begets more stress. And so just because we're seeing an upward march in the context of all of these scary things does not mean that the scary things aren't valid. It doesn't, though, mean that those scary things are going to become a problem today, tomorrow. And this is why the flows.

44:00We're talking about big picture distribution. Fundamentals, and this is well documented, have zero correlation to market outcomes in any period less than 10 years. This is why Schiller did his 10-year PE, because it matters over 10 years historically. It may not in 10 years, but historically, there's a correlation. But over one year, two year, even five year periods, fundamentals have little to no correlation to the outcomes. Eventually, they matter. Fundamentals matter. But the path to getting to those fundamentals can be completely, much like it was in 99, completely unrelated in the short term to the long-term outcome.

44:47And the short-term markets are a voting machine. They're a supply-demand machine. You must understand those flows if you're betting on monthly, quarterly, annual outcomes. They're all that really matter over that period. But if you're really betting for the long term, the next 10, 20 years, yes. Getting the big picture right is critical. It's everything. You just might go on a really wild journey on your way to that final outcome. And that's what the weighing machine is, right? This is what Graham calls the weighing machine. At the end of the day, the weighing machine wins up. Usually, that rebalancing happens in the lack of liquidity.

45:25Everything comes back in line when there's no longer liquidity. And that's what I suspect will happen here. Into a decline, things will become more logical. By the way, for those not familiar with the quote, this is the great Benjamin Graham quote. In the short run, markets are voting machines. In the long run, they're weighing machines. In the short run, they're popularity contests. But in the long run, they are ultimately about fundamentals. And the fundamentals ultimately do have an impact. And understanding that and balancing that really is the art and the science. By the way, which brings us to this great question from Andrew, who wants to know, So what do you think, what do you see the S &P 500 and NASDAQ doing for the next 30 to 60 days, next month or two?

46:10So we said about two and a half months ago now, sorry, about two months ago in late April, early May, to expect what we call the summer of George. This is a Seinfeld reference. We've called for this before and been spot on. What is it? When vol supply is where it is at this point, markets have a very, very hard time moving down. There is skew in the market, which ultimately forces a buyback of stock by dealers, market makers, banks, et cetera, every day. And it accelerates into expirations. And then when months are up and the market's up, then there's a buyback and a momentum re-leveraging effect that happens at the end of the month that then forces more buy.

46:56As we enter, throughout the summer when volatility is low and less is going on and people are in the Hamptons, at the beach, wherever they are, there's just less liquidity to overwhelm this vol supply and these structural effects as well. So it was pretty clear to me coming in several months ago that we would see this. What have we seen in two months? We have not seen a decline in the market of greater than 0.5 % for the whole two months. right? And corollary to that is dispersion. What have we seen? Historic dispersion, right? Much like we talked about, those two things are bedfellows. If index fall is well compressed and the market continues to grind higher, dispersion is going to go to a record.

47:39So this is specifically what we call it for two months ago. And I said two months ago that expect for it to last for three months. So we have until I put the marker on the board, people have circled it. People think I'm crazy when I name out specific dates, but August 14th, right? 13th, 14th, somewhere in that week, which is the week of August expiration, would be the time to start expecting volatility to have a higher probability of starting to come out of that extreme vol compression. So don't step in front of a buzzsaw before then, right? That said, prepare for what is likely to come September, October, November.

48:23Now, my belief is that this is an if-then statement, right? Assuming that we continue to march down this path again for another month and a half, a month and a week now, what lays on the other side? Well, I'm not looking for a crash. I'm looking for an increase in volatility. In my view, that'll likely happen into a rally. And the way that these things unpin themselves is generally into a rally. It's counterintuitive, but they're skew in the marketplace, which means downside options are priced on a higher implied volatility than upside options. So naturally, if we continue to ground higher, options will get cheaper and cheaper on their own accord, not to mention all the vol selling as getting them to a point, which is even cheaper.

49:07At some point, that vol just gets too low. And the acceleration generally in those things becomes on the upside. The realized volatility on the upside gets to be just too big relative to the impact. Which means it becomes profitable for entities to come in and start buying vol at these lower levels. Add to that the vol supply is likely to dissipate a bit as we get into September, October, November. Why? We have an election sitting there in early, right? There's already a lot of hedging that's happened out there, which has made dealers shorter out there. They're hedging it with shorter dated options.

49:41They're able to manage it and be still long gamma. As we approach that level, that vol supply kind of dissipates because the positioning out there is already. Not to mention you have all the realized potential risks and all that volume comes back in September. People come back from the beach and all of a sudden, some of this vol supply just looks too cheap. And that can take dealers out of that vol supply. That can take market makers and banks out of that vol supply and start to create a reinforcing loop. Now, just because that's likely to happen, in my view, it doesn't mean I'm looking for a crash in it.

50:16I do think increases in volatility will likely increase the volatility of the market, which means we're likely at that point to get declines of greater than half a percent. We're likely to start getting some real volatility again. In my view, we'll get some type of pullback in that window. I would say sometime between mid-August, that date I gave you, and sometime mid to late, I'd say late September probably. we'll probably get in that window something. And there's a reason that volatility happens in those windows. The seasonality is not a magical construct. It's tied to these flows that I'm talking about.

50:56So if we do, again, I think it's a viable dip into the end of the year. Now, there's no insurance there. If it goes big enough, it will become a self-reinforcing loop. But the highest probability is that we get some type of wobble there. That's not too big. Call it 5%, 10%, maybe 10%. But on the implied vols that we're on, and with vol increasing, that'll feel big. I mean, at these levels, that's a 500, 600 point, 500 point decline in the S &P.

51:30When that happens, I think implied volatility will stay elevated after that and start to go higher from these. When I say elevated relative to these levels, it will normalize. and that vol supply which took people out will change the characteristic and the distribution of the final leg of the rally in my view, which will be into the end. I think we'll get a continued rally after a pullback in the early fall. And I do think that rally that we see at the end of the year will be pretty dramatic from some lower level. Think a 500-point decline sometime in the late summer, early fall, followed by 1 ,000 returns.

52:08to 1500 point rally. I could see us going from, you know, 5 ,800 or so, 5 ,750, somewhere in this area, you know, that we get to, you know, 100 points higher or 150 points higher from here, then declining down to 5 ,100 again. And then seeing 5 ,100 give up to 6 ,000 by the end of the year. Something like that with volatility increasing into the rally, un-pitting a bit, and accelerating at the end. That ultimately, I think, could be a really dangerous place early next year. That's our current view. Again, a lot of if-then statements. We've gotten them right one, two, three, four, five in a row.

52:48The first one is important in order for the second one to happen, which is that we continue to see, and it's the highest conviction one I have now, that this rally and this ball compression will continue in the short term for another month or so. But again, given that will happen, if that happens, I would expect that being an opportunity to buy volatility broadly into a rally. So long-dated calls are a great position to have out in September, October, November, December on out. And yet funding them with short-dated options and allowing you to not pay for those options and the decay of them until that time comes.

53:28Yeah, it was just a fascinating conversation. I really enjoyed this. And you definitely have the courage of your convictions, picking dates, picking levels. Really appreciate you going that granular for us. It's just fascinating. And I hope I haven't gotten too carried away with the bear case here. You know, I have genius for pointing out the obvious. Just looking at the current near 18 % return on the S &P, outstripping the roughly call it 10 % or thereabouts over the last 65 years. Clearly, obviously, here only about halfway through the year. You look at that, you see some of the things that we've talked about, some of the structural risks, geopolitical, political risks, specifically here in the United States and in Europe, some of the rising structural challenges just not being priced into markets.

54:09Fascinating, fascinating take, Jem, on the behind-the-scenes mechanics, how markets really work. Final thoughts, key takeaways, Jem, that you'd like to leave our viewers and our listeners with. The last bit that I didn't mention is your average election a year during populist periods, which I classify this as, is about 22%. So your bogey is about another 4 % or 5 % from here. We believe that we will hit that and it'll be close to in line somewhere in that general area by the end of the year. The other reason, other than just historical precedent, is that up markets see big positive flows into the end of the year.

54:49We're looking at about$100 trillion of global equities in the world, when that market is up 25%, that means$25 trillion of new collateral, new cash value. That wealth effect, as people call it, is very real. That allows for more capital, more investment. And those reinvestment periods for that leverage happen not every day. Some of it happens every day, but monthly, quarterly, and biggest of all, annually. So as you get into the end of the year, and if the market is up big, it is highly probable that people start trying to front run those lows that are coming in. If only 10 % of$25 trillion, right, gets reinvested on January 1st, that's$2.5 trillion.

55:41That is a dramatic amount of flows that comes in at the end of the year. So again, we have a wobble likely coming here. If it doesn't undo things big enough, the bet will be back on into the end of the year. And if the volatility is unpinned, that lack of vol supply into that window will increase the volatility of the coming final rally. So you really need to be thinking about these in this context. All the flows matter, but the vol supply and what the people warehousing the risk of the market are wearing are most important. Jim Carson, such a pleasure doing this with you. I hope you'll come back and do this again with us soon.

56:16My pleasure. Would love to. Look forward to it. Thanks for joining us. Thanks for watching. Thanks for listening. Have a great afternoon, everybody.

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