Has the Equity Market Rally Run Its Course? w/ Cem Karsan

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2:07Has the equity market rally run its course? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Jem Carstone, founder of Kai Volatility. Hey there. How are you? Hey, how are you? Good to be back. I'm doing well, thanks. So we're still waiting on the final deal on the debt ceiling, but But how are you thinking about the markets as we sort of work our way through this final stage? Oh, wow, that's a big question. There's a lot of moving parts here. I think first and foremost, we'd be remiss if we didn't start with kind of the biggest story, which is kind of breadth, right, and the lack thereof.

2:46NVIDIA is the tip of the spear on that. and all the AI kind of excitement, exuberance, right? The reality is I think very few people understand why breadth is important. It has a direct connection to volatility. Everybody thinks indexes are a constituent of its parts because that's what we've all been taught, right? And indexing itself takes the single, stocks adds them together, and it equals the index. But in today's day and age, the reality is that the index is just as powerful, if not more, than the parts, because that is where the majority of the directional trading takes place and the hedging takes place.

3:34And the index vol is very well supplied and very compressed. And when that's the case, but you have fundamental pressures on liquidity, as we're seeing as interest rates have gone to 5 % and we can get into the TGA kind of refilling and all the concerns there. But as that starts to happen, stocks that are not vol centers, that are not compressed, you know, take on the liquidity of the primary source, which is, you know, the Fed and all the other primary liquidity, fundamental liquidity sources. And if those start to decrease, right, if those stocks start to decrease and the index vols pinned, that means whatever is not pinned, which is the short vol center, has to go the other way to balance it.

4:23Just mathematically speaking, it has to happen. So the vol is very compressed. Indexes are pinned. We're at over one year lows kind of in realized vol, implied vol has followed suit. And guess what? Only 10 stocks represent 97 % of the increase in the market. And so as all the other stocks are declining, something has to counterbalance on that. And that is not surprisingly the shortfall center, which is all those calls being bought in NVIDIA. Eight days ago, we had record levels of call buying in those names. That speculation is forcing dealers shortfall in that complex. And this is a simple dispersion trade at its finest, right?

5:09And this is market microstructure at work. This is why breadth matters. It gives you when the index is not moving, but the majority of the stocks start going down, that tells you something about the reality, the fundamental realities of liquidity versus what might be happening just structurally under the hood. And when you start to see divergences, not just like that, but in other parts of the market, that's a clue that this is a flows-based phenomenon and not a fundamental phenomenon. When those divergences happen, that's generally a very, very good clue to what might be coming. So we'll start there.

5:41Jim, yeah. Do you think, and there's a lot in there, and I know a lot of people are listening to this and totally getting it. Some of our viewers may not who don't sort of look under the hood like you do. So we'll try to pull it apart a little bit. Do you think that the liquidity issues are kind of permanently driving now? Is this just sort of a moment in time or has this sort of functioning now become more about that and less about what you call the fundamentals, which I presume are the kinds of things that we used to look at when we look at stocks? It hasn't been about fundamentals for decades.

6:21Now, we can again, that's the narrative you hear on CNBC, right? And that's what 98 % of RIAs will tell their clients because the truth is too complicated for your average person to really look at or care about. It's not the narrative that most people have been told. I've given the analogy, I think on here even about the airplane, right? I'm not going to redo it, but the reality is that liquidity is what drives direction. Valuation is the elevation off the ground, And the reality is you can be way off the ground, but if the liquidity is still firing, the plane will still continue to rise in a steady, solid fashion for years.

7:02Stock markets, at the end of the day, factually, a matter of buyers and sellers, and it's a function of supply and demand. And liquidity goes straight to demand, right? And that is what matters. Supply and demand is what matters in the market. Fundamentals will matter at some point as a function. they will affect supply and demand. But how do they do that? Generally, as a function of cash flow, they are put on a business. And what do I mean by put on the business? If there is no liquidity, at some point when liquidity gets removed from the system, all that ultimately matters is can a stock itself provide the liquidity it needs to stay in business?

7:38And that's the context under which fundamentals matter to the extent fundamentals affect demand for stocks. But we go often not just years, but often a decade without, and we have gone at least that, more than that, since 2009 at least, where all that's mattered is, you know, not earnings, but liquidity. And when that's the case, stonks go up, you know, to use a Wall Street bets phrase, right? Like, that's the reality. It's all that matters is their demand. Now, that's starting to change, And when that happens, the engines go off. If they start sputtering and there's no more gasoline in the tank, then guess what?

8:23The elevation off the ground does matter, and particularly on a stock-by-stock basis. Now this is when kind of value growth rotations and all kinds of things start to happen because that put all of a sudden becomes a lot more important. That's a great, great way to put it, because I think that it's very different, as you say, when you listen to so many people who still talk about it in terms of those sort of earnings and their sales and their, you know, like the types of things that used to really count. That's a really good way to look at it. So when this is happening now, how does the whole that whole AI narrative fit in?

9:04Do you just think that's sort of like a red herring right now? Or does it matter at the margin the same way? Does that fit into that sort of fundamentals that matter, but they're not driving necessarily until you see things evaporate? Because everyone was like, AI is going to change our life. That's why NVIDIA is going to new highs. You know, look, much bigger than NVIDIA is the market and the S &P 500. And if the S &P 500 vol is pinned and structurally you have a buying and selling force that is keeping realized vol temporarily or for however long it may, 2017, it lasted a year, a year and a half at bay.

9:47And fundamentally, certain stocks are decaying based on the lack of liquidity for them and the fundamental pressures that they're facing. that means for one or two or three stocks, that's a massive amount of counter, you know, 490 or 500 stocks are going down or, you know, static. That means there has to be a pressure, right, on the other side. That pressure, think about how much that is. 10 stocks that are getting, are having to counterbalance 490. You know, so that is a tremendous amount of buy pressure and it is exacerbated by leverage, right in a short vol center this is what call squeezes kind of are about right this is a meme stock uh or you know on the other side we we saw it with the with the bank stocks recently but once gamma gets involved there's a tremendous amount of leverage uh short gamma itself can be incredibly powerful and when it has a tailwind in the force of structural flows to counterbalance what's happening in the other part of the market it can be incredibly powerful so my view is that uh yes The call buying, the speculation in those names is driving, is loosening the liquidity and increasing leverage into a system that already has massive flows and is trying to find a home to push certain assets in a certain direction.

11:10And that's like the weakest point, right? And so that's where we're seeing kind of this get going. And momentum begets momentum, begets more calls, begets more short gamma. And it's a self-affiliant prophecy. See, the thing is, this doesn't go on forever, as we've already seen in several other parts of the market, as these same things have already played out in the last several years. So, you know, be careful shorting it, but also understand that when it ends, it's going to end violently and, you know, it will be painful. Yeah, that's exactly as you described that. I'm thinking to myself and I think we're all thinking this can never end well.

11:47There's that much pressure. that much pressure so what's we're at 35 times 35 times revenue right um i mean listen anything can it can keep going up as long as liquidity is there and that's the point um but it is not uh you know if if we get to a point where the liquidity in the market is truly going out right the tide's going out um there is a point where the put matters and you know at those those valuations there is no put within 90 % of that valuation. So what are you looking at in terms of liquidity then, if that's the key? And for those of you who are on the platform, you're going to see a thread here because this is what Raoul's been talking about.

12:28I think we're going to tackle it on Friday. Michael Howell's been on it. This is what folks who are looking at the markets are really, really underscoring right now. So what are you looking at in terms of liquidity, Jim? um well i mean look the reality is uh we talked about breadth but just to give you some stats you know we're at uh only 29 you know outperforming stocks uh are down to only 29 percent of the market that's the lowest since 1999 that's a pretty big uh year to to keep in mind right People talk about how crazy valuations were there on a discount rate relative to interest rates were more expensive than the recent peak by significant margin.

13:16And that's all kind of fundamental. But from a liquidity perspective, we've also increased interest rates from zero to five. And the lag of that is about 18 months. And guess where we are? Right. About 18 months. And I think that's, you can reference a lot of different people in terms of how those lags work. And I think we've referenced this before here, but it's really, it's, you know, there's a$450 trillion global asset market. And, you know, about$380 trillion, sorry, of that$450 trillion is in lagging assets, real estate, private equity, venture capital, right? A lot of loans that really take a while to catch up.

14:02And even the equity market itself is lagging in terms of supply and demand because of buybacks, which themselves operate on at least a one-year, if not more. We had almost record buybacks in the first quarter. That's after an increase of 5 % in the year prior. That's not because interest rates haven't hit the market or aren't important. It's just because there's a lag in terms of the approval of buybacks and how they enter the market. So that's happening. And right as – right where the shorter-acting liquidity pieces, which is kind of the Fed's balance sheet, the QE, QT part, has really not worked through the pipeline.

14:40And again, you can look at a lot of different liquidity models. People have been like, where's the QT? We've been talking about QT for a year and a half. What happened? And that's been counterbalanced by factors like the draining of the Treasury General account. It's a really big one. By most estimations, we're going to, by the end of the year, once the debt ceiling gets passed, we're going to have to issue$1.4 trillion in debt before the end of the year. That is a massive sucking sound out of asset markets. Right. That money's got to go. There's got to be buyers of that debt, which means that money's got to come from somewhere.

15:21And if that means interest rates go higher. Right. As that demand, you know, that supply comes on the market and demand has to be met. That means equity markets or somewhere else, some of the risk asset has to, you know, has to reduce liquidity. So and that's a real time effect, to be clear, that supply demand straight into the veins of the market, as opposed to interest rates, which is through the economy. much slower acting. And so you're going to get this very quick acting kind of reduction in liquidity, right as kind of the lag on kind of the other things is coming down the pipe at the same time.

15:55And so that's a pretty kind of bitches brew of kind of liquidity issues all at once. I would pair with that liquidity issue, the fact that the last year and a half, there's been a lot of short speculation, a lot of vol buying. And that led to a reduced reduction in volatility, reduction in downside, and realize vol, as we've talked about in the last year and a half. But a lot of that has also dramatically changed because it didn't work. And a year and a half is a long time to be investing in vol on the long side and eating decay. And on the other side, it's a wonderful time, right, to be speculating short.

16:41And a lot of people have been, you know, I'm getting calls all the time now like, hey, I bid 30%, 40 % for the last year and a half just shorting these kind of puts. Why wouldn't I just keep doing that? So it's back. This is a cycle we go through. I could go through the history since 2015 of the sine curve of vol supply and people crowd into shorting it, crowd into being long it. And it's dealer positioning at its core and how these things move when things are working. You know, greed is unavoidable. It's a feature of the system, not a bug. And so is fear, right? And, you know, I think we go from vacillate from one to another structurally because we have to as money managers, as entities trying to seek up highest returns.

17:37And so where are we on that curve? And I'll quite frankly say that we reduced 30-day vol hedging by 40%, 50 % as we moved to zero DTE. Nobody's talking about how much real Vega hedging has reduced. Everybody's talking about the increase in zero DTE. Why? Because realized vol was working and implied wasn't, right? But then what happened? All the buyers of originally buyers of zero DT have now turned sellers of zero DT because guess what? That wasn't working either because everybody crowded in there, which compressed realized vol. So now you have a broad phenomenon where it's broadly sellers across the board.

18:16That's making dealers long, right, which is forcing this kind of pinning. But what it is more and more creating is an unbalanced system where institutions are not hedged. Yes, dealers are hedging, but as soon as you break out of the general range, you can get to a really unbalanced position in the market. So we're in a fundamental liquidity situation, which is dramatically deteriorating, while at the same time, the actual flows are pinning the market in the short term, but are structurally more and more unstable and more and more unhedged. So kind of, again, a particularly dangerous point in markets.

18:55It certainly sounds like that. I mean, it sounds like you're really kind of setting up for the perfect conditions for a major event. Yeah. I mean, the reality is the more people know about this, I'm not the only one talking about these circumstances, right? The harder it is for it to transpire, but that doesn't mean it won't transpire. It just will transpire broadly. And this is what always happens as a function of time and price that makes it very difficult to shorten. And that's broadly what we're looking for. It's kind of what a topping process kind of looks like. Generally, you get a short squeeze, some overextension that is fairly violent or that unpins vol, or just a simple function of enough time where more and more vol speculation, more and more tail kind of unhedging kind of happens where eventually you get a kind of 2018 type kind of forcing of over leverage in a system.

20:02And what the trajectory on is some function of time and price. We're looking for the stretching of a rubber band, ideally. The more we get that, the more the opportunity is there. We would have liked to have seen a bit more squeezing of those shorts into this period. What's happening in Avidia is definitely welcome. That's definitely creating an imbalance and getting more and more people off sides and corners of the market. But generally, this topping process necessitates a kind of some type of path that will squeeze shorts, make it harder for long ball entities to be long. But the fundamental flows and the underlying flows are definitely heading quickly in that direction.

20:53And so it's just a matter of, in our opinion, when and how. It's going to take conviction. It always does. If it was easy, you know, you know, it would it would be everybody would be shorting this all the time. But whether it's 2007, you know, 2000 or even more recently, Feb, March 2020, it generally is very counterintuitive before it's intuitive. And that is a function of squeezing shorts and changing narrative and really shaking weak hands. I think that's what's necessary here in this final stage. Final stage. So I want to throw something else out as you describe this. I mentioned that Raoul has been really focused on liquidity.

21:38So Raoul sat down with Jeff Snyder. I'm going to play another. It was an important conversation. We played a clip yesterday about inflation. I'm going to play another one for everyone today talking about the sort of mismatch that they think that there is in the market. The market's telling them at least that something's not right. Let's have a listen to it. Now, Eurodollar markets are pricing in what, a cut by July, isn't it? Well, there's always probabilities. And I think the market right now is saying that we don't know about July. We don't know about June. June's kind of up in the air. July, you go back a couple of weeks, the market was saying that there was a maybe 50-50 chance of a rate cut by July.

22:25That's kind of gone away now because of ebbs and flows. What the market is saying is that September. By the time we get to September, rates are going to be lower, the short end as well as the long end. So that's really something happens this summer when we get to September, which only makes sense because you look at every crisis period or near every crisis period, it's always September. The middle of September, like the middle of March, that's a seasonal point which we always go through these things. So if you're thinking ahead, there's probably a really good chance that something happens in September, if not beforehand.

23:00So that full interview is on our website. If you're not a member, scan the QR code and join our community. So, Jim, you know, it's interesting. We still have officials like even today, Cleveland Fed President Loretta Mester saying there's no compelling reason to pause U.S. rate hikes. And yet, as Jeff points out, they're looking at the global markets and the global markets are pricing in rate cuts. And so both sides can't be right. How are you thinking about this? Yeah. So a general risk off positioning has partially is partially what's responsible for the cap in rates, right? People have been flooding into the bond market.

23:43But the fundamental realities of inflation have not changed. And I think that's the important disconnect, right? You know, the labor market's the strongest it's been at 3.4%, right? You know, we're seeing historic on-shoring, deglobalization. or refilling reserves and the SPR, right, as OPEC's kind of underpinning oil prices. The dollar has been relatively weak. You know, long-term rates are down the back, which is also itself reflexively stimulative. Like all of these things, not to mention, you know, markets have been hanging in really well in terms of a wealth effect. All of these things are structurally, you know, inflationary.

24:28in the context of, you know, the Fed was much more activist and hawkish right three months ago, before all these things happened. The difference is we had a little bank run in between, and that's it. So structurally nothing has changed. And by all accounts, that's, you know, again, we can argue whether it's going to be over or not, and we're going to force those shorts, But that is a tail in the market that is not core to the central realities of inflation. So, yes, the market is completely out of step with the bond market. But I think that's more of a function of supply and demand, broad macro flows.

25:09And the Fed is going to, not just the Fed, the Treasury as well, as we talked about with the TGA, is going to force those rates higher. It's going to come to balance that. We've already seen it. I talked about this about a month ago, I think here, but also on a couple other platforms, how the market was dramatically underestimating the realities of June. Yeah, let's talk about that. At the time, it was a 0%. Guess what? Now it's more than 50%, right? And the reality is that is likely to continue to go that way. I think the Fed is going to have to continue to push against that. And, again, not just the Fed, but importantly, the Treasury on a short term much more kind of, again, right into the veins, as we talked about, you know, reality is likely to have to force those higher just in terms of issuance.

26:03Again, just to put some numbers out there,$1.4 trillion in issuance before the end of 2003. By some accounts, a trillion of that will have to happen by the end of August. I mean, how does, you know, this is in a world where the daily net liquidity, which sounds crazy, by the way, to some people, but the daily net liquidity that drives market direction is 50 to 75. This is for equity markets, 50 to 75 billion, right, per day. So a trillion dollars is a tremendous thing to work against. And again, that should have reflexive effects on the market in short order as soon as this – ironically, this debt ceiling is kind of a sell the news event in that regard.

26:50And so something we need to be very, very thoughtful of. I do think there is a disconnect now because liquidity matters in the short term. But as soon as this reverses, I would expect the bond market to kind of meet the equity market where it is and then the equity market itself to kind of reflexively respond to that liquidity as well. So you don't think the Fed's going to be cutting? You think that bet is wrong in the bond market? It is wrong, yes. The only way they will is if the equity market has a dramatic decline. And can we get that dramatic decline? Absolutely. So one of the two, you know, the two are going to converge.

27:26And my guess is that the bond market will force an increase in interest rates right as the equity market will also have to decline somewhat to kind of meet somewhere in the middle. And that bond market, those yields are going higher, not because people will listen to what you described before, where you have the lag effect hitting all those assets, you know, that 18-month lag effect. And then you've got this liquidity. And that sounds like it's bad news for the stock market, but bad news for the economy. So then you would think that would take the pressure off the Fed. But you're saying that bond yields are not necessarily going to be looking at that.

28:04They've got to attract buyers. It's an issuance issue. Correct. Everybody's still playing the last 40 years cyclical game, right? The whole game was very clear to the average watcher. It was the Fed was in control of a system. We had not had inflation for 40 years. It was a structurally deflationary environment. And anytime we got a cyclically deflation, all the Fed had to do was come in and cut rates and stimulate liquidity, and we would simply push back up. that's all fine and well, but why can't the Fed continue to do that? Well, they have a dual mandate, price stability and maximum employment.

28:44When we're in a deflationary environment, they can cyclically stimulate all day long and push against that deflationary pressure. But that has changed. And we can do another three hours on why that is. I've talked about that ad nauseum. But the reality is there's structurally inflationary pressures that we've seen, again, historically in other environments for the same reasons. At the end of the day, it's about balancing inequality and populism. But there's other generational factors which tie it to this moment. But the reality is that we are in a structurally deflationary environment until we decide as a people, not just as a government, but as a people to not make those things a priority, then those structural inflationary forces will continue.