The Risk of Being Bearish on Stocks with Cem Karsan

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1:24And now to the top analysis of today's markets.

1:41Is it stupid to be bearish stocks? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Jim Carzon, founder of Kai Volatility. Hi, how are you? Welcome back. Thanks. Great to be here. Always fun. So I need to credit, before I even start, that opening question to Brent Donnelly, who used it as the title of his daily piece today. For those of you who get Brent's work at Spectra, you'll recognize it. But it was such a good question. I thought to myself, I'm stealing it because it's kind of what everyone's asking, right, Gemma? I mean, we have a situation today where US equities close the day up again in rally mode.

2:18We have the Dow. Oh, wait, we turned around. Yeah, it kind of turned midday. So it was kind of a big reversal. See, I like to check in real time. OK, so it was in rally mode. And we'll talk about why that happened. But it was in rally mode. And we have been had this sort of relentless push higher, even though a lot of people have felt weird about it. So even better now that we've turned, is this just a momentary thing? Or are people trying to sort of say, wait a minute, this thing's gone too far? What do you make of the turnaround today that we saw? So you know when you have me on, it's a little different, right?

2:53I'm not going to give a point to a macro reason as much as a flow-based reality, right? The market is a voting machine in the short term. And the reality is that this market has run up based on structural flows up into OPEX and has really, much like it did last month and much like it did the month before, swooned, right, for a very short period before taking off again into the end of month. and then the first two weeks of the following month. That's been the trend. This is a flows centric push that we've been seeing for quite some time. We've called for this blow off top dynamic that happens a lot of time into what's otherwise a structurally bearish environment.

3:37This is markets purposely have to squeeze shorts before there can be reflexively before they can decline. So this has been a very, very strong move. It has changed the narrative as price always does. It has changed positioning. And most importantly, which I think we'll get into later in the show, vol has been incredibly well supplied, which has allowed entities to take risk and natural structural flows to kind of flow back in the market in those periods of structural strength. But here we are, a week period after the Fed came in, once again, being a little more hawkish. I've been trying to do that for a while.

4:18The market hasn't been listening. But this time, up against a much different positioning backdrop. So I think what we're seeing here is, again, a very important level here, 45-65 in the S &P futures makes sense to test these levels and see how things go in the next 24 hours. Okay. So that's super interesting. And that's why you would have seen as you got up to that point today, because it was pretty strong, you know, when we were looking, uh, which is why we're all in this situation. It's summer, right? And heaven forbid you go turn your head into something else. Um, and, and it can turn very quickly.

4:52So it sounds like what you're saying, and we will dig into some of the meat behind that because you, you do pay attention to things that aren't always on our right radar, which is why we love catching up with you. It sounds like if you've been hearing people say valuations are stretched, all this kind of stuff, it sounds like you're saying it really hasn't been a fundamentally based move this last stretch of the rally anyway, right? Is that what you're saying? Fundamentals, there are lots of studies on this. Fundamentals are not predictive statistically for market performance in any period less than 10 years.

5:27It matters over 10 years rolling periods. I know that throws a big bomb into a narrative of what everybody else in the world thinks is important. They are statistically irrelevant to market performance at any period longer than 10 years. They do matter over 10 years. They do matter eventually. But the way they matter, given the plane analogy, they matter when the liquidity, when the jets stop firing on the plane. It's the elevation. And it's a risk management tool. And eventually, during periods of illiquidity, think about 1998, 1999. We knew there was a tech bubble. NASDAQ doubled in the last nine months before it dropped 92%.

6:07Were fundamentals important when it doubled, when the NASDAQ doubled 100 %? No. But when the liquidity came out of the market, things got back to rationality. We know that now. But we watch everything day to day and week to week and month to month and try and assign a fundamental value to it. But NVIDIA rallying 200 % in a matter of months is that fundamentals. Yeah, there's a narrative behind why it's fundamentals. But no, it's a flow-centric reality in the short, meaning month, quarter, annual, even multi-year. But over the long run, the macro realities will catch up generally when the liquidity is no longer there.

6:45And all that matters is the put on businesses. Wow, that's so interesting. And this is one of these moments where you have to take a step back because a lot of people follow that narrative story, right? AI, it was gaming before, it's AI, and now we're, meta's up. Meta did hold up today. I just checked that. It's still up 4%. Their revenue is up 11%. And you turn on the TV today and you're hearing advertising, social media advertising is really strong. And you always hear the fundamentals. So explain to us what's happening from a position point of view. And maybe importantly, is that changing? So what's been going on that this flow-centric reality that took us to this point?

7:28And do you sense that maybe we're entering another phase now? Yeah, so positioning was dramatically underweight early this year, particularly in the NASDAQ. Put-to-call ratios were dramatically heavy to put. People were speculating. It's hard to imagine that, right? Because this is only back in February. Speculation was massively on the put side. We had seen a dramatic liquidation across the tech space. Commodity-centric and value names had really held up. And guess what? When everybody gets on one side of the boat, what happens? You've got a bunch of speculation and call buying, which calls were cheap relative in the AI complex.

8:12You had massive vol supply, which you continue to have. And we'll get back to that in the S &P 500 itself, pinning the market, allowing it for for the broad market decline to slow. Once that took hold, the reversal, and by the way, the Nvidia story that nobody talks about is back in last year, Nvidia was actually a big bearish thesis for a lot of people because of what was going on in Taiwan and China and the fears related to that. That narrative was all-encompassing at the time and put speculation was dramatic in the stock and the calls were in the price. What happened, it caught the complex really on the wrong side, and the squeezes started.

8:50But guess what? Now, it's the complete opposite. Now, there's massive call speculation of the tech names AI. Everybody is now on the other side of the boat. We called actually at the beginning of this month that that had gotten too far. Now, we had called in February that we should see a tech dramatic outperformance. Now, guess what? Going into expiration, when the vol compresses and these calls decay for dealers, you get massive stock selling from dealers. And that's what we got in the two weeks heading into expiration. Again, this is how these flows work. And now you're starting to see the rotation of the way.

9:26The narrative for everybody is, oh, the bank stocks are, they got oversold and they need to be bought up now. The narrative is that oil is stronger now and the commodity names should be doing better. And the NASDAQ has gone too far, but the reality is the positioning just got too far the other way. And there's structural dynamics when it happens, particularly in the vol space, that feed back into reflexively forcing back rotation. So that's kind of a, there's a lot more to it than that. But the thing that hasn't, so those are things that have changed. This is the world rotating around the center of the S &P in the market.

10:02And we've seen dramatic historic moves in rotation and lack of breadth. There's a lot of people who have talked about that. The seven names leading the whole rally for the longest period. The massive value growth rotation a year and a half, two years ago, back to this last six months, the other reversal, small cap versus large cap, all of that is rotating historically. We're seeing historic dispersion between the index and the constituents. That continues to be the case and will continue to be the case as long as the S &P vol, the vol at the center of the market, continues to be well supplied.

10:41And that is the one thing that has not changed for two years now. That eventually will run its course as well, but we are not there yet. And that is really a function of bigger structural flows. There's structured product issuance to dealers, massive selling of all that structural that's been coming on the market. Again, that's a function of higher interest rates, better yields to these structured products that are getting stacked above T-bill rates with higher of all, right? And look much more appealing now in a market where people aren't sure how markets are going to perform going forward. And that's caused a wave and massive increase in structural product issuance, which is selling vol to banks, which are selling vol to market makers, which are compressing the S &P 500 and causing a pinning of the S &P 500 relative to everything else and massive rotations around that.

11:32So this is just a glimpse, right? But these are the things that matter under the hood of what's actually driving. That's a world that you really have sight into. When you're talking about structured product for people who may not be familiar, you're talking about what, like asset-backed securities, that type of thing, mortgage-backed securities. Yeah. I mean, in particular, in the S &P 500, right, there are tons of structured products that will allow you to sell vol, whether it's this JP Morgan structured trade, which is not a structured note per se, but things like that where they're essentially selling vol to pay for locking in some type of downside protection or some type of upside limit.

12:09They can sell puts and calls, right, sometimes. OK, so these are structured sort of in the options world around equities as opposed to the sort of bond products. They're all kinds, right? But the ones that I'm most specifically talking about are the ones tied to the S &P 500 because we're talking about equity markets specifically. And so that has the function of dampening down volatility in the S &P 500? Correct. As a basic example, imagine you can sell a strangle, something 20 % out of the money on the downside, 20 % out of the money on the upside, and yield at 1x notional to your assets and yield maybe 3.5 % in doing that.

12:49There's other ways to do it. There are iron condors or other structures. We can get into all of them. But in the most basic sense, that gets stacked upon a risk-free real to 5.5 % now. That's a 9 % yield. If you can get a 9 % yield and then only start losing 1 % every 1 % below 20 % down the market or 20 % up in the market, that's a very appealing alternative for people who are less interested right now in having that equity beta exposure, particularly markets having run as they have, and the risk that we're seeing with higher interest rates and worse liquidity and all the fears that we have with geopolitical concerns.

13:26So two years ago, you would have yield 0 % or close to 1 % on the T-bill, and maybe this yields 4%. That's not very appealing, right? Particularly after a 14-year run of 15 % returns on average, why would you be out of the market? And so the risk-reward of these products, ironically, as interest rates go up, are causing vol supply at the center of the complex, which is the S &P 500. And that vol supply is a consistent force in the current window and forcing this cycle to go longer than you might expect. Hey, everyone, we're going to take a quick break right now to hear a word from our partners.

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15:15And when you say cycle, you mean the run-up of tech stocks or the rally of stocks in general? The stability of markets in general, which by definition, if markets are stable, there's a natural positive bias to markets, which I can get into the structural causes of that. There's these bond of charm flows I talk about. There's the natural just cost of money, the discount rate that forces arbitrage for markets to climb naturally. There's the earnings that come in from companies. There's inflationary focus. Because all of these drive some positive flow to markets, never mind vol targeting strategies and all the other quantitative strategies that force these flows.

15:52But a market that is pinned, think of 2017 as the proxy where implied vol is massively pinned, naturally has an upside bias because of the positive buyback of stock and everything that happens underneath the hood. That is very much kind of where we are and have been in this market. But now at the bottom, it was paired with very high short interest in the market, wrong-footed relative balance in the market of supply and demand. That is not where we are now in terms of the supply and demand and delta-1 kind of exposure. Vol markets are also broadly, in terms of delta-1 positioning, much more unbalanced than they were at the bottom.

16:33I should say more balance there, if anything, more aggressively long. Sentiment positioning have all dramatically changed really in the last three months in particular. And so all of that now is paving the way for potential more risk to the downside. But that vol compression is still in place. And that's the part that is going to make it continue to make it hard for this market to decline for some period. and will likely, as we've argued for some time, will likely continue to lead to a squeeze higher for a bit. But the structural macro effects, which we've talked about, which matter over the long run, are withdrawing liquidity from the market.

17:19The Delta-1 exposure is now much more balanced, if not a little bit longer than it should be relative to macro. And so the windows of weakness, these short periods where there's not as much structural positive flows coming from the small compression, we're going to see weakness like we have seen the last week or so. And this is exactly what we saw in June and May. And so these are periods to take advantage of, to look for potential greater weakness. Tomorrow is an important 24-hour period where on a Friday with low liquidity in the weekend, where there isn't strength yet. If a breakdown is going to happen, which I don't think is highly likely here, but it should really be here in the next 24 hours.

18:04If it can't happen here, you have to keep buying back into this because the vol compression is simply just going to force continued end of month, beginning of month strength, and then into the next expiration cycle here. So I want to ask about that, sort of the conditions that are going to change, because it sounds like some of the dominoes are falling off, but you've still got that core suppressing volatility, which is going to create upward pressure. A couple of different people pointing out or suggesting that the sell-off today was on the news that the BOJ is going to tweak its yield curve control.

18:35I would say we've heard that before. We have a BOJ meeting tomorrow. So how do you, when you're looking at these sort of market functions and operations and the signals you're looking at from the markets you track, how do you marry that to that sort of fundamental catalyst rumor that may or may not have been the trigger. It sounds like the market was ripe for anything to turn it. Yeah, I mean, I can't tell you the number of times, you know, the, you know, earnings have been, you know, negative, and you've had a positive move in the market where unemployment numbers have come out hot in market rallies, that CPI is, you know, seemingly bearish in the market rallies.

19:16You know, people point to the fundamentals when they go in the same direction. The reality is they matter, but really matter in the context of flow. So when flows open windows where there's structurally potential weakness, when the probabilities, when that tinderbox is packed with potential dynamite, that's when things can actually, these narratives can take hold. And reflexively, as the market declines, become a more important thing. The bank run was a problem in a window where there was weakness, right? And then there's strength. And all of a sudden, oh, there's no bank run anymore. It doesn't really matter, right?

19:48You can argue it was the Fed coming to the rescue, et cetera. But the reality is these markets are reflexive. And the more potential risk there is, yes, a spark like the Bank of Japan doing something along those lines can, in the right environment, cause a major sell-off. but the fundamental fragility that has been put in place by a lack of flows or a change in positioning is really the core necessity for a decline to actually take place. Yeah, I think it's really important, right? It might be one part of the story, but it's not the whole story. And if you really want to understand what's going on, you need to sort of look at it through that lens.

20:34I want to get a question in from Boris, because I think it's related to this before we unpack a little bit more of what you said. And he says, I'm curious about your opinion. Do you agree that low volatility is generally followed by low volatility with regards to the VIX? And therefore, the fear of a volatility shock that some people are talking about is probably wrong. Yeah, so this is a very important fact that people don't understand. Most people who look at volatility and they think it's mean reverting, right? And on a broader sense, it is. But if you look at the majority of the VIX or the implied vol at the money phenomenon, they're between 8%, 9 % and 20%, 25%.

21:21Within that range, which is the normal range of implied volatility, what we actually see is the opposite. that the lower vol, buying vol when it's low and selling it when it's high is actually not what works. The lower vol gets in this range historically, the more on even a risk-adjusted basis, not just in absolute terms, on a risk-adjusted basis historically, the more profitable about selling vol is. And the higher it goes into that range, the 20 to 25 range, the more positive outcomes that you see for implied volatility. That's counterintuitive. Why would you want to buy high and sell low. Why?

21:59Because reflexively, when vol is well supplied, when it is low and everybody has it, it actually itself pins the market. It actually reflexively causes less realized volatility outcomes. And when it's unpinned, when vol is at a higher level, markets are able to move more. And generally, there are more reasons to be concerned because that vol is higher for other reasons. And those tend to historically lead to more positive outcomes for vol, even relative to that price. So very counterintuitive, but this is reflexivity at work. This is what I'm trying to express to people. When the vol is very well supplied, dealers are long vol.

22:37When the market goes down, they have to buy massive amounts of stock. When the market goes up, they have to sell massive amounts of stock. Markets are stable, they're well pinned. And for the most part, it becomes a losing reality of owning implied vol because realize vol is pinned, which leads to more selling of vol, which leads to more pinning, which leads to more selling of vol. It's a hot potato until everybody is selling vol. Harking back to 2017, you get historic pinning of vol. It's all relative. It doesn't mean we're always going to go back down to this 9 % vol that we saw in 2017. But it becomes more and more compressed until somewhere in the market there becomes a concentrated short, whether it's long term capital management, whether it's XIV, whether a concentrated short, which gets at risk, and then something happens, and it's enough concentration in some area, there's too much risk taken in one area, and you get an XIV blowout, or you get a long term capital management implosion.

23:33Macro will be the spark, as I mentioned, but the groundwork has been set, that tinderbox has been packed under those environments, but it takes time. And the original portion of that. And it can take quite a number of months, a year or two for these things to kind of play out. And this is part of why markets can stay irrational longer than you can stay solvent, why the fundamentals really don't matter nearly as much as the flows and the realities of positioning. But this is how the market works in the real world. And this is what the voting machine looks like. The weighing machine comes after many years.

24:09We'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.

24:20So where are we in that process right now, do you think? So it sounds like short term, in the very short term, even though we saw this down like today, maybe we'll see more weakness tomorrow. There's a setup where that's possible. It sounds like there's not all the conditions are in place for a major turn. So how do you see this playing out if we extend the lens a little bit? The way I would, it's always a function of both, right? Let's go back to COVID, right? We knew about the COVID phenomenon late December, early January. Markets went up for almost two months, a month and a half till mid-February.

24:58A vol got compressed and then eventually started going up at the end. And then we got a 30 % decline in a month, right in a window where there was weakness, where the people were not as well hedged, that going into that March OPEX, there's been It started the day after February OPEX, ended the day after March OPEX, and that declined. Not a coincidence, right? This is positioning at work and how fundamentals still matter, right? But ultimately, in the context of positioning. This, you know, where are we right now? We are amidst the squeezing of the shorts. We are amidst a blow off top, a topping process.