25 Sayings on Vol and Risk…Part 2 of 5

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. Well, like Slim Shady, I'm back.

[00:00:22] Hopefully you had an opportunity to catch the most recent pod we dropped with Matt King, the founder of Satori Insights. A couple of brief comments. First I have to say that I'm excited to see the increasing intersection of high finance and entrepreneurship.

[00:00:36] Matt had a distinguished two-decade run at Citi before founding Satori. It's inspiring to see high caliber professionals hang a shingle, as they say, and look to deliver their thought process directly to clients. It's risky and mistakes will surely be made.

[00:00:52] But what could be cooler than founding a business based on your own IP? Second, I really enjoyed learning more about the framework he uses to understand the motion in market prices, with a heavy emphasis on the role of central banks and

[00:01:04] the liquidity dynamics their presence and programs and markets create. I've said before that ascribing cause and effect with respect to price moves is a Wall Street and financial media sport. The path to understanding the why can be complicated and I certainly think Matt

[00:01:19] has some interesting ideas on this front. So as they do for passengers who have boarded a flight, let's make sure you are in the right place. We've reached part two of our five-part series, 25 Sayings on Volunt Risk.

[00:01:33] Over the first half hour episode, we kicked off the first five. Over the next 30 minutes, we shall explore Sayings six through 10. But first, because by now you know I love anniversaries, we're going to talk a little bit about 1984.

[00:01:47] No, not the book, though that seems kind of relevant these days as well. We're going to go back 40 years and highlight some of what occurred in the year 1984. Mean you say. I wasn't even born yet. All right, well hang in there anyway. This won't take too long.

[00:02:04] Let's start with three songs celebrating the Ruby anniversary. We've got to start with Twisted Sisters. We're not going to take it. Man, this feels like the voting public saying no moss to a Biden-Trump rematch, doesn't it? D. Snyder, hailing from Baldwin Long Island by the way.

[00:02:21] It turns out in 2012, Republican Vice Presidential nominee Paul Ryan's campaign used the song in Mitt Romney's presidential campaign until Snyder asked Romney not to play it anymore. Snyder said that he didn't support Ryan and that he planned on voting for Obama.

[00:02:38] Two more personal favorites from 1984, Bon Jovi's Run Away and the epic O Sherry from Steve Perry. What a great voice. I'd add Van Halen's Jump, a top single from the band's album 1984, but it turns out the song was released in December 83.

[00:02:56] 1984 was full of developments both good and bad. The first Mac was made. By the way, the split-adjusted price of Apple stock was $0.09 in 1984, headed to a nickel a year later. A decade after that it was at $0.14. Sometimes it takes a long, long time to get things right.

[00:03:15] Today, $186 a share and a near $3 trillion market cap. Hello. Also in 84, Ronald Reagan won an astounding 525 electoral votes to Walter Mondale's 13, taking 49 states. Can that ever happen again? Carl Lewis dominated the Summer Olympics in LA, winning four gold medals.

[00:03:36] Indira Gandhi, the third and only female prime minister of India was assassinated. What else can we say about 84? The S&P was basically unchanged on the year, rising a whopping 1.4%. CPI was 4.3% and the Fed policy rate was, wait for it, 10.75%. Real interest rates anyone?

[00:03:58] Paul Volcker was the Fed share. I've been fortunate enough to interview both Greenspan and Bernanke. I was set to interview Volcker as well in 2018, but his health was on the decline and we were unable to do it. He would pass away a year later at 92.

[00:04:14] I really enjoyed his book, Keeping At It. It's so interesting to learn about the inflation fight he took on in 1979 and his book takes us inside his thought process. On a rare Saturday press conference on October 6th of 1979, Volcker announced the change

[00:04:30] in policy in which the level of bank reserves would be targeted. Three-month T-bill yields rose by 300 basis points in a matter of two weeks. They reached 16% in March of 1980. They were at 6%, three months later and by the end of 1980 stood at 17%.

[00:04:48] Imagine backfilling the move index to include this period, nuts. Also in 1984, the Terminator told us, I'll be back. And the Chicago Bulls drafted a 6-6 guard from North Carolina, Michael Jordan. Okay, with that brief review complete, the task at hand is to make headway on our 25

[00:05:09] sayings on vol and risk. My goal, share some of what I've written down on the back of napkins over the years to help me tie together what I've observed and experienced in markets. Through these aphorisms, as one might call them, I'm hoping to give you some stuff to

[00:05:24] chew on and expand your thinking on matters of risk. So in the spirit of once but no longer prominent CNN anchor Chris Cuomo, let's get after it, shall we? By the way, who thought it was a good idea for him to interview his brother, the

[00:05:39] governor of New York, on live TV during the peak of COVID? I digress. Our first saying is that, quote, the next crisis to occur is the one that happened longest ago. I'm not sure what made me think of this or if it's even true.

[00:05:55] I certainly can't prove it so. However, I believe the statement speaks to some of the fragilities in markets that originate as Kamala Harris is always reminding us from the passage of time. With respect to risk, times passage dulls our capacity to appreciate historical events.

[00:06:14] Acute as it materialized, a market crisis event looks blurry in the rearview mirror. Back to Volker, who among us, especially in the long period of low-flation post the GFC could even conceptualize year over year CPI well north of 10 percent?

[00:06:30] Staring at Bernanke's post-GFC Zerp regime, if I told you the fund's target was 20 percent in 1980, could you really relate to what that implied for the cost of credit for businesses and individuals at that time? Given this astounding level of rates, Vig is a word that comes to mind.

[00:06:49] Acknowledging that a broken clock is indeed right twice daily, I'll give myself some credit for arguing in 2019 that inflation, being the crisis that was arguably the one that happened longest ago, was going to be the next one.

[00:07:03] Of course, we got to a peak CPI in June of 2022 for some complicated reasons. But my view was based on the observation that investors are prone to recency bias. We humans believe what we see. Just ask the folks succumbing to the magic of Michael Carbonara.

[00:07:19] For those of you not familiar with the Carbonara effect, it's a true TV show that makes for great family TV watching. It's David Copperfield meets Candid Camera. Check it out. In markets, we really do believe what we see. We take in prices all day long.

[00:07:36] As Mark Hanna said in Wolf of Wall Street, quote, you're dealing with numbers all day long, decimal points, high frequency, very acidic above the shoulders mustard shit. Man, I'm not sure McConaughey came up with that, but it's gold. These numbers, gyrating, spiking, plummeting, reordering themselves, they are both

[00:07:55] a response to what we think and responsible for what we think. Let's corroborate our theories, underpin our narratives. In 2006, would monetary policymakers and the fine folks at the IMF have so self-assuredly declared they had tamed the ups and downs of the business cycle without the endorsement

[00:08:13] of extremely low vol and credit spreads? I think not. In markets, because we overindulge in the study of price, we become especially vulnerable to sameness. When inflation tracks between 1.2 and 1.8% for a decade, as CorePCE did 70% of the time from

[00:08:32] 2009 to 2019, the market clearing price on the inflation straddle is going to be pretty low. How to imagine something much different with a decade of reinforcement? I recall doing some work on inflation hedging for a client back in 2016, a year when the

[00:08:49] German tenure went to a negative nominal yield. Not only were US inflation metrics low, they also exhibited low volatility. We looked at inflation swaps and inflation caps. Even as you could have the latter for a song, it felt like you'd be torching premium.

[00:09:05] And with the benefit of hindsight, you mostly would have. We stare at this data, studying it, reacting to it, and making decisions based on it. The lender incorporates low inflation and low inflation vol into his or her models.

[00:09:18] The Fed, loud and proud, thinks the QE is a linchpin holding the system together. Don't stop buying bonds. Inflations too low, they exclaimed, sipping chai lattes and looking for moose sightings at Jackson Hole.

[00:09:31] When the data is on rinse and repeat and the cycle is enduring for long enough, we are just prone to forget, plain and simple. Our ability to fully appreciate changes in risk regimes is compromised by a lack of recent experience in the data.

[00:09:46] We put we suffer from a lack of imagination. Instead, by default, we are left believing that tomorrow will unfold much like today has. And it mostly does. But we've got to force ourselves to entertain wayward scenarios. As they say in French, c'est la vie.

[00:10:03] As we say in English, shit happens. So you must be asking what's the next crisis to occur that happened longest ago? We had several bank collapses last year and just recently NYCB is teetering. But these aren't systemic as they were in 2008. An oil price shock?

[00:10:20] The price of crude and its option implied vol surged in March of 2022 when Russia invaded Ukraine. In a November 2023 report, Fitch argued that an oil price shock would impinge on global growth while adding to inflation.

[00:10:34] They model a scenario in which oil averages $120 per barrel in 2024, lower in today's prices relative to the 7980 shock, and calculate a negative impact of around 50 basis points on US GDP. You get a negative demand shock but also a positive shock to inflation. Does the Fed look through it?

[00:10:54] Does the bond market assume the Fed will do so? As Alec Baldwin said in his 2009 movie with Meryl Streep, it's complicated. That of course was before things really did get complicated for Alec Baldwin. Where else to look for the next crisis?

[00:11:09] Perhaps the risk is hiding in plain sight. It's covered breathlessly on CNN and Fox and Twitter. As we argue about how much money to give Ukraine, is there not already a war on our own soil? The US political system is on shaky ground to say the least.

[00:11:25] And in an era of vast polarization and with technology playing a role in weaponized campaigns of disinformation, it's hard to be optimistic on where this is all headed. Take a peek at the VIX curve which I posted on Twitter recently illustrating the

[00:11:38] election hump already obvious in October VIX features. It was 50 years ago that Nixon resigned. There are some other fraught episodes in US political history. It took a Supreme Court decision on December 12, 2000 to settle the dispute in the Florida vote count paving the way for Bush to beat Gore.

[00:11:56] The stock market fell but one might argue the tech bubble was already in the process of bursting. 2020 of course marked a quote jump condition as markets people like to sound smart in saying, in voter skepticism that the process is legit.

[00:12:11] Once established skepticism is a very hard habit to break. This is especially true given the profitability of the grievance business model vastly aided and abetted by technology. Just ask Tucker Carlson and Rachel Maddow. With that unsettling monologue behind us let's move to saying number seven on

[00:12:28] vol and risk and that is that quote there are no bad securities only bad correlations. I really liked this one and I created it as a modern day version of the old Grammandod inspired there are no bad securities only bad prices.

[00:12:43] First, a little on the original quote which I think is really instructive. Even the sexiest most profitable stock becomes risky when the earnings expectations embedded in the price become unreachable. The opposite is also true.

[00:12:57] Sure the concept of a value trap should resonate that is some securities are cheap and cheap for good reason. But the entry point established matters a ton in the overall financial outcome. It's not the security that is bad it's the price.

[00:13:11] It was Jim Grant who talked about quote toxic mortgages and super safe treasuries in 2009 suggesting the descriptor of the two assets ought to be reversed. No doubt treasuries became a toxic asset in 2021 simply a function of the price.

[00:13:26] If you bought the triple Q in March of 2000 it took you 15 years to get even. If you bought the TLT in August of 2020 you've suffered a 40% drawdown. I'm not sure 15 years will be enough to get back to even who said bonds weren't risky.

[00:13:42] But let's consider my saying that there are no bad securities only bad correlations. It was Q3 of 2017 when I wrote a piece for Bloomberg under the same title. For me a troubling correlation in the post GFC but pre COVID era was

[00:13:56] the deeply negative one between stock and bond returns. Use the HS function on your terminal to get a peek at the correlation of daily returns between the S&P and TLT from 2009 to 2019. Click the upper right box called core. You'll see an average of around negative 42%.

[00:14:14] If I'm long stocks during this era duration exposure was highly effective in buffering the portfolio during risk off episodes. And over the same period the TLT managed with dividends to deliver a total return of nearly 58%, 4.2% annually.

[00:14:32] I found the positive carry hedge yelled the quant geek who'd been looking in all the wrong places structuring look back options doing heavy maths to price auto callables and writing way too much Python code in the process. Sadly however there is no such product.

[00:14:47] Again we look to Mark Hanna from the Wolf of Wall Street to teach us a thing or two about high finance. He says it's very dust. It doesn't exist. It's never landed. It is no matter. It's not on the elemental chart. It's not F in real.

[00:15:03] Just like there's a first rule of Fight Club, there's a first rule of insurance. And that is that insurance cost money. But if you've got this security that so consistently perhaps the 2013 Bernanke inspired taper tantrum an exception rallies in a risk off and manages to carry positively.

[00:15:21] How can you blame the institutional community for espousing the 6040 portfolio? Oh and alongside you is the Fed hoovering up securities robotically in size and with no attention whatsoever to value. For the Fed there are no bad prices. What's the modern day bad correlation?

[00:15:39] I'd argue it's implied correlation in the S&P. Hit up the VCA page on the terminal. Make sure your upper left box reads index and your term reads three months. Then click the tab implied correlation. 23% is pretty skinny stuff on the S&P front in the fourth percentile

[00:15:57] over the last 10 years. Now it's not to say that this clearing price is unjustified given the level of realized correlation amongst stocks in the S&P, which is even lower. Over the past year the average level of correlation amongst stocks in the S&P is just 20%.

[00:16:13] During market crisis periods such as 08, 2011 and 2020 stock correlation can reach 75% and higher. But even in generally benign markets, correlation is typically closer to 40 not 20. A 40 correlation input will boost implied vol on S&P options by around four to five points. Here's the concern.

[00:16:35] History tells us that periods of macro and global uncertainty propel both individual stock volatility and the correlation amongst stocks higher at the same time. One source of macro risk is the Fed. When its tightening cycle was at its most uncertain point. In 2022, three month realized correlation

[00:16:53] got to as high as 58%. During the COVID crash it got to 80%. For investors the result is that the salubrious impact of diversification. Yes I did say salubrious fades away. Like a fair weather friend diversification disappears when you need her most. So back to my main man Michael Carbonara

[00:17:13] and believing only what we see. This 20% realized correlation is muting the daily swings in stock portfolios. And because we size our exposures based on these swings using some version of value at risk to do so, all else equal we need more units on our sheet

[00:17:30] to get to a target vol. History tells us emphatically that vol and correlation are themselves correlated. Are we accounting for this? Or as I fear are we banking today's muted correlation and sizing risk accordingly? My portfolio is much more diversified than I expected.

[00:17:47] Said exactly no one amidst an episode of market turbulence. My own experiences that investors often underestimate the speed with which the co-movement of assets in their portfolio can jump from low to high. All right let's move on to saying number eight which is that quote equities are short

[00:18:04] the straddle on rates. For different reasons if interest rates either fall or rise very quickly the outcome is bad for risk assets. In the first a shock has compelled a flight to safety and a duration rally. In the second like the 2013 taper tantrum or the 2022 Fed tightening cycle

[00:18:22] the risk free asset is itself the sponsor of the event. Forcing equity markets to reconsider assumptions used to discount cash flows and sometimes creating a var shock in the process. If equities are short the straddle on rates and the value of that straddle is driven by rate vol

[00:18:38] then we should see a rather consistent negative correlation between the S&P and the move index. And by golly we do. Now of course this assertion isn't perfect because at some point rate vol can get pinned to the floor should the Fed react to a violent risk off

[00:18:54] by bringing the Fed funds rate to zero and promising to keep it there. But in general periods of fast transition in the interest rate market are an unwelcome development for the equity market crowd. Better for the Fed to establish a level

[00:19:07] and as Joe Pesci said about Billy Bats in Goodfellas to keep them here. Let's just highlight two sides of the straddle. In 2022 the S&P lost 19% as the 10 year yield rose by a remarkable 220 basis points. In 2008 by contrast the S&P lost 38%

[00:19:27] as the 10 year yield fell by 185 basis points. A good friend told me that perhaps it was easier to argue that equities were short the strangle not the straddle. Point taken there's noise in the middle where stock and bond changes aren't as connected

[00:19:41] but at extreme bond market moves equities suffer. I've been highlighting two kinds of risk off. The first one which I call the classic goes like this. There's a market shock where stocks and risk assets buckle as they absorb uncertainty. The bond market is the recipient of capital

[00:19:57] and rallies on this de-risking. Stock and bond prices are negatively correlated. In the second risk off which I call the taper this causality is reordered. Here the bond market sponsors the event and higher rates and rate vols send stocks lower. Stock and bond prices are positively correlated

[00:20:14] during the taper episode. There's a third risk off and it's the worst of the three. I call it the liquidation. Here stock sell off and the bond market initially rallies. However, the need to raise capital is so desperate the bond market loses its capacity

[00:20:30] to remain a flight to safety vehicle. Investors need actual cash not duration exposure. The most recent example is of course March of 2020. And that's a good segue to saying number nine which is quote in markets it's move fast and things break.

[00:20:47] I came up with a saying in the midst of the COVID crash. Like you sitting at home in March of 2020 watching volatility at unimaginable levels it felt like the terrifying moves were going to impose vast destruction on the financial system. Mark Zuckerberg, yes, the same gent

[00:21:03] who was dressed down on Capitol Hill recently and yes the same fella whose net worth rose by 20 billion in the same week. Originally stated quote move fast and break things to express a hard charging view on innovation in Silicon Valley. In finance the inherent fragility of markets

[00:21:21] reorders this catchphrase to move fast and things break. When markets are as chaotic as they were in March of 2020, the valid self imposes a great threat to the asset price system. Is it no wonder that the Fed statement on March 23rd of 2020 read as follows.

[00:21:38] The federal open market committee is taking further actions to support the flow of credit to households and businesses by addressing strains in the markets for treasury securities and agency mortgage back securities. The Federal Reserve will continue to purchase treasury securities and agency mortgage back securities

[00:21:56] in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions. Jay Powell's in the amounts needed of 2020 is Mario Draghi's whatever it takes of 2013. When I think about this idea that when markets move fast and things break

[00:22:17] I'm certainly channeling my strong view that the trades, the exposures, the counterparty linkages and all of the assumptions that underpin them matter a great deal. In fact we've seen many instances in which the trades themselves become the chief problem. A stampede for the exits among investors

[00:22:33] can complicate the crowd control efforts for monetary policy makers. I think modern day central banking gives us a lot to consider and very possibly criticized. On one hand these folks are simply too visible and too involved in markets. However, it's hard not to sympathize

[00:22:49] with the likes of Jay Powell during COVID playing whack-a-mole trying to keep the system together. I believe that allowing market prices to clear at honest levels ought to be the goal. March 2020 rescue QE is one thing but March 2015 QE is another. That said our system is complex, leveraged

[00:23:08] and comprised of highly interwoven counterparties. Those clearing prices if low enough or in the case of GME high enough can wreck havoc. All right we are now at saying number 10 and that is quote, green span was right sort of. What do I mean you ask?

[00:23:25] Well in 2005 the Fed share in testimony to the Senate Banking Committee said that quote history has not dealt kindly with the aftermath of protracted periods of low risk premium. He articulated this concern as the largest leverage bubble on record was inflating and working its way on the path

[00:23:43] to self-destruction that began in 2007. Greenspan saw it but also oversaw it. He was right sort of. In 2008 Greenspan said this in testimony to Congress, quote I made a mistake in presuming that the self interest of organizations specifically banks and others were such

[00:24:03] that they were best capable of protecting their own shareholders and their equity in firms. He went on to say quote, I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. I had been going for 40 years

[00:24:18] with considerable evidence that this was working exceptionally well. In his 2006 assertion that long periods of low vol generally and badly, Greenspan was channeling Minsky. I find the work of Hyman Minsky incredibly powerful, especially given that he's from an era well before long data to see vol,

[00:24:37] the CDO squared and the leveraged inverse floater. You know, the kind that orange counties Robert Citron imbibed in. Minsky told us that quote stability leads to instability. The more stable things become and the longer things are stable the more unstable they will be when the crisis hits.

[00:24:55] Damn, that's good. All right, our second of this five part series is now in the books with 10 sayings under our belt. I appreciate the feedback coming my way and hope I can keep these both informative and at least somewhat entertaining at the same time.

[00:25:10] Numbers 11 through 15 look like fun to me, especially when I can riff on a Mark Twain quote and apply it to markets. Wishing you a good week, good month and a good year. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend.

[00:25:26] And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com.

[00:25:44] Thanks again and catch you next time.