Digital Gold and Actual Gold

[00:00:01] 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.

[00:00:19] Good listeners, welcome to 2025. And at the risk of offending Larry David and violating his strict three-day statute of limitations, I gotta wish you a happy new year.

[00:00:30] I'll be saying it for another week, and then I'll transition to wishing you an excellent 2025, so be prepared.

[00:00:38] Kindness and goodwill, I say, may be the only ARBs left in the world. That, of course, and Sailor's Bitcoin buying machine. Just kidding.

[00:00:47] As it's the beginning of a new year, we all ought to be thinking about whether our portfolios are set up to succeed in good times,

[00:00:54] and, less fun, but still very important to contemplate, consider whether we are overexposed to the downside.

[00:01:02] You're probably supposed to do this at the end of each year, but I was too lazy to get to it.

[00:01:06] I was too busy binging Landman. That Billy Bob sure can act. And Jerry Jones, who knew he could as well.

[00:01:14] Jon Hamm, always a favorite. It looks like Paramount Plus will live to survive another year somehow.

[00:01:20] This being a markets-oriented podcast, I do have a couple of things on my mind that I wanted to share in the realm of both risk and portfolio construction.

[00:01:30] As a fresh year is upon us, there are lots of interesting prices to take in already.

[00:01:35] A 10-year note yielding $475, a VIX at $20, a reawakening of FXVAL.

[00:01:42] Eight moves in the S&P north of 1% in just three weeks.

[00:01:45] NVIDIA even went down 6% in one day. I didn't know that was possible.

[00:01:51] I ripped through Landman, as I mentioned, and I've also been on a binge of succession again.

[00:01:58] And I got to bring in Logan Roy again. Let's get into it.

[00:02:03] The main subject at hand is diversification.

[00:02:07] What composition of assets yields a favorable return with bearable drawdowns?

[00:02:12] After two straight years of 25-plus percent returns on the S&P with just 13 vol, portfolio construction might be considered an open and shut case.

[00:02:22] I buy spy, said the robotic indexer, savoring the Sharpe ratio above 2 and noting that realized vol on down days was just 13% in 2024.

[00:02:34] Hard to argue with.

[00:02:36] Risk can be characterized in a number of ways.

[00:02:38] It's clearly related to volatility, but many in our profession draw a rather sharp distinction between the two.

[00:02:46] For me, the notion that risk is the scenario in which you are forced to make decisions you don't really want to has always resonated.

[00:02:54] That is, unwinding exposure to limit further damage because the potential losses from inaction are deemed too costly.

[00:03:02] And that ultimately comes down to some combination of improper sizing and portfolio construction.

[00:03:08] My portfolio is more diversified than I thought it was, said absolutely no one amidst a correlated risk-off event.

[00:03:17] There's a tangential theme here that comes to mind, and that is the notion of mark-to-market risk.

[00:03:23] There are few, if any, truly mark-to-market insensitive investors in the world.

[00:03:28] Perhaps it's a large pension fund.

[00:03:31] Maybe it's Warren Buffett, who sold an absolute truckload of S&P Vega before the global financial crisis and marked it wherever he wanted to over the exceptionally turbulent period that followed.

[00:03:43] Ten-year S&P vol is at 38 in the month after the 2010 flash crash.

[00:03:48] Warren's got it marked at 21, basically where he sold it.

[00:03:52] For the rest of us, mark-to-market risk is the definitive risk.

[00:03:56] And even entities with unique ability to ride out a storm are paying some attention to the value of their assets at a given point in time.

[00:04:04] Remember all the discussions around underfunded pensions circa 2020 as rates and stock prices plummeted.

[00:04:12] Equable estimates that the average funding got as low as 72% around that time.

[00:04:18] As I sat on the investment committee of the board of a charity, I can say that the unwelcome exposure to low rates and the burden they imposed on discounting future liabilities was a very active topic.

[00:04:30] Even long-term pools of capital respond to the prices they see.

[00:04:34] Rates are lower than they've been for 100 years.

[00:04:37] Who's to say they won't go lower still?

[00:04:40] Last year, inspired by some of the work of Cliff Asnes, I did a podcast called Vol Laundering and the Portrait of the Perfect Hedge.

[00:04:49] Here I explored the value of optionality in creating exposure that embraced rather than ran away from mark-to-market risk,

[00:04:56] turning vol laundering upside down in the process.

[00:05:00] Check it out if you've got 15 minutes to spare.

[00:05:02] Speaking of 15 minutes, in the time that follows, let me make the case for a few simple portfolio tweaks that I think are worthy of consideration.

[00:05:13] I like adding three assets with quirky distributions to a base exposure to the S&P 500.

[00:05:20] Specifically, while one might surely advocate for being over or underweight the implied sector allocations that result from owning the index,

[00:05:30] I'm not here to do that.

[00:05:31] History has shown that this is just very difficult to manufacture alpha in this way.

[00:05:37] I've said it before, the S&P is one beast of a benchmark.

[00:05:40] The folks at Standard & Poor's might contemplate charging $2.20.

[00:05:45] On the spider front, the folks at State Street charge 0 and 10.

[00:05:50] 10 bps, that is.

[00:05:52] Leave the index alone.

[00:05:54] It's massively over-allocated to tech, of course,

[00:05:57] and its valuation multiple speaks of expectations that the rampant profit growth of the MAG-7 will continue.

[00:06:04] It's also, however, experiencing a uniquely, and I will continue to strongly argue, unsustainably low run of realized correlation.

[00:06:14] You want details?

[00:06:16] As Ben Affleck said in Boiler Room,

[00:06:18] One-year realized correlation on the S&P is 12.

[00:06:22] Now is that right time to repeat something I've said many times to colleagues and clients,

[00:06:28] to my wife, kids, my dog Griffin, and anyone else who might listen.

[00:06:33] Quote,

[00:06:34] The very same set of uncertainties that cause stocks to become more volatile also cause them to become more correlated.

[00:06:42] It's not rocket science.

[00:06:44] Contemplate four sources of risk, economic, financial, monetary, and geopolitical.

[00:06:49] These are sufficiently macro in nature as to impose themselves on markets from the top down.

[00:06:55] So what we see in episodes of macro uncertainty, and it's unclear if this is a cause or an effect,

[00:07:02] or more likely some combination, is a material gravitation of investors to index products.

[00:07:08] The, quote, market becomes a single stock.

[00:07:11] When correlation is north of 75, as it was during the GFC, or the 2011 Eurozone crisis, or during COVID,

[00:07:21] there's no differentiation among stocks by style factor, sector, or geography.

[00:07:26] You don't need single-name equities when the S&P is realizing 45+.

[00:07:31] The old adage, don't put all your eggs in one basket, is certainly good advice.

[00:07:36] But even diversifying through a basket of stocks, timeless and sensible as it is,

[00:07:42] nearly always proves less a risk mitigator than we expect it will when markets ultimately confront a stress episode.

[00:07:49] In 2023, the S&P was up 26% on a 13 realized vol.

[00:07:55] In 2024, in a sequel on par with 22 Jump Street, the beastly benchmark was up 27% on a 12.4 realized vol.

[00:08:05] As I said, the thousands upon thousands of pages devoted by the street to 2025 outlooks notwithstanding,

[00:08:13] the portfolio construction case could reasonably be considered open and shut.

[00:08:17] If it ain't broke, don't fix it, I say.

[00:08:20] Stay with what's worked, and critically, what's low cost and liquid.

[00:08:25] The spy checks all of these boxes.

[00:08:28] But markets are a never-say-never business.

[00:08:31] And sadly, risk management suffers from the failure of our imaginations.

[00:08:36] What could go wrong?

[00:08:38] Just about anything, history tells us.

[00:08:40] Sadly, we are seeing a natural disaster play out in real time.

[00:08:45] Listeners to this podcast will recognize that I think it's perfectly okay to simultaneously believe in the VRP,

[00:08:52] that is, the vol risk premium, and to embrace the value of long optionality.

[00:08:58] Let me explain.

[00:09:00] First, it's difficult to get away from the empirical observation that there is excess premium to be earned over time

[00:09:06] by providing options-based insurance to those who want it.

[00:09:10] Geico and State Farm don't sell insurance for free, so why should Goldman Sachs?

[00:09:16] Second, I believe in the value of owning convexity.

[00:09:19] Certainly not all the time, and certainly not at any price.

[00:09:23] But at a good price, vol is the only anti-fragile asset in the world.

[00:09:27] When everything else is breaking, vol is quickly strengthening.

[00:09:31] That is really unique.

[00:09:32] So the first portfolio overlay I believe is sensible in the current environment is owning some options-based protection on the S&P 500.

[00:09:41] We're sitting here with the VIX flirting with 20, so it's difficult to jump up and down on its nominal cost.

[00:09:48] As a result, I'll stay with the trade structure I've been recommending for a bit now,

[00:09:53] and that's a three-month 95-80 put spread on the S&P 500.

[00:09:57] Your protection begins at down just 5% from the current level, and you are protected for the next 15%.

[00:10:05] A couple of thoughts to add here.

[00:10:08] Eight of the last 15 sessions in the S&P have featured a move of 1% or more.

[00:10:14] One-month realized vol in the S&P is now close to 18.

[00:10:19] It may be too early to say, but we could be entering a new vol regime.

[00:10:24] We could also easily be settling back to 10.

[00:10:27] It's just too early to know.

[00:10:29] These transitions typically do happen, though, in broad daylight.

[00:10:33] The 50 basis point moves are replaced by one percenters, and then you throw in a 3% shock,

[00:10:39] and then the moves themselves become the topic of conversation in markets.

[00:10:44] All big risk-offs start as small ones, I like to say.

[00:10:47] This 95-80 put spread will cost you about 100 basis points.

[00:10:51] I want to be sensitive to the institutional straightjacket that is imposed on risk-takers in our industry.

[00:10:58] Benchmark hugging, to borrow from the great Howard Marks, is such a real thing, and it means that underperforming the S&P is riskier than outright performance.

[00:11:07] This is to say that the 100 basis points I think is easily worth it is also difficult to come by in a world in which relative performance becomes such a driver of the asset allocation process.

[00:11:20] What you get for parting with the option premium is some version of anti-correlation.

[00:11:26] That is, an asset that gains value as your base exposure is losing it.

[00:11:30] Price is always key.

[00:11:32] I call it calc, C-A-L-C, convexity at lowest cost.

[00:11:38] Insurance is always about the price.

[00:11:40] And I'm here to say that outright long vol is not a slam dunk to me, but set against the aforementioned increase in realized vol,

[00:11:48] as well as a skew that remains in an elevated percentile, put spreads are well worth consideration.

[00:11:54] I especially believe this because of my beat-a-dead-horse campaign that the unsung risk is diminutive realized correlation.

[00:12:03] These realized correlations are due to rally considerably at some point.

[00:12:08] So throw some put spreads on top of your S&P exposure.

[00:12:12] Don't sell the out-of-the-money call to fund these put spreads, however.

[00:12:16] Pay for them yourself and enjoy the upside in an unbounded way should it materialize.

[00:12:21] Remember, the put spread caller is effectively a long put funded by a short strangle.

[00:12:27] Acknowledging fully that it has worked over the last couple of years, I don't like being short that strangle right now.

[00:12:34] Let's turn to gold and its digital equivalent, Bitcoin.

[00:12:38] I'm not so sure it's fair to call Bitcoin digital gold, to be honest.

[00:12:43] I've done some poking around on how these behave, and I'm concluding that there are similarities but also some important differences.

[00:12:49] Let me give you the TLDR or the podcast version, TLDL.

[00:12:55] Too long, didn't listen.

[00:12:56] Gold is considerably more durable to S&P shocks than Bitcoin is.

[00:13:01] Both do share return distribution characteristics that allow them to enjoy episodes of AssetUp, VolUp.

[00:13:09] And related, both seem to capture a growing skepticism of the fiat currency endgame.

[00:13:15] So again, TLDL, I like having small allocations to both gold and Bitcoin on top of your S&P exposure.

[00:13:23] Let's run through some numbers.

[00:13:25] It was 100 years ago that John Maynard Keynes coined the phrase barbarous relic in describing the gold standard.

[00:13:33] A century later, while you still can't really take it with you, gold is an asset with important financial properties.

[00:13:40] It is a decidedly psychological asset that has value because we say it does, and it can become VIX-like during crisis times.

[00:13:49] The GLD delivered a 26% return and a sharp ratio of around 1.5 in 2024, even as the DXY was up 5%.

[00:14:00] Gold serves as a consistent diversifier, and the GLD was just 26% correlated to the S&P last year.

[00:14:07] It's difficult not to stay with what is working.

[00:14:11] You can quickly learn a lot about an asset by simply asking the question,

[00:14:16] how does it do on the best and worst days for the S&P?

[00:14:19] That's a great shorthand.

[00:14:21] I looked at the down 3% or more days in the S&P since 2017,

[00:14:26] and the performance of Bitcoin, gold, and the TLT on each of those days.

[00:14:32] Gold is down only 70 basis points on average for these big down days in the S&P.

[00:14:37] That's critical.

[00:14:38] There are not a lot of assets that can do that.

[00:14:41] The TLT for all of its risk-offness is up only 50 bps on those days.

[00:14:47] Gold is durable to large shocks, not every time as a put option is, but broadly speaking.

[00:14:53] The characteristics of the distribution of daily returns of Bitcoin are still being developed.

[00:14:59] Bitcoin is for now more a risk asset than anything else.

[00:15:03] On those down 3% days in the S&P, Bitcoin is down nine times what gold is, averaging a decline of 6.1%.

[00:15:11] When the S&P fell by 10% on March 12, 2020, Bitcoin fell by more than 27%.

[00:15:19] On Volmageddon, Feb 5, 2018, as the S&P swooned by 4% and the VIX skyrocketed, Bitcoin fell by 12%.

[00:15:28] Gold was up small.

[00:15:30] Gold was 26% correlated to the S&P in 2024.

[00:15:33] As I mentioned, Bitcoin was 39%.

[00:15:37] However, if we limit the sample to just down days in the S&P, the correlation of Bitcoin to the S&P rises to 46%.

[00:15:47] But as I covered in a recent podcast on Bitcoin options, iBit, the hottest option on the planet,

[00:15:53] the daily return profile of Bitcoin has some truly compelling attributes.

[00:15:59] Specifically, while it remains a risk asset for now, it's also an upcrash security as well.

[00:16:05] That is, the realized vol on up days is mostly higher than the realized vol on down days.

[00:16:12] An important corollary to this is that the asset and its implied vol can be often positively correlated.

[00:16:19] Assets like this are rare.

[00:16:21] Typically, when an asset rises, its vol declines.

[00:16:24] For Bitcoin, rallies see an increase in implied vol.

[00:16:29] Think about what's happening here.

[00:16:30] As the asset increases in value, the implied probability that it can run further, perhaps decidedly so, increases.

[00:16:39] That's what the increase in implied vol is telling us.

[00:16:42] The far out of the money calls get very well bid.

[00:16:45] Gold, of course, much more mature than Bitcoin, also has this characteristic.

[00:16:50] The correlation between the GLD and the GVZ, the gold VIX, is consistently positive.

[00:16:58] These are highly convex securities.

[00:17:01] They are options.

[00:17:02] And they have been going up.

[00:17:03] I want to be clear that these are not sources of portfolio protection.

[00:17:07] But they do have very unique return profiles, oftentimes having nothing at all to do with the MAG7.

[00:17:14] I think that both gold and Bitcoin are important to own at a time when evidence that the U.S. fiscal situation has so much agency cost and there doesn't seem to be an adult in the room or a business plan is growing.

[00:17:29] Paul Krugman used to call people like me deficit scolds.

[00:17:32] I will proudly take on that moniker.

[00:17:36] Gold and Bitcoin are assets with a certain psychological value proposition.

[00:17:39] They are some version of anti-system.

[00:17:42] And I worry quite a bit that our monetary system is being exposed for succumbing to the exorbitant privilege.

[00:17:50] The fiscal path projected by the likes of the CBO points to debt-to-GDP ratios that approach 200% over the coming two-plus decades.

[00:17:59] Is it reasonable to think that a financial accident is not in the making?

[00:18:04] As I typed these words on Friday, January 10th, we just had a solid payrolls report, which, of course, hurts the S&P, which is down almost 100 handles and 1.5%.

[00:18:15] The 10-year has breached 4.75%.

[00:18:19] The dollar is up 40 basis points.

[00:18:21] The GLD, mostly vulnerable to higher rates and a stronger dollar, found a way to rally by a percent.

[00:18:28] Bitcoin rose by almost 3%.

[00:18:31] All right, that's it for now, but we'll be coming back with much more.

[00:18:34] Something tells me 2025 is going to be really important from an investment perspective.

[00:18:40] And while I'm a big fan of Larry David and especially his sidekick, Leon, I want to wish you a happy new year as well.

[00:18:47] Let's make it count together.

[00:18:48] Until next time.

[00:18:50] You've been listening to The Alpha Exchange.

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[00:18:59] As we aim to utilize these conversations to contribute to the investment community's understanding of risk,

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[00:19:14] Thanks again and catch you next time.