GeoVolitics, Implied Correlation and Option Pricing

[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. With the U.S. 10-year notes sporting an impressive nominal yield of 7.4% and the VIX at 15, the 85th episode of Seinfeld came to be on May 12, 1994.

[00:00:31] For fans of the series, perhaps The Contest or Marine Biologist or The Stall, remember Can You Spare a Square, are more famous than episode 85, The Hamptons. But really, who could forget the sad side of George, mortified, suffering from shrinkage, and screaming, I was in the pool!

[00:00:54] Poor George. No wonder one of the other most-watched episodes was The Opposite, in which he enjoys a rare period of success simply by going against every instinct he's ever had. I start this pod with that Seinfeld reference because a recent Bloomberg piece cited Goldman's Scott Rubner, who suggested that not just George, but, quote, everyone is in the pool.

[00:01:19] It's his bearish take on crowding, asymmetry from CTA strategies to the downside, and softening seasonal flows. For me, crowding is that elusive, difficult-to-measure, but critical risk factor that we always have got to be thinking about. Crowding works in both directions. When investors crowd in to a risk exposure in sufficient amounts, market prices give way, reducing the risk premium.

[00:01:46] It's hard not to see the period before its demise when LTCM hoovered up option premium and earned the nickname the central bank of volatility as a period of crowding in. If enough folks sell equity vol, the competitive forces in place can put downward pressure on implied volatility. This yields positive mark-to-market P&L to those that were already in the trade at higher levels. Those profits can often wind up being recycled back into the same trade.

[00:02:16] The trade gets larger, but the margin of safety erodes in the process as an exposure becomes more concentrated. On the back end, a crowded trade can get unwound in a hurry. As I often say, risk on and risk off are curious cousins. Markets have gotten really interesting over the last few weeks.

[00:02:35] I probably say that too often, but it's a statement that reflects a sincere fascination with seeking out some alpha through analyzing a broad spectrum of prices, specifically the ones that imply some probability. I will repeat that it is the options market, not the stock market, that is the best economist in the world. Option contracts carry the dimensions of time, the expiration, and distance, the strike price.

[00:03:01] And the resulting prices help us gauge two important questions for investors, when and how much. So, in no particular order, a few things on my mind that I invite you to consider alongside me. First, in the realm of crowding, it would make sense to start with the dispersion trade. Mark Twain, of course, told us, Put not all thine eggs in one basket. In markets, and more broadly in life, they say, better to scatter one's money and attention.

[00:03:32] On the latter, social media is doing quite a fine job on that front. I just bought an old school Kindle, the one without any apps on it, just books. My hope is to reclaim my attention span and dive into more books, rather than darting from Twitter to Bloomberg to the FT, and then, of course, to DailyMail.com and the New York Post, where I get most of my hard-hitting insights.

[00:03:56] The idea that it is better to scatter one's money, i.e. diversify, has been around forever. Newer, however, is that financial innovation allows us to trade the scatter. If the GFC or COVID are periods of, quote, anti-scatter, that is, high correlation, today's markets are the anti-anti-scatter. That is, supremely, epically, eye-poppingly, and most surely unsustainably low correlation.

[00:04:26] Diversification is traded actively through the options market. In my ongoing conversations with investors on the dispersion trade that has profited from such diminutive realized correlation among stocks, I'm left continuing to view the entry point as poor, the positioning crowded, and the tendency for us all to experience recency bias, i.e. stocks just aren't correlated anymore, on full display.

[00:04:53] Further, the P&L from January in the dispersion trade is low quality, as without that 17% giant move lower in NVIDIA on January 27th, things would have been different. Too much of the trade has depended on massive one-day moves in single stocks. If the dispersion trade is indeed crowded, and if investors are in the trade without a lot of margin of safety, the setup, at least, is there for a sharp unwind. What needs to happen for this to be the case?

[00:05:23] First, the market needs to be confronted with new and, almost surely, unwelcome developments that force a repricing. One might argue that this is upon us now. My trusted VCA page on the Bloomberg Terminal tells me that the market prices S&P one-month implied correlation in the 83rd percentile over the last two years. Further, the spread of implied correlation to realized correlation is in the 99th percentile.

[00:05:50] This occurs as international developments are moving more quickly and gathering uncertainty along the way. It's difficult to handicap some of this stuff. Russia's propaganda machine is in full beast mode. European leaders are holding emergency summits. U.S. political parties are going to be more divided on this issue than any in recent memory. I just googled the word geovolitics, and nothing came up, so I'm going to take it.

[00:06:20] This, of course, is a play on the word geopolitics, but with a little sprinkling of market vol. Is the reawakened bid for equity correlation a function of the reality that situations like Russia, Ukraine, U.S. are exceptionally challenging to understand? Something tells me that Scott Besson is going to have a stressful few years. Stepping back, what is a higher level of implied correlation telling us?

[00:06:46] It's the market assigning a greater proportion of the index implied vol to the degree to which stocks are expected to be correlated. In the worst of the risk-off episodes, we have seen this basically get to one. The S&P becomes a single stock. There's no reason to evaluate a company from a bottom-up perspective because the macro forces so dominate.

[00:07:08] Further, liquidity is compromised, and what's left of it can be found only at the broad index S&P level. If there were an index like the VIX, let's call it the GVIX, that tracked the price to insure against a negative geopolitical risk outcome, it has surely risen a bunch in the last few days. Polymarket tells the story. Four of its top bets are focused on Russia-Ukraine.

[00:07:34] The odds that Trump will end the war within 90 days reached nearly 40% recently, and now is as low as 19% over the last couple of days. The mineral deal odds have plummeted in the last week or so. I say keep an eye on Polymarket. There's a forward-looking element right now in equity vol and implied correlation, and perhaps it's a recognition that geopolitical risk, so often more bark than bite,

[00:08:02] is something the market may not be able to ignore. The GVIX doesn't yet exist, but Polymarket will serve as a gauge of whether matters are improving or breaking down in Russia, Ukraine, U.S. What we know from markets is that vol events can, quote, cluster. That is, when things get in motion, the pace of change can be reinforced and become a stress episode. We should certainly view developments as an escalation in the level of geopolitical uncertainty.

[00:08:32] At some point, this uncertainty may become so profoundly difficult to price that market participants throw up their hands and assign a substantial level of risk premia, i.e., a higher price for insuring against loss across the major asset classes. At risk of repeating myself—actually, there's no risk at all. I am constantly repeating myself—when stocks become more volatile, they also become more correlated.

[00:08:59] The same conditions—economic, monetary, financial, and geopolitical—that make stocks more volatile also make them more correlated at the same time. Here's a very simple, stylized example. Suppose you had a two-stock portfolio, equally weighted, consistent of Apple and NVIDIA. Life has been good. Suppose they are each running at 30 realized volatility, and let's use their three-month realized correlation of daily returns of 10%

[00:09:29] to compute the volatility of this two-stock portfolio. Using those as inputs, our portfolio vol is 22%. Now, let's introduce some uncertainty and, with both logic and history on our side, push both the realized vol and realized correlation higher in tandem. Let's use 40 vol and 50 correlation for our two-stock portfolio.

[00:09:54] The vol at the portfolio level is now 34%, up 56% from the previous 22%. That's a meaningful increase, to be sure. The market has experienced a run of anti-correlation like never before. I worry about recency bias and how the delivered level of low correlation has so dampened the vol at the portfolio level that investors have let their guards down. Let's cover two more topics, gold and credit vol.

[00:10:24] Gold has had a fantastic run and was clearly due to give back some of the recent gains. It was telling to me that it fell by 1.2% on Tuesday, February 25th, even as the bond market rallied sharply with 10-year yields falling by 11 basis points that same day, and the dollar also modestly lower. These two rates in the dollar are typically the best explainers of changes in gold, and they moved favorably, but gold responded in the opposite direction.

[00:10:52] That seems like profit-taking on a winner. More broadly, the two-month realized correlation of the GLD to the DXY is currently right around zero. As gold is often considered something of a currency, its returns are typically very much a function of the dollar. The correlation of daily returns of the GLD to the DXY typically averages around negative 40% or so.

[00:11:15] As the GFC intensified and what to do with Fannie and Freddie became an open conversation in 2008 in markets, PIMCO's Bill Gross famously said, shake hands with the government and buy what they're buying. It was a brilliant, if not slightly coercive strategy. While it's much slower moving, there's a similar notion in the long trade on gold via central banks. China, Turkey, India, they're all accumulating the yellow metal.

[00:11:45] Even as gold is up and to the right, it's doing so in a very well-behaved fashion. There's no strong feedback loop yet between price and vol. I think this is something to watch very closely. The gold VIX, the GVZ index, is still low, all things considered. Gold is often called an inflation hedge. Some call it a deflation hedge. I don't like either of those. I think that gold satisfies a psychological component of how investors think about risk.

[00:12:14] Gold benefits from a sense that all is not well. And sadly, at least from my perspective, in markets, all is not well. Back to polymarket and how much price discovery we now get in very fine-tuned bets, many of them now focused on geopolitics, I will suggest that volatility in the probabilities embedded in these bets is going to be good for gold. I want to close out with some brief comments on credit spreads and credit vol,

[00:12:44] both of which recently scored near zero-th percentiles at the same time over the last couple of years. IG credit spreads have been so tight for so long now, not even doing much on August 5th or December 18th of last year, the two recent VIX spikes. The VIX IG, the index of credit-implied volatility, can be interpreted as the market saying, quote, not only are credit spreads tight now, but we expect they will remain that way for the near future.

[00:13:13] Plenty of reasons why pricing lines up this way, but certainly these are low-priced options. Note that I used the same methodology to find a lot of value in VIX options last year. In and around May and June of last year, we had joint extreme lows in both the VIX and the VVIX. With no crystal ball or forecast of doom, I strongly made the point that VIX calls were very low in price, both through the low VIX and the low implied vol attached to VIX options.

[00:13:41] Those trades, of course, hit fantastically on August 5th. Way back in 2021, with the Fed still promising low rates ad infinitum, I made a similar point that the combination of near zero yields out to two years and the incredibly low implied vol attached to options on government bonds paved the way for bets on change. For me, it's not about predicting change,

[00:14:07] but in trying to find market prices that suggest change is nearly impossible to come by. Perhaps options that pay off if credit spreads widen are currently in that category. It had to have been around five years ago today that Bill Ackman was putting the finishing touches on one of the most convex tactical credit spread hedges in market history. Well, that is it for me. I hope that these first two months of 2025 have been good ones for you. Let's keep trying to figure all of this stuff out together.

[00:14:37] Be well. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend. 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. Thanks again and catch you next time.