Man and Markets On Wire

[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. As you all know by now, I love anniversaries.

[00:00:23] There's something special to me about looking backwards, contemplating what was happening 10, 20, 50 years ago. Time is certainly continuous. It moves slowly but passes quickly, as it has been said. Every year is fascinating because that's the nature of our world of vast interconnectedness

[00:00:39] filled with triumph and tragedy, heroes, and heartbreak. But 50 years ago in 1974 there was a particularly unique set of events. The S&P had one of its worst years ever down 30%. The price of crude oil quadrupled. Hank Aaron broke Babe Ruth's home run record.

[00:00:57] Holly and George Foreman fought in Zaire, the epic rumble in the jungle. How did these events capture the nation's attention at the time? How were they reported? How were they related? What were the New York Times headlines? As oil prices surged, the CPI was 12.3% in 74%.

[00:01:14] The Fed Fund's target went from 9% to 13%. Sounds somewhat calamitous to me. In an October speech to the American Bankers Association entitled, Maintaining the Soundness of our Banking System, then Fed Chair Arthur Berens began with,

[00:01:29] This year, for the first time in decades, questions have been raised about the strength of our nations and indeed the world's banking system. It is profoundly disturbing to me as indeed it must be to you all. Shish, is that it?

[00:01:45] And almost exactly 50 years ago, and not by tweet, President Richard M. Nixon addressed the nation late summer 1974. For all of what happened in 74, what's got my attention and what I'd like to share with

[00:01:57] you as the theme of this podcast is not what happened on August 8th when the 37th U.S. President announced that he was resigning from the office. I'd like to tell you about the day before.

[00:02:09] It was on August 7th 50 years ago that Philippe Petit, a 24-year-old Frenchman would captivate the nation as the man on wire. Being on a tightrope that he and his small cohort of mischief enablers connected across

[00:02:24] the top of the two World Trade Center buildings with a bow and arrow no less, Petit went back and forth eight times in the early morning of August 7th to the utter disbelief of onlookers on the ground 1400 feet below.

[00:02:39] To say he had no business being up there is an understatement to say the least. It's a story so remarkable that it's next to impossible to capture. If you haven't seen it, please rent the documentary Man on Wire.

[00:02:52] In Petit's Conquest we see mankind's unique capacity to will and events into existence, bringing others compelled by his vision along for the ride. We see obsessive practice and planning, love, friendship and joy and pure hijinks. The scale of this caper is simply overwhelming.

[00:03:11] I was down at the New World Trade Center building for meetings last week and I couldn't help but reflect on those beautiful twin towers which I commuted to for years in the 1990s while at Nemora and then Lehman Brothers.

[00:03:24] It'll be 25 years since September 11th in the blink of an eye. Man on Wire like Free Solo and the Alpinist is unsafe to put it mildly. Walking on a tightrope is an idiom that conjures the notion of danger, of exceptionally

[00:03:40] little margin of safety and of particularly significant consequences should things not go as planned. Markets today feel like the man on a wire. Acid prices are full. Sharp ratios unsustainably high. Correlations unsustainably low. The US is running unsustainable deficits. Our political polarization is unsustainably high.

[00:04:02] And to quote Herbert Stein, if something cannot go on forever it will stop. We got a whiff of risk off recently with the S&P breaking its more than 500 day streak without a 2% down move on July 24th. How'd we get there?

[00:04:17] Well, if the index is incredibly top heavy then the first place to look is at the supercaps. And we see that complicit in the index move was a joint 2% down move in all components of the MAG7.

[00:04:31] It's only happened twice since 2023 both of which were in the last two weeks. Since the June CPI report and the quote locked in September Fed easing expectation, the size factor has gotten hit the hardest.

[00:04:44] Bloomberg's FTW page reports that the market neutral size factor is down more than 7% since July 11th CPI day. I've talked too much about the magical but unsustainable internal diversification that has been happening in the S&P captured simply in the almost zero correlation between Nvidia and Apple.

[00:05:05] That's changed since July 11th as realized correlation is almost 50% between them. When stocks become more volatile they become more correlated, said a derivatives nerd and podcaster. That's me. As we all reset the days since an S&P 2% down move clock we should appreciate the role of

[00:05:25] correlation in getting us there. The index moves result from the combo of the single stock moves and the extent to which they are in the same direction or not. The drum beating on low correlation has been justified by just how low it's been

[00:05:38] and how unbelievably forceful a suppressor of index volatility that it has provided. In fact since the June CPI print it's been different especially as the growth and size factors have been pummeled and if growth and corporate profit concerns become the

[00:05:54] focal point of market risk correlations will be considerably higher than they've been. And this brings us to the VIX curve. We've chatted plenty about the hump in the curve centered on the October future no doubt a risk premium due to the US election.

[00:06:10] The September OX spread was hovering around 2.4 until the June CPI release. It flattened to 1.6 shortly after the release and has since re-steepened to just under 2. Let me share some observations on this VIX curve perhaps relating its shape to that of the risk free yield curve.

[00:06:31] Like the US government bond term structure the natural resting place for the VIX curve is in Contango. If we simply use the spread between the front and second month VIX future as a proxy for

[00:06:41] the overall shape of the curve Contango a premium of the second to the first prevails 84% of the time since inception of the VIX futures contract. In the Treasury market the three-month two-year yield spread is in Contango 83% of the time since 1993.

[00:06:59] Curve inversions in equity vol are highly related to an increase in realized volatility. For the times when the VIX future is in Contango one month concurrent realized in the S&P is 13. For the periods of inversion that level of realized is much higher at 28.4.

[00:07:16] In the extreme inversions like November 08 and March of 2020 realized vol has exploded well past 70. The reason for backwardation relates to the demand for short dated options that emerges during a risk off event.

[00:07:30] All option prices rise and implied vol moves up across the curve but because the short dated options are more gamma intensive the poppin realized pushes vol trades to demand them the most. That is to say that the high gamma of short dated options translates

[00:07:46] the increase in realized to profits from being long at most directly. Like yield curves vol curves can steepen or flatten an inverted curve is unlikely to remain so for very long. As I stated earlier the natural resting place for the curve is in Contango.

[00:08:03] When a substantial risk off event materializes and the curve inverts there is some process of the market working through the higher vol levels and ultimately finding some runway to buy the cheaper assets that present themselves. Of course the monetary and fiscal authorities are also

[00:08:19] a part of this especially north of 40 the VIX is a sitting duck for the Fed and its compatriots who do not enjoy financial instability and are apt to throw public capital at the problem.

[00:08:32] As I've argued forcefully vol is the only antifragile asset but only at a reasonable price. If calc CALC is convexity at lowest cost then investors must recalc their hedging plans when insurance costs balloon. The recent VIX curve is a real doozy with portions of it in Contango

[00:08:52] and other portions in backwardation. Let's consider its close on July 24th the day of the 2.3% downdraft in the S&P. The VIX closed at 18 and was in backwardation versus the front August VIX future which closed at 17.1. Now typically that inversion would suggest the entire curve was inverted

[00:09:13] but here we see the September future slightly higher at 17.5 and then the October election focused future much higher at 19.1 thus far we have both backwardation and Contango but the November and Dease futures closed at 18.5 and 18 respectively so there's backwardation from October to November

[00:09:36] and December and then in a final plot twist the curve points back up again with Jan 25 at 18.6 Feb 18.8 and March 25 at 19. Two portions of the curve are in backwardation and two are in Contango

[00:09:53] something for everyone I'll have more to say on this in my next podcast. Let's finish this short podcast with some politics shall we? I speak these words roughly one month after the June 27th Biden-Trump debate. My goodness what a month it has been. It was Robert Fulford

[00:10:11] who once said when days seem like years and years like days if the last 30 days in U.S. political history don't apply to this statement then nothing can. Let's review a disastrous debate material moves in the polling as a result Biden's ineffective recovery tour the sudden

[00:10:29] claim by CNN that they too have been gaslit by the president's inner circle murmurs of discontent among democratic elites the Clooney op-ed further widening in the swing state polls betting odds favoring Harris as the dem nominee over Biden in unusually quiet Trump

[00:10:45] an assassination attempt on Trump a wholesale shift back to Biden in the nominee betting odds a further widening of the election polls Biden calling Harris Trump and Zelensky Putin a resurgence of Harris in the betting odds an intensification of pressure on Biden to step

[00:11:02] down from the dem elders a few I'm not effing leaving speeches from Biden a trip by Schumer to Rojavik beach and then of course the inevitable a tweet from Biden that he is leaving with an

[00:11:14] oval office address to come a few days later I like to say that markets are a never say never sport that is whatever you might find yourself capable of entertaining in terms of possibilities however wide or weirdly shaped your distribution of outcomes might be it's probably underestimating

[00:11:31] the realities us politics is officially never say never and for me personally without a strong view that any of this has a significant read through for asset prices yet the emergence of predicted and poly market as real-time trackers of betting probabilities has added a new dimension

[00:11:48] to the drama the predicted odds live where I do on Bloomberg they are tickerized and after a while I just knew that the Biden odds of being the nominee could be found by punching in

[00:12:00] PRIT USDB the odds of Biden winning the election a bit different at PRIT US for B a couple of thoughts on the behavior of these time series that I'd like to share that I think can be related to financial assets first let's consider the time series of Biden

[00:12:17] as the dem nominee this quote asset was running at 10 realized vol until the late June debate almost no daily movement a week after the debate that vol jumped to 160 by the time Biden tweeted on July 21st the realized vol over the prior 10 days was 1100 punctuated by a 94

[00:12:41] percent down move on that day we see this same behavior and asset prices a security with a modest vol profile experiences a shock this is the new news the ceo has caught in a scandal

[00:12:54] there's accounting chicanery there's been a seismic shift in the macro landscape now the daily moves are orders of magnitude what they were the new vol is both a cause and an effect it's got its roots in fundamental uncertainties it also causes behavior perhaps investors flee the exposure

[00:13:12] because it blows up their risk models unruly price action then becomes an operative dynamic with biden the disastrous debate was the initial shock the implied betting odds were a real-time mark to market that cemented the deal the second observation on these betting odds

[00:13:28] that readily relates to markets is in the correlation space let's consider the relationship between the odds of biden and harris as the dem nominee before the debate these two series had no relationship at all there was almost no movement in either series and there was no

[00:13:44] explanatory power in one series in driving movement in the other from April to the debate the average correlation was indistinguishable from zero from the debate onward it was negative 80 two assets previously unrelated became completely tethered to each other in an anti-correlation way

[00:14:03] in financial markets examples of this come to mind the correlation of italian sovereign spreads to the vix circa 2011 these assets were unrelated before the eurozone crisis and largely unrelated after it but during those bad days in fall it was nearly a sure bet that risk

[00:14:22] off days were some combination of s and p down vix higher euro lower and spreads higher in peripheral countries like italy when dragy got matters under control the correlation de intensified and ultimately died down all right that's quite enough on us politics it sure makes for good

[00:14:39] theater and i'm personally exhausted by the wait for it paul vol but i'm bum i've been mainlining some combo of fox news and cnn for a month now a break is in order this ought to be a bruising

[00:14:52] coming months for all of us take care of yourself and put the phone down except of course if you're listening to risk and volcentric podcasts by now i'm over my 2000 word limit have a fantastic

[00:15:03] week and catch you next time 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

[00:15:18] community's understanding of risk your input is valuable and provides direction on where we should focus please email us at feedback at alpha exchange podcast dot com thanks again and catch you next time