Transcript of Christopher Cole’s complete remarks on the Grant Williams / Bill Fleckenstein End Game podcast — Episode #10


(the publishing of this transcript is NOT associated with the End Game podcast nor with Christopher Cole— the full podcast can be found at this link and the conversation took place on Weds., October 28, 2020: — more on Christopher Cole at this link: You can find Christopher Cole on Twitter @vol_christopher along with Grant Williams @ttmygh and Bill Fleckenstein @fleckcap


“Before we get going here’s the bit where I remind you that nothing we discuss during the End Game should be considered as investment advice, this conversation is for informational and hopefully entertainment purposes only. So while we hope you find it both informative and entertaining please do your own research or speak to a financial adviser before putting a dime of your money into these crazy markets and now on with the show. Welcome everybody to another episode all the end game joining me as always my partner in crime Bill Fleckenstein.”

Chris Cole’s complete remarks

“The idea that there’s only one asset class and that is volatility and there’s only two types of traders or investors out there, long vol (volatility) and short vol investors and what I actually mean by that is that if you look at the way assets behave, if you decompose them based on their return stream. They have characteristics that are mean revertive with big fat tails to the negative; assets that make money most of the time, but then lose money very quickly in big draw downs and I tend to follow mean reversion characteristics. And those assets tend to be correlated to the growth cycle, they tend be long DDB types of assets as well, so it’s interesting almost all equity linked investments kind of follow pattern. But short vol could be, the way I look at it, could be something like value investing, you know a value investor is going out there and looking to buy inexpensive assets, they look to see when the market has over corrected or has gone too far too quickly and seek to buy the low intrinsic value, that is a mean reverted strategy. Warren Buffett is the smartest short volatility trader out there. So people who are short volatility tend to bet on mean reversion, the expectation of stability and in various myriad different forms, whether that’s an expectation of mean reversion correlations, mean reversion in asset price direction or some sort of expectation of tangible value, of course there’s a literal shorting of volatility where people are shorting options but I extend the definition to really unique bets on overall stability. Then there’s long volatility style of investing and really a lot of the global macro traders on tail risk investing, systematic CTA seek to profit off the trend. These are strategies that look too, they don’t make money most of the time but they make most of their money in small periods of diversions and turbulence in asset prices and they tend to be non correlated to the business cycle or anti correlated to other long GDP assets. These types of return streams profit when correlations break down, they profit when interest rates explode higher. they profit when there’s a lot of turbulence in markets.

The problem with most investors is their portfolio is entirely constructed of these long GDP short volatility style assets. And I always say, you break down the composition of the average pension, which is mostly 70 percent equity linked investments, maybe 20 percent bonds and at the end of the day, the majority of that is short volatility in nature. Many of these risk premia strategies are short volatility in nature and they tend to collapse all at the same time. Now of course you know for a long time bonds were this classic hedge, you know in many ways people say what was the best tail hedge you could possibly buy was long duration bonds when bonds were 20 percent. you know what now with the zero bound, bonds as a put option it has really failed. You and I talked about that years ago, we talked about that years ago and we’re seeing it play out today. So in today’s environment most people are just layering on additional correlated bets either through risk premia through leverage through credit or through liquidity in essence to meet their retirement return targets and it’s a disaster in the making because they’re only relying on the shortfall component and they’re not balancing long and short volatility in a way that that can create the best outcome over long periods of time.


Let’s take a step back and I’ll relate how the options market is playing a role in this. I think you know we sit down and we talk about how do you define capitalism, what is the medium of capitalism, and it’s fiat money. And Of course this gets into the idea of does money even exist. It doesn’t exist if it’s not tied to gold, it’s purely a thought abstraction. So it’s only worth something because we collectively believe it is. And that’s kind of interesting, we are dependent on thought abstractions, so in this sense when we look at thought abstractions; a nation states exist because we believe in it, money exists because we believe in it, political parties exist because we believe in it, reality becomes these thought abstractions become reality. And that in many ways is an esoteric concept. You know in Jewish mysticism there’s this idea of a ‘golem’. You know you can make something out of clay it becomes real and in Daoist mysticism there’s this idea of a ‘tulpa’.

Today in this world where they have flooded liquidity into the system and they’ve sought to create the illusion of value by transmuting the medium of money. This has created I think a trillion dollar question, which is, can the medium by itself create value or does value exist independent of the medium? So the idea, and there’s two schools of thought here: One is the school of thought that as someone who has a CFA designation I grew up believing in, which is that value is independent of the medium and intrinsic to the asset.

René Magritte “” (The Treachery of Images)

That’s you know Warren Buffett that’s Seth Klarman, that’s this idea that the bid ask don’t represent value anymore than a Magritte pipe represents a real pipe (or a painting a pipe represents a pipe). Prices might fluctuate but those prices are and independent intrinsic worth. Well now there’s a second realm of thought that says value is generated from the medium and in this sense liquidity is the soul determinant of value defined by that constant bid and ask price. And as long is constant liquidity is supplied with a narrative, value is created. And that’s true whether the ‘tulpa’ is corporate debt, whether the ‘tulpa’ is the success of Elon Musk, whether the ‘tulpa’ is a factor premium in the market. It doesn’t matter as long as liquidity is flowing and there’s a belief in wherever that liquidity flows that alone creates value.

What we saw in March of 2020 this year, this is a solvency crisis, it’s a continuation of the solvency crisis that started in 2008. And we saw correlation breakdowns, we saw basis trades blowing out, we saw all of these major problems. But I think what’s really interesting is that they can’t deal with the solvency issue, so what global policy makers did is the printed twenty trillion dollars to try to create value out of the medium to fool people into solving a credit insolvency problem with excess liquidity. And the net result of that is something absolutely kind of fantastic and incredible as it’s transmuted in all these different forms.

Now how does this tie back to the options market? I think this becomes interesting. The options market has exploded to a degree that has never before been seen. For a long time options were a derivative of the stock market. Option prices move based on their underlying (stock market ). But when options become the dominant form, the dealer hedging of those options can in turn impact the underlying stock market. So this dealer hedging and the money flowing into options transforms the stock market into the derivative of the options market. So for the first time in history this year we have consistently seen the volume of the options market, U.S. options exceed the volume of the underlying stock market. And a large part of that is you have your 13 million in Robinhood accounts, you have all the speculative trading but it really comes down to the fact that you have policy makers print ten trillion dollars globally funneling liquidity injections into this market. And options have become a method for people to place speculative bets in the medium or the manipulation of that medium.

Well, how is that turning around into a reflexivity. The options market we’ve seen for the first time in history, or excuse me it’s not the first time in history, we’ve seen a tremendous number of people bidding up call options instead of put options. That’s not new. People talk about it like it’s new but it’s not new, that dynamic where call options were more popular than put options existed for long periods between 1996 and 2000, so we’re actually replicating that regime in the options market but what is new is how big the options market has become. The options world was a tiny world, relatively small back in the late nineties and it was an arena where you know you had dentists and doctors with a little extra money betting on these tech stocks through options, but it really was not widespread. Now there’s been a democratization and we have these flows that are much bigger than they’ve ever been before, so it’s not the fact that the speculative fury has been new it’s the reality that the importance of the underlying derivatives market has become much more pronounced, that is the main shift.

Well, dealers are forced to hedge these flows. So when a lot of people are buying put options and I’m going to make this relatively simple because we can get into the weeds here but there are different exposures; Delta, Gamma Vega,Vanna that when you buy an option or sell an option there’s presumably a dealer or bank on the other end of it, the bank is looking to or the market maker is looking to manage, they’re not looking to take a directional position they’re looking to earn the best spread so they hedge those flows. And as a result of it they’re supposed to hedge their Gamma or their Vanna flows or their Vanna positions. I want you to imagine that like gamma is like a rubber band. And most of the time when there’s a lot of of when there’s a lot of put buying out there. And when there’s a lot of call selling out there it results in a dynamic where there’s a relatively tight rubber band that increases the mean reversion of the market. But when there are imbalances on either side it can create situations where the rubber band snaps. You can snap in either direction. What we saw in March was the rubber band snapping to the left side. And one of the things we’re seeing in this (current) environment is the rubber band snapping to the right side, as dealers are forced to hedge these option flows that are more dominant than they’ve ever been before.

In 2017 I wrote a paper called The Alchemy of Risk and it introduces the concept of the ‘ouroboros’, this idea of a snake eating its own tail and I said that there was three trillion dollars of short volatility products in the equity market that had the potential that we’re reinforcing volatility in a mean reversionary and lower and lower pattern, but that in the event that they broke could reinforce volatility higher. And those three plus trillion dollars represented a variety of financial engineering products that sought to use financial engineering and bets on stability in a myriad of different forms in order to create excess yield.

So the most obvious of those were at the time the VIX ETP’s and the very popular short volatility trade in those VIX exchange traded products that actually Mike Green and I quite famously got into an argument at the EQ derivatives conference with the CIO of a Velocity Shares product and we told him his product was going to blow up. And that got into a pretty heated argument and sure enough we were correct just one year later. But that was the smallest portion of that short vol (volatility) trade. The much larger portion of the short vol trade were things like risk, AQR wrote a paper that called out my characterization of risk parity as being a short volatility, well in my definition short volatility means short correlation, risk parity or short correlation. We saw risk parity products blow out in March when both stocks and bonds, people forget this, were declining at the same time, for a portion of time in March.

So you have risk parity products that were short gamma and short correlation, they were short trend and they were short correlation between stocks and bonds, you had strategies like leveraged share buybacks by corporations, which were actually literally short volatility through the mechanism that they used to execute that. So all of these strategies created a feedback loop that led volatility to be lower and lower and lower, but when it broke it would cause an expansion of volatility higher. Now we saw that occur, we saw the wash out in the breakage of that ‘ouroboros’ of risk occur just as predicted in that paper, this last March. It was not just the short volatility risk premium products but was everything from risk parity to all these leveraged basis trades.

You know some people talk about the Federal Reserve coming in and spending all this money to support the credit markets and inject liquidity into the system. It was not meant for the middle class. It was not. This was bailing out many of these multi billion dollar hedge funds that had leverage basis trades on, that had leverage risk parity trades on and who we’re stuck in a liquidity feedback loop. And it had very little to do with the corner bakery or the store down the street. This was a violent unwind of that ‘ouroborus’ of risk which many people had, you know, Mike Green and myself had explained that was a major risk and it was a violent unwinding of that massive multi trillion dollar short volatility trade. And as a result of that, they had to supply liquidity because the gears of the market had completely broken. But what they’ve done is they’ve sought to inject so much liquidity that the solvency problem, the debt solvency problem is still alive and well.

And there are practitioners out there, derivative practitioners, smart ones who will say that volatility, all it is is liquidity, that’s all vol is, is liquidity. When there is a disruption in the medium and there’s not liquidity that’s the sole determinant of what volatility is. I actually think that’s short sighted. I think liquidity is a big part of the issue, liquidity is the structure of the medium but volatility is a combination of liquidity and credit and solvency. So the classic problem of a volatility spike is a situation where there is a solvency crisis which leads into a liquidity crisis because of leverage. And so what the Federal Reserve has done in attempt to grease the gears, they have thrown so much money to solve the liquidity problem, they made the solvency problem the worst it’s ever been in history.

And People say “that’s it, there’s no more vol (volatility) we’re fine, we’re out of the woods”. No, the ‘ouroboros’ of risk has come unglued, but the solvency issue is more massive than it has ever been and that’s not hyperbole. Corporate debt to GDP, all time highs. The idea that our government debt to GDP at the highest levels that it’s been outside of wartime. So we’ve never had corporate debt to GDP this high and we’ve never had … we can go down the list of what’s occurring, you just go down the list of what’s occurring because we’ve temporarily pushed everything off , look at bankruptcies for companies with over fifty million dollars in liabilities, that’s at all time highs, corporate debt to GDP, all time highs, banks reporting C&I (commercial and industrial loans) tightening, all time highs; these are things that typically happen before the big vol spike not after the big vol spike.

This makes me think, and you guys had Lacy hunt on the show a while back, I had a wonderful time talking to Lacy in our offices when we did Real Vision interviews together, it was fantastic to bring him in and I get a chance to speak with him for an hour. He talks about this idea that you know once you reach this threshold of debt adding more debt doesn’t solve it, it exacerbates it. So I don’t think we’re out of the volatility woods yet but what they have done is they have injected so much liquidity it’s created a Frankenstein monster out of the options market that is causing distortions I don’t think we’ve ever seen before in the interplay of the way the options market and the stock market are working together.

I think there is an end game in the destruction of the belief, volatility is a collapse in the belief system and that results in the collapse of the medium. So what are two routes that can occur? In my recent paper (The Allegory of the Hawk and Serpent) I talk about this idea of a hawk that comes down and attacks the ouroboros killing the serpent. The serpent is that cycle of short volatility that is broken up by the serpent and the hawk has 2 wings. And there is this left wing and that’s when people stop believing in the ability of companies to service their debt, in these bad business models and that’s what we saw in the nineties where all of a sudden there is a collapse, a classic debt default collapse. The other framework (wing) is one where central banks have a debt jubilee. We go ahead and we make the Fed’s balance sheet legal tender and people lose belief in the medium of money, which has happened many times historically, as you are a scholar of, a much deeper scholar than I am of that history. So in either of these wings you have to be in long volatility style strategies to survive. You have to be by any study of history, now the problem is that doesn’t necessarily mean going out and buying put options you know we’re just rolling tail, we have to broaden our concept of what volatility is because if you’re talking about the left wing of that secular collapse which is what occurred during the Great Depression, which is what occurred in 2008. In that scenario you want your long volatility exposure comes from left tail protection, it comes from cash. It’s hard to get exposure in bonds now with the zero (bound) but in the past you got a lot of ability from bonds, not so much anymore, but you want to be in high quality assets in that sense that can preserve capital or that can pay off non linearly like tail risk protection onthat left tail. The right tail is something much more interesting and that’s how most recently saw that in the in the seventies after the Nixon shock where they devalued versus gold and in that scenario you want to be in, you actually want to be in real assets, you want to be in things like gold. You can bet on the right tail options but financial assets lose the real purchasing power, so that’s the other form of long vol. Now this is the problem is that people’s belief in the stock market and people’s belief in the bond market reflects massive recency bias, so in my in my recent paper I talk about this idea that the last four years were a remarkable period in financial history, the last four decades was one of the significant periods of secular stability an asset price growth ever, driven by this combination of interest rates dropping from 20 percent to zero; this large baby boom generation coming on in and spending; huge reduction in taxes over that period of time; huge ability to export our inflation globally due to globalization and you know it’s incredible, I think it’s ninety-four percent of the returns of domestic equities over the last one hundred years come from those four decades. The period between 1984 and 2007, seventy-six percent of profits from bonds. So you know this is incredible and what’s truly scary is that the pension systems out there have bought into this and have now placed their bet on that model of equity products, private equity and bonds, and are really just leveraged to this tremendous recency bias of the last four decades. But on what will get you through the next four decades of secular shift and secular default will be being able to be diversified in left tail and right tail exposures.

Now I am not smart enough to know which way it cuts, because what’s going to happen is that that’s going to be determined by policy makers. And that’s going to be determined by the winds of social change. I do know one thing though, if they keep doing what they’re doing, which is just trying to inject liquidity to solve the solvency problem, further exacerbating income disparity, we run this ten standard deviation risk, twenty standard deviation risk of a breakdown of democracy.

And I told that to the New York times back in 2017. So you know I’m not scared of the left tail, I’m not really scared of the right tail; I’m scared that they take this experiment and keep going and create a tail risk that you cannot hedge, which is complete civil unrest and we are now beginning to see that. We are now beginning to see that and that’s your real risk, the political risk and that’s also how it can end. You know you can you can have a war or you can have a social revolution. Those are the other less ideal outcomes.

We talked about this in that interview back in 2017 and this idea that volatility, you cannot destroy volatility, you can’t destroy risk, you can only transmute it in form or in time and so what they’ve done is they’ve distributed one standard deviation risks into tail risks. They’ve brought that out to the world pretending like they’re destroying risk, but are doing anything but, they’re just redistributing it in different in different ways taking risks that we can’t even fathom right now. And we’re seeing the result of that just as we talked about many years ago.

There’s been a lot of talk about right tail risk recently and I’m actually of a belief system that given obviously the market is now majority passive, you guys have done a lot of great work with Mike Green and I actually helped to test Mike’s theory back in the day on passive and actually I built my own stimulation that verified the idea that as the markets are mostly passive and becomes dominated by passive investing that it becomes more volatile there’s less alpha for active investors

In that sense we already tipped the scale in that direction and someone can listen to your interview with Michael on that, he can better articulate it than I can. In this framework at the end of the day, you’re going to have massive flows coming out of markets from these baby boomers huge flows that are mandatory you know mandatory redemptions of the 401k’s and IRA’s, on top of that we have this major corporate solvency problem where the idea that we have some of the highest corporate debt in all time. And we’ve put off a lot of the problems with the consumer, so let me give an example on this, we have the CDC that has a moratorium on evictions that runs through the end of this year, you have the moratorium on student loans which runs through the end of this year, the FHA loans. Most people don’t know this, Danielle DiMartino Booth has done amazing work on this. The FHA loan delinquency rates are higher than they were in 2009 but they’re not allowed to foreclose on these individuals, but that runs out in March. So you know some point the piper has to be paid and for that reason I believe we have one more big sucker punch on the left tail one more big deflationary sucker punch coming. And that’s kind of what we saw in the Great Depression as well, where there were these huge rallies after stimulus but I think at that point the social unrest will be so much that we just open up the floodgates and we just do full money printing and we will see right tail risk at the level that we maybe have never seen in America, that people’s great grandfathers know about in Europe. In those scenarios you know let me give some numbers on this about how you construct this; well I think you need that left tail exposure in that next deflationary sucker punch, but when the fed opens up and when they go ahead and make legal tender and they just print. I mean gold vol is at 20 percent, gold vol in the seventies reached 80 percent. I mean that’s the volatility not only the price direction, so if you’re owning physical gold you’re betting on the nonlinearity of right tail options on gold and the vol goes from 20 to 80 and gold goes up 800 percent as it did in the seventies you know in that in that scenario is what happens during the fiat devaluation. You are making money in triple convexity. You’re making it on the underlying movement, which is linear but you’re making it on the gamma of that movement you’re making it on the expansion of the volatility and you’re making it on the expansion of higher interest rates. And we can talk about how interest rate volatility is at all time lows, that’s the other amazing thing, so in the event that they let the floodgates go, rate vol (volatility) should pick up dramatically .

I do think we’re gonna get one more big sucker punch before they will be forced, if I had to kind of make an educated guess, I can’t predict, I don’t claim to have this ability to predict but if I had to make an educated guess I would say that deflation is going to have one more big sucker punch on the left side before they’re politically forced to completely deflate and completely destroy the medium of fiat in order to have a debt jubilee. And I think the presents tremendous opportunity if you’re playing volatility and if you’re holding a balanced portfolio in long vol (volatility) and short vol assets. I think it’s going to decimate the traditional pension in the way the traditional pension fund is situated and it’s going to decimate unfortunately the way that traditional retiree has their portfolio structured.

I always talk about this aspect about volatility during Weimer Germany, I’m not necessarily saying that we’re going to get Weimer Germany but in 1919 volatility was around twenty percent in Germany and by 1923 nominal volatility in their stock market would have topped out at over two thousand percent. What occurred during period if you read the history, every time you come out and the loan would be at five percent and the people they all say my goodness rates have jumped so high and then it would be at ten percent and people say rates have jumped so high and then twenty percent, then forty percent. So I think these trends tend to go on for much longer than people imagine and I think we began to sort of see the signs of that, we began to see a lot of signs of the breakdown of many of these relationships that have persisted for many many years. One was the stock bond correlation break down and I think the one thing that hasn’t got enough press, it has not got enough press, is the fact that stocks and bonds were selling off in tandem in March 2020, and that was causing massive pain in risk parity, it was also causing massive pain in the pension systems and that’s when the fed stepped with a lot of liquidity. Another thing that doesn’t get a lot of attention, I pay attention to it because I trade a lot of gamma which is trend, you know you own an option you own volatility which is vega, but you own gamma which is trend and when we talk about how the flows in the option market are distorting the underlying stock market it’s because dealers are hedging that second derivative to get back to the basis on this but we have we reached in March all time lows in negative auto correlation, but let me put that a different way, all time highs in mean reversion. This is probably the simple way of putting that. Mean reversion in the stock market reached all time highs ever in March, ever after the Fed injected money. And this is after mean reversion was already at historic highs for the last decade.

So what does that mean? It means that a buy the dip strategy in the stock market which is by nature a short volatility strategy, one of the ways that you replicate a variance swap which is a vol bet if you’re short it, is by buying dips, so this idea that if today was a huge down day in the stock market so what you do is just say okay, I’m going to buy after the down day and I’m going to sell after the up day. The profitability of that strategy is based on this idea of mean reversion or we might call that negative auto correlation of negative serial correlation. So each day’s return is negatively correlated to the next day. That reached, that negative auto correlation, another way of putting that mean reversion, that reached the highest level ever, ever, in over 100 years of stock market data. The reason why mean reversion is measured by that auto correlation that reached the highest level in March is because of this liquidity Fed interest rate reaction function. One of the things that we see in markets where the medium of fiat breaks down is that negative auto correlation becomes positive correlation to daily returns. So that means equity markets start trending. That means if today was a down day, tomorrow is going to be a down day, the next day is going to be a down day or if today was an up day tomorrow is going to be an up day, the next is going to be up day, that’s what we see. Guess when mean reversion was at its lowest or put another way when trend was at its highest? It was actually in the seventies after Nixon devalued versus gold. That was the secular high in trend, we reached the secular peak right when interest rates peaked. That’s when all of the turtle traders and trend followers were at their power. Since that secular peak that coincided with the rise in interest rates and peaks in gold we have been on a secular down draft in trend or a decline in auto correlations, reaching the worst performance of trend and the best performance for mean reversion ever. So if you go back and look across history, typically what you see is that when a period of secular growth reaches its nadir, that’s when mean reversion is the most profitable and that’s what occurred during the last great depression, rates go to zero, the central banks have no more money and you have to devalue. During the devaluation process and the inflation process, that’s when you see trend come back in. So in many ways, the way of looking at this, this is a mathematical way of saying this is the transition between a short volatility and a long volatility environment. And all of a sudden when when a trending equity market becomes back in vogue which generally occurs when there is interest rate volatility, when there’s uncertainty regarding inflation and when markets are just allowed, when companies are allowed to fail and actually allowed go bankrupt because when there’s actual creative destruction is when things trend and I think in one way when you see that come back violently that is one of the mathematical ways you can actually measure when this occurs, of course we will we will know through to the policy action. Keep in mind that that trend can occur in either direction.

In a very fundamental way in this very simplistic idea of trend versus mean reversion we take for granted this mean reversion in markets but we don’t recognize that mean reversion as being a function of the interplay between interest rates and risk assets and the Fed reaction function. And that mean reversion that we’ve become so used to and we take for granted; I was just on a panel the other day and people were talking about “oh you always have to take your profits on a vol (volatility) position”, well if you look over 100 years, like a long vol position carried positively for the greater part of that. I actually modeled this in one of my papers, you can show the long volatility positions mainly through the trend component carried positive and by long vol (volatility) I mean that could either be an option on the right or left tail carried positively for most of seventy years, the last forty years have been the anomaly, particularly the last ten. But we suffer from recency bias so the very nature of how financial markets work and what we think about price movement will change if that theory is correct. And that actually causes massive problems for a lot of pension systems and quantitative managers that have really only looked at maybe ten or twenty years history to sort of base their their leveraged strategies on, which is exactly why the Fed needs to inject so much liquidity. It goes back to the idea the Fed gave a select group of massively leveraged hedge funds that I can’t name but I think people can figure out, a de-facto bail out in March you know via QE infinity and this repo liquidity, and this is all the time all the middle class is waiting for a, middle class businesses are waiting for a lifeline. So too big to fail has moved from banks and it’s been privatized.

So the passive component and this is part of the work Mike Green has done, two years ago I wrote about this and Mike came to me said look I’m basing the simulation can you test it for me and I have two hypotheses; one hypothesis is that the more the market is passive the more it should be a volatility amplifier and I said okay that makes perfect sense to me intuitively. And the second thesis in Mike Green’s theory is that the greater the market is passive the more it crowds out active investors. So I said I didn’t buy that second part, I actually pushed back on him, that doesn’t make intuitive sense to me why would crowd out the ability to generate alpha for active managers? Well I built a simulation and came up with nearly the exact same numbers that Mike did that showed both of these both of these elements to be true. The way I looked at it, it’s almost like a drunk guy at a bar. So imagine you have this wrestler he’s a giant and he gets really drunk at a bar and he wanders out to find his way home of course he’s hammered. The result is that there’s going to be a lot more volatility in whatever way he walks. It’s clear. Now imagine you’re an active manager who gets paid to guide him home. So okay I’m gonna give you some money can you help my friend who’s really drunk, just make sure he doesn’t wander off on the freeway somewhere. The problem is that the drunk guy keeps growing and he becomes this giant and the active guy is this tiny guy with no muscles. So that’s what happens when the balance comes out because the role of active investors to act as a volatility buffer you know they buy when things get too high and they sell when things get too low. If these active guys that are trying their best to drag the drunk passive investors home to value but they can’t they’re just dragging along on his foot. They’re not gonna get paid because they’re too small to influence. So the predominance of passive becomes this massive volatility amplifier, now throw on leverage and the options market and tons of new entrants into the market via democratized platforms like Robin Hood and lots of uninformed investors. And Here’s the kicker: Options, I won’t get into the mechanics of it, actually become more volatile to hedge the options market the lower interest rates go. If you push interest rates into negative territory, an option can actually have a higher delta exposure to the underlying, it’s incredible. So maybe not for short dated options but definitely for longer dated options this is a phenomenon. So they’re just laying on anomaly after anomaly on and my God here we are in this Brave New World.

I mean theoretically if you move into a market that’s dominated by passive players and there’s not enough active players to buffer you remove either the bid or the ask. It can go in either direction so this is what I talk about I think you know flows over fundamentals. Fundamentals are dead, the only thing that matters are flows, that’s the Frankenstein monster that they created. Passive investing becomes a liquidity momentum flow and all that matters is who’s putting money into who’s taking it out and then the options market, which is now bigger than ever before now amplifies the second and third order effects of those flows through dealer gamma hedging in dealer vanna hedging and the only person who’s able to backstop that is the Federal Reserve.

They have to keep spending an exponential amount of money to do so, this is the lie, this is the lie, they talk about how the fed balance sheet expansion was important in March — it began way before March. It started in the fourth quarter of 2019, there were cracks in the credit market, there were cracks in inter-bank lending market and they began expanding their balance sheet at the highest rate actually even greater the early 2009. COVID was just an amplifier, so COVID has been a convenient excuse “we had to take extraordinary action because of this”. COVID was an amplifier for a solvency and liquidity crisis that was already coming. And in this flows over fundamental world, the problem is it requires an increasing amount of flooding of the medium, the medium of money in the framework of liquidity. It is extraordinary the idea of lending money to the treasury department the treasury to to set up an SPV to buy corporate debt, this is incredible. It’s absolutely incredible and so there’s an exponential amount that needs to occur and we’re not at that point because the trust in the medium is still there, the trust is still there, people still firmly believe in the medium. But we will be at some breaking point, I don’t know what tail that goes in but I think it could be both as we discussed earlier.

I presented to Jim Grant’s conference in 2012 and that was based on my 2012 paper that talked about the idea that we were a bull market in fear. And that everyone was hedging the wrong tail. In fact there was so much fear in the left tail.

At that point in time, a lot of times when you’re buying volatility you’re not buying vol (volatility) you’re buying what the market’s expectation of vol, an insurance premium and that left tail event that tail risk hedging that left tail event was priced like a standard risk and that left tail exposure was no longer really affordable the way it was pre crisis. The ‘ouroboros’ of risk that I talked about before, that short volatility has unwound and there’s a much better bid in left (tail) then there was pre crisis. That being said I don’t think we’re anywhere near the levels that we were in 2012, in fact what we’ve actually seen is because of these massive liquidity injections we’ve been seeing a tremendous amount of right tailed buy. And what that has done is created, without jumping into the technical framework on it, we’ve seen on a lot of it is very similar to a repeat of the nineteen nineties where we’ve seen a lot of stocks skewed to the right side where people are buying call options in Amazon and call options in Tesla at a much greater degree, the ninetieth percentile level of right tailed skewed buying those names. We’ve seen a situation where are the indices there’s been much more call buying compared to put buying. There’s been elevated equity returns with elevated volatility. And we’ve also seen this phenomenon of spot up and vol up. So this is what we experienced in September and October where when there was a lot of right tail call buying. The way the dealers have to hedge their exposure it creates a framework where stocks and volatility will rise in tandem. This is based on the way the dealers are forced to hedge what are known as the gamma the second order exposure or the vanna , you know I talk about that being like the rubber bands which way the rubber band snaps. So what occurred is that temporarily in September and October the correlation between the VIX and the S&P broke down because of the way that the dealers were forced to hedge all of these call options that they were buying and that becomes very interesting. Now we saw that in the nineties, the main difference is nothing new it’s something that we experienced in the nineties but what makes it fascinating today is the options market is much much bigger today than it was in the late nineties and much more prevalent. So the way the dealers are forced to hedge their exposure has resulted in the perversion in some of the traditional relationships between volatility in the stock market that we see as evidence. We were down here the tenth decile in terms of S&P VIX correlation. Is that a long term phenomenon, it’s hard to tell right now as the market has begun to show weakness and during the last roll-off of options we’ve begun to see a more traditional allocation, there’s been a tremendous amount of hedging around the election. That’s something we definitely saw, I talked on Twitter how that was one of the most richly priced known unknowns in the history that I’ve ever seen. It was seen by the market, it was priced by the market. I believe that you sell known unknowns that you bought and even though the election was very richly priced I know for timing go longer longer out of the volatility term structure and find better bargains. I think to go back to the original question without getting too technical, I would not say we are in bull market for fear yet. If anything we entered briefly into a different type of nineties frenzy where there was a focus on leveraged bets. Now that regime is being challenged and now volatility is not dramatically underpriced, it has come back to a level that’s more fairly valued than it was pre crisis but that left tail is not dramatically overvalued the way it was in 2012.

It is fascinating “ is the dumb money actually the smart money?” because the money that tips the equation. In that sense because the dumb money because it’s so impulsive and comes in with us so much velocity that it actually becomes correct and becomes the smart money and it goes back this Jim Rogers concept at the end of the days then he said at the end of at the end of a massive bull market in the end of one regime I want the ‘old school guy’ who’s been through ups and downs but when there’s been this regime change or at the beginning of the bull market I want the young 22 year old who is fearless. I think it comes down this idea that it’s like smart money has problems with regime change to get another quote on it’s like you know Jim Grant talks about this idea that Wall Street will find a good idea and then turn it into a bad idea.

I was on a panel with two really good colleagues at the EQ derivatives conference and there was a great question from the audience: “if everyone tail hedges and you systematize the execution of the tail hedges and the taking of the money, does that result in a framework where you never have a tail realize or does it change the underlying market, and absolutely what would in that philosophical experiment?”. So in this sense if smart money, you take all these PhDs, you take all this machine learning technology and you optimize to the last ten or twenty years you become susceptible to the regime change that occurs, then you become fragile to that regime change and then when the regime change actually happens it’s the kid who walks in with no idea of what’s going on who’s like let’s just do this because and then if enough of those people do that, it tips the market direction particularly when it’s dominated by passive actors. So I love the question you know it’s the dumb money becomes smart money at the point of the regime change.

It’s almost kind of funny because you have sophisticated hedge funds spending millions of dollars trying to front run Robin Hood and front run Wall Street. I can’t I can’t think of a better living real life example of that exact topic. It goes back to the whole ‘tulpa’ concept. At these moments. where you have all of these actors that are passive and you have central banks of incentivized flows over fundamentals and then you have leverage being applied to that and re-hedging of the options market reinforces all these trends. Whatever narrative. Whatever ‘tulpa’, someone imagines and they’re able to convince everyone else and that becomes the ‘tulpa’ or the ‘golem’, it becomes a real creation. And it’s enough to truly tip the market in that way. And that’s exciting and also terrifying.

Pensions are one of the biggest systemic problems in our industry today and I would climb to the top of mountain and scream it. Now I think there are very smart people in these pension systems but they’re heavily bureaucratic, many times they have a board of trustees they have to report to, in many cases those are well meaning people who aren’t financially educated. This is a disaster that is about to happen, the average pension system is seventy-one percent tied into equity and equity linked products that amount has risen and they have about twenty percent in fixed income. The game plan is that they want to use that fixed income to hedge those equity exposures and they believe that the solution to meeting their 7.25% return target is by layering on more private equity and leverage. In essence they they have a massively short long GDP portfolio that is not hedged by any right or left tail convexity. So I did in my paper the the allegory of the Hawk and Serpent I looked back over 100 years we look at the returns of the average pension system based on data from global financial data over a 100 plus years. It’s incredible, right now based on the rosy assumptions about seventy four percent of state pension systems are under the critical eighty percent funding threshold about one in 10 systems are under the fifty percent threshold but if you go back and you look at the numbers that they actually will get, they think they can get 7% or 8% you know what they’re going to actually get is closer to 4% or 5% and keep in mind these are pre COVID numbers, so based on that what I found is that the majority of pension systems are already effectively insolvent, effectively insolvent right now. And that one third of pension systems have under thrirty percent funding ratios and this is if you adjust their returns by what is a more realistic assumption based on 100 years of history.

Worse yet the systems have no protection against either of the right tail fiat to valuation scenario that we discussed for the left tail default scenario. They don’t have long volatility exposure, they don’t have gold exposure, they don’t have convexity exposure, they’ve got none of this because they don’t want it because it hasn’t performed in the last 10 years. So if you go ahead and you adjust these numbers, right now we see the average pension liability is about $1.4 trillion. But if you expand the numbers to something much more realistic the actual liability is about $3 trillion for US state pension systems and that’s what was the cost of four bank bailouts during the great financial crisis or the entire tax revenues in the U. S. government no actually there are scenarios, these were number these numbers were pretty COVID, there are scenarios where you could see up to $10 trillion of unfunded liabilities. There is no way out of this, these systems are going to default, either default in the sense of not being able to meet their obligations or are going to default in the sense that they’re going to have to inflate away the real value of those assets. I think that eventually a scenario where the states issue pension obligation bonds that are bought by the Fed to close this funding gap is inevitable. This is the only way out that I see, that the Fed will print money, there will be some conduit the way there is with the corporate debt market right now, you will see that with the pension systems, the pension systems will issue debt that will stop gap their funding liability and then the treasury will buy that debt with loans from the Fed, or the Fed will just print money flat out — of course this is an inevitability, this is the great tragedy that is coming down. It is not a tragedy that they could they could prevent this. Because you know I talk about this idea that if you had a portfolio that can sustain for 100 years: twenty percent gold, twenty percent equity, twenty percent volatility exposure, twenty percent trending commodity exposure, and twenty percent fixed income. That portfolio applied in a risk adjusted way can meet the return targets and consistently perform through all market cycles, the portfolio these pension systems have today will collapse if there’s a secular decline and I think it’s a great tragedy and it’s coming.

It’s a social problem too, you’ve got a barbell right, because you got in effect you’ve got the Baby boomers and the other Millennials and Gen, and these are your 2 big segments of the population and I think this is contributing to political polarization. So on one framework a portion of the population is going to want to defend those asset prices at all costs in order to maintain the quality of life in retirement and the other part of the population which is coming in with inflated home prices, no job prospects, massive student debt loads, they are going say “screw it, let’s inflate it away”. This is going to create a generational crisis and a political crisis in the country and I think some of the political polarization we’ve seen, I mean there’s a lot of elements going on there but I think there is an economic argument that comes down to a generational crisis that we have not even begun to see how that one segment of the population benefits from the QE / liquidity policies as the other segment is really getting hurt. This is this this is spilling over into a social crisis and that’s that’s why it’s beyond even an ability to know what happens in markets, you have to look at it from a social angle as well.

I think if you go up to the average person and I think people can articulate they are angry, they have a sense that things are not right. They understand that their lives are harder and they understand that the income disparity is at the greatest level in American history, that’s a fact. Yet they can’t tie it exactly why, which I think is why conspiracy theories are so prevalent in today’s world. I think you know conspiracy theories are just base theorem gone crazy you know over inflate apriori and then whatever confirmation comes in you take an over inflated apriori and then add to that massively, but you know in effect because it’s very difficult to explain the complexity. It is hard for professionals to understand the workings of the euro dollar market, the workings of how the options market affects underlying stock prices, how passive investing does, it’s incredibly difficult for professionals, it requires a multi disciplinary, you know people look at me on as a hedge fund manager but you know I’ve one expertise, in the world of asset management. You need multiple expertise to understand the total picture and it’s almost impossible for somebody to to be able to do that when working as a fireman or working as a teacher, much less if you’re a trustee for pension system overseeing asset allocation, but there’s a sense that something is wrong and that the world is not right and that the economics are unfair and that there’s something deeply perverted and so it makes conspiracy so much easier to accept as a way of having some feeling of control over the economic randomness and chaos.



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