Shownotes
Cem Karsan joins Alan Dunne to chart a market running on more than just momentum. Beneath the surface: a structural liquidity engine, political incentives aligned with asset reflation, and a surge in non-correlated flows reshaping risk itself. As institutions scramble to catch up and volatility begins to rise with price, Cem draws on lessons from the late 90s to explain why the real story is not about valuation - but positioning. From AI’s misunderstood impact to the growing role of options, gold, and crypto, this is a portrait of a regime defined not by fundamentals, but by reflex and constraint.
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Episode TimeStamps:
00:23 - What has been on our radar recently?
02:00 - Industry performance update
03:07 - Are current valuations a sign of a bubble?
12:13 - The importance of reflexivity
18:59 - The move towards non correlation is upon us
22:55 - What is driving up asset prices?
26:34 - When will the supply/demand imbalance normalize?
31:56 - Reaching an uncontrollable situation
35:47 - What are markets showing us about options?
39:38 - Precious metals is the place to be
42:26 - Is AI actually the game changer that we all expect it to be?
52:07 - Will better technology = better performance?
56:03 - A timeline for possible risk dates
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Transcripts
You're about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor series.
Alan:Welcome back to the latest edition of Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It's Alan Dunne here sitting in from this week, who's away. Delighted to be joined by Cem.
Cem, how are you? How's all in Chicago?
Cem:Doing great. Fall in Chicago is always beautiful. So the leaves are changing colors and.
Cem:The kids are back to school.
Cem:So yeah, things are good.
Alan:Good stuff. Noticing any impact from the shutdown or not yet?
Cem:Not really. Not really. I mean I. More like here in Chicago, the ICE agents and you know those, those things don't seem to have shut down at all.
Alan:Okay.
Cem:I went to Wrigley Field yesterday and there were helicopters circling from ICE agents. It's really kind of a bizarre situation.
Alan:Okay, wow, interesting. We like to kick off with asking what, what's on your radar since you've been last been on? What's. I mean plenty going on.
There's no shortage of things to talk about. Anything standing out.
Cem:Oh, I mean obviously you can't really ignore kind of some of this the political, I hate the word political because it's not really political but the governmental changes that we're seeing. So I think that's starting to. Markets don't care about that until they kind of do.
And I think those are starting to have structural effects and I think that's all going to really accelerate here into the midterms next year and I think people will, markets will increasingly probably focus on what's going on there.
Alan:Okay. But I think that's definitely part of what we will get to as we go through the conversation.
But maybe just to kick off, set the scene, give a quick recap on performance. It's kind of positive month for pretty much everything.
We're seeming to be in the midst of a bit of an everything rally and fortunately Managed Futures CTA is participating as well. So in terms of trend following and managed Futures performance on the month, soccer CTA was up 3.82% leaving it down 2.66 on the year.
SocCen trend up 5.66 on the month leaving it down 2.32 on the year. B top 50 up 3.5% on the month and actually positive on the year 66 basis points.
And the Short Term Traders index was up 1.4, but still down 5% on the year. I mean, outside of that, as I say, it's the relentless ongoing rally in equities. The MSCI World up 3.3% and the S&P 500 up 3.6%.
The real standout, I guess on the month was gold up close to 12%. And it's been about see a phenomenal run in gold. And I have a feeling that's also something we'll get onto.
But I know one of the topics, very timely you wanted to talk about was bubbles.
And when you look at those numbers, I mean, okay, maybe the equity numbers this month are strong, not exceptional, but we're just seeing relentless gains in equities. We do hear talk of a bubble from time to time.
Maybe not as much as we might have in the past, but, but I mean, how do you characterize where we're at in this bull market now?
Cem:Yeah, so I've, I've always used the analogy that, you know, to be, for, to be clear that valuations are, first of all, valuations are not a, a good timing mechanism. Right. There's a lot of research that says fundamentals have zero predictive value over any period less than 10 years.
And that's like, you know, that blows people's minds whenever I say that. But now over 10 years, it does, it starts to become much more predictive.
And the way that operates is, is, you know, markets are a function of liquidity. I've used the analogy that, you know, you're on an airplane, how far off the ground are you?
That's the fundamentals, you know, so if you're at 60,000ft, that doesn't mean you're going down, but it does mean that when the gas stops going right, that there's a long way down. And, and eventually, you know, if you wait 10 years, long enough, the gas runs out. At some point, something happens.
And generally when that happens is when the mean reversion to fund like fundamental values happen. So I, I, I really, really think of valuation as a risk management tool.
Okay, so bubbles happen and they're going to happen and you're going to go to crazy heights because it doesn't, it's not what drives fundamentals, is not what drives the outcome. And so we shouldn't be surprised that we're here again.
k I, I will say a naive me in:Make the same mistake again. Here we are. And it's not a merely a mistake, right.
I want to be clear just the way markets work, you know, I've learned a lot in the last 20, 25 years.
And, and, and the reality is, you know, you've heard all the, the, you know, the, the sayings like, you know, markets can stay irrational longer, can stay solvent. It's because it's not really irrational. It's, it is. Markets are rational in the sense they just operate based on supply and demand.
And supply and demand often, actually most of the time has little or nothing to do with fundamentals. And so here we are, right?
You know, and what's driving the supply and demand record structured product issuance, short interest, so that that structure product issuance compresses volatility and allows for a lot of these other flows to move forward.
Short interest, a lot of that from the size and growth of hedge funds and a lot of lot more kind of relative value investing out there on top of that.
You know, we've talked about this before, but there's a momentum releveraging effect not only from passive investing but, but from all investors who operate with massive leverage. And that leverage has to means reinvestment on a gunko basis.
You can add these all together and if the market stays under control with the volume compression kisment, we're just going to apply it higher. Lastly, I talked about the top. You have an administration that is super incentivized to keep pushing that gas and providing that plane with fuel.
And so at some point they may not be able to. And we'll get to what those instances are and what drives the final end the, of a, of a bubble.
But you know, this in my mind is 98, 99 and, and you have to play accordingly. And the way you play that, you know, I was fortunate enough to get that experience early in my career is incredibly different than any other market.
And there is a ton of real edge by playing the distribution, which is really mispriced as a function of, of those realities that supply and demand imbalance at the end of this bubble. So we can dive into that if you'd like, but there is.
Alan:Yeah, well, good starting point. I mean the late 90s analogy is always interesting and it, you know, obviously fairly obvious in some respects.
orrection this time around in: We've had another one in:I mean there are differences from a macro perspective as well. I was talking to somebody this week about it. You know, the deficit is one big difference.
or:And I mean what came with the IT spend in the late 90s was that productivity boom. It was for real. I mean growth was much stronger this time around. Growth is solid, but it's not as strong.
And productivity has been kind of up and down. So definite parallels, but some differences. I guess you're zeroing in on the market dynamics as the major parallels, I guess. Is that fair to say?
Cem:Yeah, yes. I mean I'll add to what you said. So the same and yet different the inputs for a bubble to really get to these heights is a liquidity push.
And in 96 we had the lowering of the natural rate of unemployment and Greenspan coming in and really changing the liquidity dynamics. Here again we have a historic change in how we provide liquidity.
We're getting a, a loss of Fed independence and a takeover of the Fed and a willingness to do, to do something bigger and different and do it proactively regardless of the inflationary kind of outlook as well. So those two are parallel. Nothing you obviously need is a narrative.
You need a narrative that is by the broad mass people are able to at least suspend some historical reality, are able to say this time may just be different. You know, the Internet was big enough for people to say, well this time this may just be different. Well guess what?
AI is big enough for people to say, you know what? AI is different. This is going to change. You cannot use the same rules.
Okay, we have those things and that's why, that's a big part of, of why we're here at, at the core.
But you also, this time to your point, have actually more risks, well known risks that, some of which you mentioned a deficit again, we were in a budget surplus in, in 98, 99 2. We had just become leaving the United States and the west broadly had begun become the world hegemon. You know, the USSR had just fallen apart.
There was no rival in terms of economic strength, military strength, anything. So the US had absolute control. In a sense, I think it's safe to say that's not where we are today. Right. So there are some big differences.
So given those risks, it's actually even more, I don't say concerning but you know, you have to look at this and say how do we get here?
And the answer is more absolute control from government than we had back then and ability, despite those risks, to, to yield a much bigger, you know, set of tools to keep things going.
And lastly they have the help of a very different and changing market structure because of those risk and, and those things we can get into, I think they're very important, but they are again, you know, the structure, product issuance and the, the move to other, other vehicles and more non correlated things. A lot of things that you and I talk about, Alan, that are driving actually ironically, reflexively a market support as well. So, so yes, very similar.
The things that drive it at its core are the same, but the risks and the things counteracting those risks are bigger. I often talk about a sumo market, right? A market where you could have two tectonic plates or two sumos pushing against each other.
That doesn't mean you're there. You know, there either is going to yield or something is going to happen right away.
But it means the potential energy, for once something does shift is dramatically bigger. And that's the environment I think we're in just.
Alan:I mean you mentioned the word reflexivity or reflexive, which I think is really important in these scenarios because obviously we know about bubbles and feedback loops. And you know, Soros had this reflexive theory about which encapsulated the idea of feedback loops.
But even more than that, that market participants have make an error in their judgment and because they misinterpret or don't see kind of a fundamental flow in the argument, the market continues higher and that improves the fundamentals until they see the flow. I mean, do you see something here? Is the flow the AI spend or what do you think?
Cem:100%. So the idea of reflexivity, we could probably do a whole episode on that. It's so important.
You know, Soros talks about it in real generalities, but there is a practical, measurable, that's a lot of what we do on the dealer flow stuff we talk about, right? There's a Measurable reflexivity. If you think about it, it's actually very logical, right? The biggest provider of liquidity in markets.
And we, we know markets are about supply and demand. So if you really want to predict where markets are going, try and understand the supply and demand dynamics, right?
And the biggest and most predictable thing in supply and demand, the market, is the potential buyers and the potential sellers and weight, which is positioning, right? So if the world is long, guess what that means. You have a bunch of sellers and not very many buyers left to buy, right?
And if the world is short, you have the opposite. But the same applies to options. So if everybody's hedge for a 3% decline, but not a 7% decline, guess what?
The 3% decline is probably not going to come. And if it does, you're not going 3%, you're probably going 12% right there.
The, the realities of positioning are, by definition, potential energy for the opposite. And that's what reflexivity is at its core.
We can talk about ideology and philosophy and all these other things, but if you want to actually understand the mechanics of it, it's whatever the way people are positioned. And that's what a wall of worry is, right?
Again, if people are worried, that means they're underweight the market, which a lot of just recently happened, right? They're worried because of the risks. And I, not surprisingly, that can lead to people being forced back in.
And that's exactly what's happened throughout the summer. And, and it's likely to happen into the end of the year as well. So that concept reflexivity, when you really boil it down, is actually quite simple.
You know, if something swings one way, guess what, it has a better odds of swinging back the other way. And, and it's not just because of the swing, but now you have potential energy, right? Because it's also in another direction as well.
So, so, so critical. And, and in this environment, I can give you one really interesting example of reflexivity that's really driving.
We've talked about structured products, and this really ties into, you know, may take us over to precious metals and crypto and stuff as well.
But there's this massive thing happening which is there is a, you know, $500 trillion long market which has expanded in, you know, dramatically as the markets have gone up. That expanded and we've gone into this bubble, right? We get, we get long and, and we get increases in these valuations as we go.
But meanwhile, everybody's getting to a valuation where they're starting to look around and they're starting to See the risks and say how do I diversify? That's a lot of what we talk about here, right? But that's been happening for three or so years since 22.
And people, because people saw that correlation breakdown, stocks and bonds, they're like well, we don't have any diversification. What do we do? And you tell me Al, and how do you diversify away? I mean we, what are the ways? Right? That's a lot of what we do.
And there's small doors. The reason people do stocks and bonds is because they are very liquid and very easy to implement.
But in our world, right, you, you need, you need tools, you need, you know, it's harder to, to deploy diversification. And what that's led to is a boom in the last three years in our broad business which is, you know, non correlated strategies.
Um, hedge fund assets have gone from two and a half to four and a half trillion dollars in just three years. By the way, it's very stable two to two and a half for quite a while before that. Yeah, you've seen a growth in structured products.
Again non correlation.
It's the use of options to get some type of other positioning other than just long the market and you know, and short bonds and long bonds and ultimately that has gone from 500 billion to 2 trillion as well. And so, wow, okay, these are all.
Alan:Growing in structured products.
Cem:Is it in structured products, quadrupling of size, of annual issuance in three years.
Alan:Where is the, is that just as you say, a diversification flow or where is that money coming from?
Cem:100%. It's a diversification flow. I mean it's coming from primarily a retail world through RIAs, through the RIA channel.
But, but these have been huge, you know, investments in Asia as you know, for a long, long time. And those flows from Asia continue to increase. But now the west is waking up to them.
And the west is waking up to them because again, how do I manage, I mean it's the big question everybody's asking, how do I manage a bubble?
How do I manage when valuations are like this and, and, and by the way, at the same time that interest rates manage not help me, you know, bonds may not help me, how do I manage it?
You know, and the answer is you can use options and I talk about a lot in different ways to structure more capital efficiently and more non correlated. And that's what a structured product is.
It's taking options positioning, making it an easily translatable kind of oh, this is my payout, which is different than just long. Right. And it's allowing people in RIAs to kind of diversify. So 100%, that's where it's coming from.
And again it's the same thing that's getting people into hedge funds. Right.
Alan:But generally, but generally on the searcher product side they are kind of autocallable type structures or more selling volatility than buying is. That's very correct. Correct, yeah.
Cem:And, and by the way, in that 2 trillion people, a lot of people like where are you getting that number? It also includes ETFs issuing similar structures.
I'm also including like buffer products, all kinds of things that are essentially the same thing in different wrappers. And so those are each growing. And I want to now tie this into another dynamic which is similar but different, which is.
It's also what's driving precious metals. It's also what's driving crypto at this point. And so. And it's not a coincidence that. How much increase of assets have we seen in hedge funds?
Okay, about almost a doubling. How much have we seen an increase in structured products? Almost a quadrupling.
How much have we seen in the increase in the valuations of precious metals? A threefold increase. How much of a valuation increase have we seen in crypto last three years? About a threefold increase.
If you take all of those assets by the way, and you sum them all together, all of these non correlated, whatever you, you know, however you want to look at them assets, some type of a way to offset risk and concerns about your long positioning. How much do you have? Four and a half trillion. Two trillion. Gold is now about four and a half of.
There's seven and a half out there, but most of it's in vaults, let's call it four and a half is what the liquidly available is. Right. You know, that's 11. And then crypto is another four and a half or so as well. So about 15 trillion dollars.
We kind of generally throw our hands around it versus 500 trillion on the other side. And people keep asking me what was the precious metal kind of thing, the crypto thing, like where are we?
Are we almost like look, this is a tripling, this is crazy. How could this possibly go further? You tell me, how are people when they really. And by the way, this is that market with markets at all time highs.
And everybody's saying well you know what happens when the real kind of we see a 22 but worse in some ways in one way or another. Right. You know, and so, so the, the move towards More non correlation is, is upon us. It's happening.
I would say we're in the second or third inning and you know, likely a decade from now all of those assets will have much more. Now the 500 trillion also might be lower. Hard to say. And you also have to look at nominal versus real and all these things as we move forward.
But, but, but I think you know the reality on, on those products, you know, obviously two of those are assets you can buy and benefit from that and that's why those things are also and they're more liquid and easier to access in some ways.
But I think as hedge fund also strategies become more liquid and available, which is happening, I think those will continue to expand as well and then structured products will become also much more available.
You know I have a deep thesis that AI is going to unlock and make a lot of options access much easier and easier for people to understand which we can get into a bit. And as that happens I think access for them and the growth of those are going to continue to go exponential.
And so I think again Robin Hood is doing some of this stuff now.
A bunch of other platforms are starting to really accelerate some of those offerings and simplifying kind of structures that allow people to be more non correlated. So I think that move towards there is one of the biggest themes you can focus on and importantly back full circle to your reflexivity argument.
They question they two of those, you know, and eventually I think crypto as well will have dramatic reflexive effects and, and are on the actual movement of markets themselves.
And so if you want clues onto how this is going to end, it's not just about the bubble and we have a lot of clues about how those operate and why and how they end. But you have to also look at this secular move that's, that's exponential and pretty dramatic into some of these non correlated products.
I think if you look at those two things together, there are some major, major themes and clues to how this might, might end up the next several years and really the next decade.
Alan: e years, say since the end of:I mean I suppose the question is how much is it just people getting more optimistic, bidding up the price of the assets and how much of it has been driven by just liquidity injection. Probably impossible to differentiate between the two.
But I mean part of it is kind of a real found and part of it is just more optimistic asset valuations.
Cem:Yeah. So the reality is the biggest provider of liquidity we talked about the gas in the airplane. Right. Is actually markets themselves.
So this is where the airport, they.
Alan:Need an initial injection to get it going, you know.
Cem:Yeah, yeah. Once markets go higher.
Alan:Yeah.
Cem:They actually create more collateral. Right. So it's a loop.
If I buy a piece of real estate worth a hundred thousand dollars and it goes, you know, and I, and I, let's say I put $25,000 down and get 75% mortgage on it. Well, guess what, if that property goes to a million dollars, how much collateral do I have? I have $925,000 in collateral.
And if I want to make the same type of bets or make the same type of money, I need to put that money back to work. I'm not at the same leverage level. I was 4 to 1 leverage. Now I'm basically went back to 1 to 1.
And, and so the machine creates more collateral which creates more ability to get leverage. And this whole system is leverage, by the way.
I mean people like, you know, most average investors like I just buy stocks, there's no leverage in my portfolio. But the whole system is built off leverage.
You have to understand banks themselves like 10 to 1 levered, you know, from the Federal Reserve and assets. So the whole thing is, is it's leverage all the way down.
And so every time markets go up and more collaterals increase, the amount of money supply increases dramatically. And I just mentioned $500 trillion in assets. Well, guess what, the market goes up 20%. You know, that's $100 trillion more in assets.
QE's got nothing on the liquidity that market markets can or take and also, you know, take away.
And, and that's why as much as the Fed and people say, oh, we don't manage the market, you don't manage the market, you know, well, if you manage liquidity, you manage the market because that's actually the greatest source of liquidity in the world.
It's also why you often, you know, it's, it's silly, the market, you know, you often hear from CNBC or you know, Fox News or wherever you get your, your financial media, like oh, the market is down because of X or Y. But you know, why, you know, you know, the reality is we had a, as you mentioned, late 90s, a boom, right.
Economically on the back of the liquidity driven by markets themselves. And what happened the second the market went down?
The second the market went down, 95% of tech businesses went bankrupt, you know, and had a massive recession. Right. People think the market is a, a result or shows the, the net effect of what's happening under the hood.
The reality is it is more the dog than the tail itself. Yeah, yeah.
Alan:So I mean it, it begs the question, you know, when does the supply and demand imbalance normalize or when does supply start to outweigh demand and, or are there catalysts? Is it just liquidity tightening? Is it market dynamics, market microstructure? How do you think about what, what are the signposts?
Cem:Yeah, so this time, you know, because of the amount.
Usually if, you know, if you have the Fed involved historically and the, and the Fed is, let's say independent, you know, the Fed is more likely to react to an inflationary outcome with redrawing liquidity or markets going too far too fast and the perceived potential risks of what could come on the other side of that. Right. And, and those are often what force a removal of liquidity to start and then you get a slow down the economy which pulls some liquidity out.
And then the big part is the market. You know, reaction eventually can undo the whole thing.
Volatility products play a huge role and increasingly more than ever now, but have always been important in the sense that, you know, involves very well supplied to the market. Despite liquidity being pulled from the market.
It could, it stabilizes things and can allow for other liquidity to come back in and, and keep supporting things.
The thing that tends to happen at the end of a bubble and we're starting to see it now and it's actually a big thesis for me and options land and what we're doing in the next year is you start to see volatility increase into a rally and you see that structurally and that happens because the moves up just start getting so big. Right. A right tail event. Right.
urns and Richard NIXON in the:It's the only real place that government can't fully control if they choose to make a decision. That is they take themselves out of a rules based or Some type of forward looking smoothing mechanism which is what the Fed is put there to do.
And what we're seeing it seems to be a removal away from long term worrying about risks for more financial markets, worrying about inflation. If we're not going to, we're going to no longer use those rules to concern ourselves in the short term. Eventually they will come back and go.
Alan:Back to bite you.
Cem:Yeah, bite you in a much worse way in the long term.
ways happens at the end again:You made money all the way up and you made money all the way down. And so that will unpin markets and then ultimately rise inflation, raise inflation.
And I think we also know just to be clear, people like that why does inflation matter? We can phys. You know the Fed can do Project Twist and keep to long and low without inflation. What's the big deal?
Like that's look, that's the real liquidity. Inflation doesn't really draw itself that much.
And I think we, you know those that are in markets know you can't keep real interest rates that negative or negative really at all for quite a time or that drives even more inflation. That's how you get it to hyperinflation. I don't care if they're, you're in the US government or anywhere else.
You know if we can, if people can borrow money at 3% and inflation is let's say 5%.
Alan:Yeah.
Cem:You know everybody on the planet who has half a brain, every institution, every investor is going to go borrow money at three and buy the thing that's going to appreciate at five and they're going to do it with leverage. And guess what? That doesn't mean the thing goes up 5% now it goes up 7% and now we go in a loop the other way. And this is what happened in the 70s.
We've seen this throughout history and lots of other places. This is why the Fed is so sensitive to inflation and why they have the mandates they do.
And so we can whistle by the graveyard and ignore those realities, but at some point that, you know, that is, that is the ultimate check. And so my guess is that that's one of the best hedges you can do out here right now.
And to manage this is, you know, is to buy, you know, the, you know the problem with break evens is they no longer, you know, the inflation numbers themselves are controlled but by, by things that are actually going to hedge against inflation again. That's why we're also seeing the, the basement trade in precious metals and crypto as well.
Alan:Because it's interesting, a lot of people out there might say oh, end of Fed independence or Fed independence in their mind that's not good for the U.S. i don't want to be in the U.S. market.
But actually as you say in the short term that means asset reflation as a means of priming the economy and boosting asset returns heading into here of the midterms. But that goes for only so long. And you see inflation has been the thing that breaks that.
Cem:Correct, that's exactly right. In the short term control, full control. Right.
Of the administration who is incentivized for, you know, for number go up especially into a midterm and a. And then eventually also presidential, presidential cycle. They are short term focus.
They don't what happens in 10, 20 years may or may not be their problem. They'll deal with that problem when they get there. And so the incentive is very short term and you know, guess what?
They have absolute control or increasingly so. And if they do, then they get the outcome they want. It's that simple. Until they can't control it anymore and they're getting to an increasing.
They will eventually get to an increasingly uncontrollable situation.
Alan:Yeah, well that's the, that's the kind of irony about all of this. It's, it's just the, the cycle how you get these broad structural shifts because of what's happened in the previous kind of regime.
We had central bank independence that central banks fought hard to achieve which resulted in the great moderation and low interest rates came down and they came down so far that central banks and governments started to borrow excessively. And now people are happy to give up that central bank independence and the inflation fighting credibility.
But it's, it's hard once you lose it it's, it's so hard to get it back, isn't it?
Cem:That's exactly right. It's, it's short, short sighted, short termism, you know, and again it's all about incentives. Like guess what?
The administration itself doesn't benefit from any. The difference of the what where things are going to be in 30, 40 years. They benefit from what's how things are going to be now.
And so that short termism is probably the biggest problem that faces the world in general. It's true for corporations, it's true for so many things.
And, and candidly, yes, if you're predicting markets, as we said, it's not about fundamentals, it's about supply and demand and control tells you who the big bully in the room who can push demand is. And, and, and you can have confidence that's going to be the case regardless of the long term realities. That said to your point, trust, right?
You know, I tell my son all the time, you know, it takes a long time to build trust, it takes very little to lose trust. And you know, we're entering a world where we've taken a long time to become, you know, a bit more kind of the almost.
We can almost all laugh when we say shining city on a hill, but there was a point, right like that was at least a view that democracy and all these things were, you know, were something special.
And, and then people, you know, came throat, you know, came in large amounts that come and work and build a life and do things in what that was generally considered a fair or nothing life is not fair, but fairer place and way. And not to wax poetic, but like I think it's fair to say people, you know, myself are a bit cynical about that these days.
And that's I think just the beginning. People lose that faith, you know, the whole breakdown and the thesis for, for why it works breaks down.
Alan:And from, from an options market perspective, I mean you talked about the right tail, you talk about the upside, obviously people are, everybody's thinking about the downside from a hedging perspective. But as you say, we could see higher markets, higher volatility.
What is the market showing in terms of how, what, what, what SKU has been correctly priced and what is not.
Cem:So we started talking about this a couple months ago as being the next big trade, meaning year multi year trade. And the last month it has exploded higher and I think we get first inning on this one.
And this is again long dated calls are dramatically underpriced relative to the risks on the right tail I mean take the debasement trade I just told you, right? Just from an inflationary perspective, the right tail is underpriced. Now take the supply and demand dynamics I just talked about.
And institutions are net short and you know, liquidity is coming in and squeezing kind of all that. Not to mention the growth of structured products. We're in the end of the year, institutions are underperforming.
I mean there is, I could name 12 things that mean the supply and demand imbalance, the right at you, you know, is dramatically underpriced. Meanwhile, we're entering a bubble. And a bubble by definition is leptokurtic, not just a right tail.
Eventually it leads to a left T. And so if you want to manage your risk with the world massively long and try and diversify, you could argue gold and precious metals and crypto are no longer cheap, right. We can argue hedge fund strategies have their problems.
or four, six months out on an:You know, be, be short all that downside, left tail, right be underweight.
By the way, the right tail, when you can just go replace that with the cheapest part of the distribution in general and particularly in this environment, which is the right tail. So add on the money calls and you don't have to do it in the S and P. But there's a million other, there's million other equity ways to do this.
But calls are underpriced. And that's what we're seeing by the way. We are seeing market up, volum market up follow up.
, think if you came around in:Nobody, I don't think say has, you know, hasn't been here that long, has seen a continuous long standing move. Meaning a year or so of of that type of general action and it's actually in the vault space one of the easiest ways to make money.
So you are, you are fortunate to be at a time where you getting a credit in a way to hedge and improve your outcomes. And if you don't take it I think you know that's on you. But, but yeah. Why at this point you know I'd much rather have a 12.
It's been very profitable already and will continue to be a. A 12 Vol out of the money call with leverage to outcomes and and and not only that left tail at this point.
So stock replacement, you know easier way for people who are you know if this sounds too complicated, you know replace your stock with calls. That's a much, much better way to play this in the next year or two. Not financial.
Alan:I know we've talked about this before with respect to gold but that was probably, probably but 50% lower from here. Now that we've had this phenomenal rally this year how is that market looking in terms of the distribution?
Cem:So the.
,:But most people don't realize it was also the most volatile asset during the that period and not just because it was upside volatile. It had a two way volatility to it. And that's logical. We've been talking about this for several years Al and you and I might have talked about it.
But the, but the you know everybody's focused on equity Vol. The best performing asset you know in a debasement era or a period of bigger structural inflation.
Alan:Yeah.
Cem: es. You equities went nowhere:So you have the push pull on a nominal basis that drive net less volatility more long. In a long term basis you have crisises so there's a role for the things that did incredibly well were FX obviously interest rate law.
But FX and precious metal and they're the same thing if you think about it FX and precious metal are integrally related. Like you know precious metals are a currency. Is currency. Yeah yeah.
And so yeah if you want to, if you really want to Find hedges or find secular opportunities in this environment. That's where you should be looking at precious metal volume crypto. So I bring that full circle to what's, what's crypto going to do?
Crypto is going to continue to perform well but it is not going to be a straight line and it has been a straight line, you know, so. And in the short term it could still very much go vertical and that volatility could continue.
But similar to me how I was talking about the equity upside volume in the short term I think you know calls are a lot more expensive in gold now. But they're the. I would say volatility broadly is, is still cheap relative to what we've seen historic.
I mean relative to we've seen in other periods like this. Again if you look at over past 40 years you'll say Jim, you're telling me to buy this gold volume crazy law.
But the dynamics that are in play are going to make this a very wild ride.
Alan:I know you had a couple of thoughts around AI and a couple of themes related to that. Obviously it's topic that everybody's focused on in terms of a major driver of the market and thinking about is the spend going to be justified.
I suppose has been a big theme in relation to the hyperscalers and technology firms. I mean I know you see it having some impacts both kind of on a trading perspective that could be quite meaningful.
Is it going to be a game changer that's going to add value do you think on the trading side?
Cem:100% but in ways people are not betting on and that's an opportunity. I think the way people are betting on AI is very one dimensional. It's very kind of first order thinking.
And by the way the same thing that happened in the 90s, the, the you know the first order thinking in, in late 99 or 99 was well you know the Internet's gonna change the world. So go buy the companies who do all the real world things on the Internet.
You know like go buy socks.com because you know what they're going to take over the sock business. Guess what? You know all those companies are bankrupt and, and lasted only a year or two after the bubble. Right.
And that's not who ultimately ended up winning actually the who the winners would end up being. We had no idea how that evolved. That would evolve and from you know search and then eventually right.
We were ISPs were, were trading at crazy multiples. I don't even exist anymore. So the point here is there's a lot that we do not know yet in terms of the evolution of AI itself.
And honestly we don't need to play that game because a lot of that will get commoditized. I would argue that, that, you know, the value of AI and the profits of AI are actually probably not going to accrue to AI itself.
That becomes a commodity at some point. Think about the real world. I mean, we have lots of bright people all over the world. I, I, a lot of people are a lot brighter than me.
I'll tell you that My value that I am able to provide, which in theory has like real value, is not intelligence. It's my, my history, my knowledge of my, which is very unique, right? And that unique experience intelligence can then use to create real value.
So data sets, unique data sets are going to be incredibly valuable, particularly in places where that data can be used to generate efficiency or more, you know, new ideas, new new technologies and things there. So, you know, the data itself is being dramatically undervalued. And then lastly the inputs, right.
At some point the, the thing we can have great confidence in is don't know where AI is going, but we know what its inputs are and what it needs to succeed. And, and this is where kind of energy and power, you know, come in. You know, and the data again is the other kind of input.
So, so that's a real focus for me broadly with AI.
The other, the other big focus more broadly with, with AI is, you know, if you think about, if you think about this, you know, who's going to be the next platform? Right? The, the intelligence itself will be commoditized, like the cell phone itself is commoditized, right?
Like, but Apple is a tremendous stock because they were able to lock in kind of a platform that everybody didn't want to switch off of. And so the question is who's going to be the big AI platform? And, and that's, that's hard to judge. And there's a lot of different places.
I have my opinions, but my guess it's the one who controls data again for individuals and for companies or manages a security of data. Right. And I think that's again a critical theme. But what areas? So like, let's go a step further. What areas?
Where is data unique data sets available and where is the greatest potential for taking that data and creating, you know, a value? And one, I think that one of the word, ironically, one of those areas is the cheapest area in markets or one of them, period, which is healthcare.
You know, it's a science. It is the science and it is the place with some of the greatest costs, particularly here in the US on the system. Why is it so inefficient?
I don't think many people ask that question, why is healthcare so inefficient? It's a science. And the answer is we have very strict rules around healthcare data.
Data is locked up, sequestered in very unique places and very hard to access. If we didn't have data privacy around healthcare, guess what? We have no data privacy really anywhere else.
But we oddly really think our healthcare data is critical. And I'm not saying it's not like I think privacy is super important in general, but we've, you know, we've kind of already gone over that.
You know, I think we've, we've skipped over that. And, and, and so my point is HIPAA aside here in the US and, and regulations on healthcare privacy.
Otherwise there are places where that healthcare data is, does exist and can be used. UnitedHealthcare, for example, is one of the greatest owners of healthcare data in the world.
Oddly they're, they're worth, you know, not so much right now. And, and I just, I think there again it's not necessarily and people want to say AI, it has to be an AI play, it has to have AI in the name.
But really what you want to start hearing is who has data in the name, who has unique data sets in their name. And I think that could be a real theme that people could start to catch on to here in the next couple years.
But the reality is that's also those things are cheap and have much less downside. So I think asymmetric things like that are really, really critical.
Another place, and this is more my domain now is new technologies or things that are complicated or are having a hard time, are better technologies but are having a hard time with getting distribution to the world because they might be complicated. They need a translation. There's a bunch of different things like this in financial markets and this is kind of what you're alluding to.
Options, right?
Options are, we've talked about this at length and people about, you know, four or five years ago I started saying this that you know, kind of got a lot of crazy looks like options are the true underlying in the sense that they are not a two dimensional up down. They're not just an expected value of a distribution. They're every moment on a full distribution of any and every asset in the world.
It is, you know, like taking trading from two dimension, two dimensional world to a three dimensional world. It is superior. It's not like now people. It's confusing to people because you're dealing with three dimensions instead of two. And guess what?
That needs to be made more accessible so that our minds it can be more logical, more easy to manipulate. Take what's in my mind and what I actually want and translate it to how to get more precise positioning based on that information.
And that's happening and that's going to happen in spades the next year or two. I think options will become much more accessible. I kind of liken it to electricity.
When electricity was first found, discovered like people were terrified by it. This incredibly powerful thing, you're not going to bring it into your home.
People still use candles at home for many, many years and it was really hard.
They had to standardize and find a way to translate this powerful thing into just a simple thing that people just plugged in something and never worry about it. And there's a million technologies that do this. Actually most technologies need this. They need a. They're. They start in the raw and they're true.
Truly worth a great value. But you got to hit get network effects, you got to get to translation mechanisms and.
And this is what's happening and it's already been happening options market. But AI unlocks that so quickly because.
Alan:It really winners in that. It's just again it's the platforms who embrace that and build a user interface. Is that it?
Cem:Anybody who is involved in options, period, it is a taking over of that whole market. It is also by the way accelerant to those other things I talked about to moving to non correlation. So the.
I wouldn't say the structured product industry but those who step in and provide those at cost. Right. Or at you know, which could be the exchanges themselves, which could be the brokers themselves.
I actually really like brokers brokerage exchanges because they're also not inflation sensitive. There's no input increase, profit margins increase in times of inflation because revenue increases and costs don't. So.
So you know, brokerages, exchanges deal particularly in the alternative space. Any educators, people who enter this space and become more involved in it more broadly.
Again technology platforms that help again with this translation and importantly you could divest in the actual assets as kind of his first order. But there's also market effects that are going to drive come based on the. The structural changes in markets going forward too.
So those that that trade in these are market makers entities that trade in these spaces. What will benefit as a function of this.
Alan:So it Sounds like, you know, with, with those types of things obviously the gains accruing to those with the best technology who have already the resources.
Is that a reason to think it'll be in our business that the pod shops, the bigger houses that already have are the QRTs, that the ones investing massively in technology will just continue to get bigger? Is that the implication?
Cem:Not really. There's a push pull, right? Because you're, the edges are decaying because AI takes away some of the, you know, the value of, of that knowledge. Right.
It's no longer a, you know, like as we're talking about data set. Your data sets kind of becoming commoditized.
That said, you know, you have a massive early on you're going to have a tidal wave of new entrants who are, you know, just using AI and less sophisticated and, and entering a space and that might create more bid ask spread in some ways as well. So I think there's a push pull. I mean it's no different than since the beginning of time and, and markets and options.
You know, I started in the market we had, you know, dollar wide markets and S P options that was very profitable. But guess what there and by the way that was more segmented, you know, marketplace because a lot of people could just go do that.
You didn't have to be that sophisticated to get a bit aspirated. Nowadays though, the volumes are through the roof. Right. And the edges have come down.
But a lot of entities that they're sophisticated enough who are making more money than ever. So, but, so I think the winners and losers will change, that is for sure. But I do think it will in some ways be, be much more profitable.
And if you're playing it from a much more, you know, you know who's going to win is people like ras who are taking advantage in this trend early because that whole industry in my opinion is changing quickly and got $500 trillion. That's one of the biggest industries in the world. That's a place I'm playing in and trying to be part of as a function of that.
So I'm kind of talking my own book here but I do think there are tremendous opportunities for that tidal wave from just two directional world to three dimensional. And that transition will be made much easier through AI and other technologies.
Alan:Well, definitely that's something I'm thinking about. I mean increasingly I think we will see a blurring of the traditional and old investments.
I mean it's already happening and over time I would expect it to accelerate and what you're talking about, obviously with options trading would accelerate that. I mean it maybe not seems like hard to believe. A lot of we get even more retail participation.
We've already seen plenty of retail participation in the options market, but I get in the US so I guess we could see even more.
Cem:Yeah. And when I say retail, I, you know, retail is actually relatively small. I mean it's gotten big, but relatively small relative to.
Because when we say retail, we're talking generally smaller traders. Right. Like yeah. Or big smaller numbers. Right. Robin Hood's averaged account size of $4,000. Right. Correct.
What I'm talking about is RIAs and the big pools of assets. And that is quote, unquote retail. But that is not a small pool of assets. That's the biggest pool of assets in the world.
And this is why again, ETF issuance with options in it, for example. Right. Which is a kind of a. I don't think that's necessarily the final step I think there.
But that is a trend that's going to just keep going exponential. We've gone from 20 billion billion of those just three years ago.
I'm talking about the most vertical trend to 300, sorry, 20 billion to 300 billion there in just three years. You know, that's not a 3x right. That's a, you know, 15x. And I think that type of growth there is just getting started as well.
Alan:Conscious of time. And I wanted to get your perspective on, you know, how the kind of the timeline looks from here in terms of event risk into year end.
Obviously, you know, speaking to you before, you'll often talk about the summer period volume compression over that period. Now we're gone beyond that.
We've got some, obviously we've got the Supreme Court starting to take arguments on the tariffs and I think in November and there'll be a ruling sometime after that. So that's obvious risk around that.
But I mean, as you look kind of next number of months, have you mapped out a timeline in terms of possible risk dates?
Cem:Always. And it's easier to do.
And the reason seasonal patterns don't really care about, you know, what's happening in the government or what's happening in XYZ is there are structural pressures that drive outcomes much more and particularly at the end of the year period than than the headlines. Now the headlines can affect things that they're big enough. Right. A nuclear bomb goes off in New York, there's going to be a market reaction, right.
China Bates, Taiwan, there's going to be a reaction that said, you Know, in the absence of some massive left tail event.
And even I would argue in the context that, you know, we've seen many situations where those happen and the market still does its thing until those flows are gone and then it reacts. Think Covid, right?
Like we knew about COVID in December, but, but you know, we didn't get a decline till, till February because the flows, you know, February opex to the day because of those flows.
So, so I, I prefer to talk about the flows and particularly here in this period as we enter October and start looking forward to the end of the year, I want to reiterate again, it all goes full circle here. Structured product issuance is dramatically bigger than it was last year. Hedge fund long short equity is significantly bigger than it was last year.
And those are also our. So it's not just seasonal. Oh, every year that XYZ happens, these effects are getting bigger. Okay.
And this year we also have a, now beginning and heading towards the takeover of the Fed, which is coming in May for in full for next year. And markets already know it, Portland markets already know it. So it's already kind of put in place there. So liquidity is coming.
It's already on the way. And unlike, let's say last year and most years, institutions are caught underweight.
So you have a recipe here of supply and demand dynamics that are not in your favor. This is a bullish period in general when markets are up. Why is a bullish period? General markets are up. Markets are up 15% for the year.
You have 5, you know, 200 trillion of equities. And so they got a $30 trillion input and about 10 or so percent of that at a minimum goes to work. Jim. $130 trillion, 10%, $3 trillion.
The average amount that moves markets on a daily basis daily is about 75 to 100, let's say a hundred billion dollars. I got a $3 trillion buy order that's sitting there January 1st.
Is it a surprise that the Santa Claus effect and the January effect together, those four weeks are the most positive four weeks, month of the year. No. And so an up market, the more the market's up, the more that the drives up. Okay, so that's, that's one. So that's sitting out there.
It's still January 1st. You know, we're in October. I get it. Like that's a lot of to play that trade now, but it's sitting out there.
And we know institutions are underperforming. That January 1st deadline presents a, A, a problem. Right.
They need to get into the year, people start looking at their statements saying wait, how much have I made? How much have I not made? Do I want to stay invested? And those decisions come up and guess what? You got to start.
You know, given these dynamics, people can't wait. That's why you keep seeing the consistency of this rally as we push into the end of the year.
An institutional position was at the 0th percentile in July and Jude sir, now it's up 25th. Dramatic move. But you still have way to go, right? And they're under, underweight.
So like you can't catch up by being even weight, you need to be overweight. And so you have those dynamics at play. And now you have structural poly issuance which is bigger than ever.
And we saw that this summer, we saw it last summer. And what that does is that drives compression in general.
But during a September, October period, or May, maybe even August, when, when there's more volume and things going on, it has less of effect. But what happens when volumes get cut in half and people start shutting up shop?
Well, that structure product ISS has twice as much effect that ball compression has twice as much of effect. And that's what we see in the summers.
That's what drives that summer of George effect, which itself is bullish because then we're, they're skewing markets, right. And it's. Then there's more open interest than ever out there, right. And all that open interest leads to decay as, as that happens.
And that's a bona charm flow push up as well and bigger than ever.
Because it's not just amount, it's not just the amount of all compression, it's amount of these structure products out there that need to be re hedged. That's the amount of charm flows are bigger than ever. You put all this together and then you have again historic liquidity.
That's like an administration who wants it higher. Do you want to be short this market? I mean could. Yes. Could we get a headline risk?
And by the way, the reason institutions are underweight, reflexivity again, let's go full circle. Is because we're at, in a bubble. And the natural thought in the bubble is oh, I got to be underweight. This is crazy. This can't keep going like this.
Or, or I'll miss the upside, you know, because, because I, I don't want that left tail risk. Well, okay, but at some point you get pushed back in. Yes.
And, and, and so you know, reflexively, this setup is, is, is very bullish here as we enter the end of the year and that goes till about the middle of January. After that January effect in Jan Opex comes and then things can get some mean inversion.
But you know, we're also going into midterm year and there's all kinds of other incentives in play to keep the plate spinning. So you know, you want a, a general road map and it rhymes with a lot of the years. But I'd say this year it's on steroids.
It's mark it up, you know, probably gets front on because you know, markets don't wait. That's what's been happening here.
They don't let you back in and, and then, you know, maybe December, Jan, like that normal seasonal period which people have caught kind of on to gets front run and maybe then that period is a little kind of sideways and then you know, again, if you look at the price action last year it was very predictable. We said that, you know, similar things last year with, with less of these dynamics at play.
And my guess is that this goes even faster because the dynamics are more short, you know, institutional and there's more catch up and there's more liquidity at play but you know, steep at first, less steep at the end. Eventually some type of pullback.
Finally probably in February or January maybe it, you know, gets front runs at Jam Opex, you know, and then, you know, that'll be. People want to get back in because they see the end of the year midterm thing and there'll be some support regardless of the.
But the whole way volatility is going to do one of these longer term, you know, this count owning calendar of all, which is very compelling and that's part of why the curve is so steep. But it's, it works incredibly well. And, and so yeah, I think those are the general dynamics.
You know, we can talk about what happens after February or whatever next year when we get there. But you know, for now, you know, as, as the front say, let the good times roll.
Alan:Very good. Well, that's a, a good note to finish on a very upbeat note for anybody heavily invested or, or not.
Well, Nils is back next week, but Jen, thanks very much for, for coming along today. Always a pleasure. As I said, Niels is back next week.
If you have any questions, feel free to send them in and we'll be back soon here on Top Traders Unplugged with more content.
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