Niels and Cem reflect on a year marked by concentration, confidence, and growing structural fragility beneath calm markets. They examine extreme positioning, record low cash levels, and the quiet dominance of reflexive flows over fundamentals. Cem challenges common readings of volatility, explains where real fear hides in options markets, and outlines why tail exposure becomes critical late in cycles. The discussion broadens into portfolio construction, questioning the legacy of 60/40 investing and the illusion of diversification built during falling-rate decades. Grounded in history, market structure, and political cycles, this conversation offers a disciplined framework for navigating regimes where leverage, policy, and inequality quietly redefine risk.

-----

50 YEARS OF TREND FOLLOWING BOOK AND BEHIND-THE-SCENES VIDEO FOR ACCREDITED INVESTORS - CLICK HERE

-----

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

IT’s TRUE ? – most CIO’s read 50+ books each year – get your FREE copy of the Ultimate Guide to the Best Investment Books ever written here.

And you can get a free copy of my latest book “Ten Reasons to Add Trend Following to Your Portfolio” here.

Learn more about the Trend Barometer here.

Send your questions to info@toptradersunplugged.com

And please share this episode with a like-minded friend and leave an honest Rating & Review on iTunes or Spotify so more people can discover the podcast.

Follow Cem on Twitter.

Episode TimeStamps:

00:00 - Introduction to the Systematic Investor Series

00:49 - Geopolitical tensions beneath the surface of markets

02:07 - Extreme bullish sentiment and record low cash levels

04:12 - Margin use, positioning, and why this setup is fragile

06:07 - Why the VIX fails as a true fear indicator

11:48 - Buffett’s concentration and risk management through quality

16:27 - Leverage, Sharpe ratios, and misunderstood diversification

21:02 - Trend following performance and late year positioning

23:48 - Positioning, reflexivity, and market microstructure

28:25 - Volatility traps and convexity before stress events

31:06 - Asymmetric opportunities in gold, FX, and bond volatility

37:17 - Populism, inequality, and long cycle market behavior

45:31 - Why 60/40 is a product of a falling rate era

54:47 - Key lessons from 2025 and structural market shifts

01:07:32 - Political cycles, midterms, and forward looking risks

Copyright © 2025 – CMC AG – All Rights Reserved

----

PLUS: Whenever you're ready... here are 3 ways I can help you in your investment Journey:

1. eBooks that cover key topics that you need to know about

In my eBooks, I put together some key discoveries and things I have learnt during the more than 3 decades I have worked in the Trend Following industry, which I hope you will find useful. Click Here

2. Daily Trend Barometer and Market Score

One of the things I’m really proud of, is the fact that I have managed to published the Trend Barometer and Market Score each day for more than a decade...as these tools are really good at describing the environment for trend following managers as well as giving insights into the general positioning of a trend following strategy! Click Here

3. Other Resources that can help you

And if you are hungry for more useful resources from the trend following world...check out some precious resources that I have found over the years to be really valuable. Click Here

Privacy Policy

Disclaimer

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.

Welcome and welcome back to this week's edition of the Systematic Investor series with Cem Karsan and I, Niels Kaastrup-Larsen, where we each week take the pulse of the global market through the lens, a rules-based investor.

Cem, it's great to be back with you this week, even though it's only been 24 hours since we last spoke. But it's great.

Yeah, yeah, not even 24 hours. No, it's wonderful to be back. I feel like we could talk every day and I always think of something new and exciting that's going on in the world.

I know, and people will already be curious about why did they record something yesterday? But we'll come to that later in the conversation.

We've got, as usual, when you're on a great list of topics, it'll be a little bit fluid today, I think, but something that people will definitely be interested in hearing. Now, I know it's been a very busy time for you leading up to year end, so I just wanted to throw out if there's something that's been on your radar that we're not going to be talking about that has caught your attention. Otherwise, I'll be happy to throw in a few curveballs on my own.

Well, I think, you know, I've been talking on social media for those who don't follow there, but really about kind of the geopolitical moves, the connection between kind of what's happening in Russia, Ukraine and oil tankers and then what's happening with the embargo that's now happening in Venezuela and the seizure of a tanker. I think there's some really interesting geopolitical dynamics if you dig into the kind of the surface about how all these things are interconnected and how we're having a really kind of geopolitical kind of war underneath the surface. And it really is war. It's not just economic anymore. It's becoming really a hot war on several fronts. And I think that's really interesting and important.

Yeah, I couldn't agree more. Now, the things I noticed this morning actually, when I was looking for some interesting stories, actually the first one was Blackstone. They have created a really funny Christmas video this year. It's also a 40th anniversary for them. And for those who have not watched it, because I think it came today, which is Thursday, we're recording on the 18th, you can find it on YouTube. But I would recommend it. It's three or four minutes and it's really fun. Well done to them for being a little bit out there and doing something very different.

The other thing I noticed, maybe a little bit more on the serious side, was the bank of American Investor survey that came out I think yesterday. There are some interesting stats I can give you and then maybe we can talk a little bit about it.

But one of the things that caught my eye was there is now a net 81% of respondents expect near-term gains for European equities, while a net 92% see upside over the next 12 months. So, both of those are the highest readings on record. So, clearly a lot of bullishness, even at these levels.

Valuation perceptions have also improved. Now a net 32% of respondents see European equities as undervalued. Interesting. And that's actually close to a five-year high. Average cash allocations among European investors has fallen to now only 2.8%. That's the lowest in 12 years.

And at the same time the concern of missing out on further gains has eased with fewer investors citing that fear of reducing equity exposure too much. And, by the way, in terms of interest rates, 57% expect a higher-for-longer rate environment and higher yielding bonds over the next year. But that has not dampened the enthusiasm for equities. So, I thought, yeah, interesting.

Yeah, and there were several other things as well. I mean sentiment can always be kind of quick moving. But what tends to not be as quick moving is actual positioning, cash positioning, it tends to move a little slower. And just like anything where people bet with their money, you know, it's real. So, cash positioning for your average investor is at the lowest ever, below 3%, and margin for investing is also at record highs.

So, you put those two together and, you know, it's a lot of Pollyanish kind of stuff out there, and pair that with record valuations, it's kind of confusing to me how people can't see the forest from the trees a little bit. But yeah, it's an interesting setup.

So, first of all, I don't love the VIX as a fear indicator. And again, to remind people why that is, the VIX measures at the money implied volatility. And naturally, the lower the market goes, you slide to a higher implied volatility. So, you know, people look at the VIX going up and the market goes down and say, oh my gosh, people are scared. It's not about whether it goes up or not, it's about how much it goes up relative to where the skew is, which is a very nuanced, difficult thing for your average person to understand. So, I don't love that as an indicator on fear.

If you had the ability to go take the implied volatilities of all the options, let's say in the S&P, and then see how they were moving on an implied vol relative to their strike, or in other words fixed strike vol, that is the best fear indicator out there. So, I think vol can be a great indicator of fear and risk. It actually is the best. But the VIX, unfortunately, is a very poor version of that.

So, what am I seeing? So, one, when you go into these OpExes, these big quarterly OpExes, particularly at the end of the year, there is so much structured product issuance that's tied to these and so much options positioning that there is a natural, as you go into the expiration OpEx, compression involved during these quarterly OPEX weeks (the week leading into it and the week of), usually we reach a nader involved in that period. Particularly if you're at some kind of a turning point in terms of potential risk and other things.

Participants understand that the supply of vol will now diminish dramatically, and they're willing to step in and buy it. And generally, that supply/demand balance then gets to a point where it is much more likely to see higher prices on a fixed strike basis. Okay, don't slouch the VIX. This is just vol in general. And so naturally, you know, this is what we've been seeing. I will say now, you know, since we really called a broader, not just a week by week or month by month, low and implied volatility in August in terms of fixed strike, we have seen significant support to longer-term vol.

You know, the bigger moves happen at the end and then eventually it's a bubble and it ends. So, you're better off on a probabilistic basis over these years to be playing for bigger faster moves and more increasing volatility, by the way.’ 98, ‘99 were very volatile years. Not just up moves, but they had big pullbacks, big rallies. And coming from the environment we were in, which was a very stable rally, a lot of vol compression in the summer driven by structural factors, that was a natural buying point in the vol, and we are seeing that.

So, structurally we believe the outcomes are becoming more leptokurtic here, not just on the left tail, but on the right tail. And when that happens, why on the whole asset when you can just own the right tail which is, by the way, the cheapest thing, on an implied vol basis, on the curve. You can buy a 25 delta call for, let's say, a 12 delta in the S&P. The long-term average of at the money vol is about a 17 vol.

So, at a discount to long term average, while you're in a bubble, then distribution itself is much more leptokurtic. It's a no brainer, you know, negative risk premia in general, and then add to that the change in the distribution (that's likely as we move forward), and it really represents an incredible relative value opportunity. So, we've been doing that, to answer your question, I guess, more directly. I got kind of technical there.

We have seen some great opportunities evolve broadly, for three months. We are definitely playing from the long vol side on the right tail. And we, even though you've seen a bit of vol compression in the last two weeks, which is what you would expect, the opportunities we're getting, we got a 5% pullback, then a rally, then we had another 5% pullback. So, we've had opportunities to also monetize that despite that.

And again, increasingly as we head into and out of the new year, out of the old year into the new year, you're going to see more opportunities in vol and a bit of unpinning due to likely vol itself going higher from here.

Yeah, very cool, very cool. Now I know we're going to talk about sort of portfolio construction diversification later on but just before we head into a little bit of a trend following update I did see a different take on diversification namely how Warren Buffett sees it because today I was reading on Bloomberg that (and this is probably not any news), but he has now 58% of his portfolio in just five stocks. Despite having sold an enormous amount of Apple, he still has 21% of his portfolio in Apple, 17.8% in American Express, 9.8% in bank of America, Coca Cola 9.3% and Chevron 5.9%. So, obviously, that kind of diversification has done very well for him even though we may not see it quite the same.

There are lots of… We talk about diversification a ton. On our wealth advisory side it is a core focus. We're optimizing to risk-adjusted returns. That's the way we think about the world. The idea of risk is something that is not actually oddly talked about in an investment advisory.

And again, most people don't know the Sharpe ratio of the S&P 500 or 60/40 when this is what 95% of people do. But the reality is there's tremendous benefit of diversification. We know that. That said there are other incredibly well documented academic research that shows that there are other great things that you can also do to help reduce risk of a portfolio.

And one of them is focusing on stocks that are not just, in the Warren Buffett model, value quality focused over a long time because that reduces volatility even though long term returns are similar to growth things. So, that's a significant and easy way to improve risk adjusted returns.

But also, to focus on companies that increase their profit margins as interest rates go higher. Because we know that as interest rates go higher multiple contraction is an issue for equities and the majority of stocks actually do the opposite. Their profit margins get worse as interest rates go higher. Why? Because interest rates are generally tied to inflation. Higher inflation means higher costs, which reduces profit margins.

So, most companies operate that way. There are a sub-subset, about 25%, a significant minority, that do the opposite. What are those companies? Think about companies with negative working capital? What do I mean by that? Warren Buffett and insurance comes to mind.

Insurance is incredible negative working capital business. Why does it do well when interest rates go up? Well, they get the money up front at scale. They get the inflation on that money, and then they pay out afterwards. There's no increase in cost, by the way, of inflation to them in any other way.

Lastly, it's also a capital intensive business. So, if the cost of money goes up there are less participants, and risk premia tends to go up, and they tend to collect more margin as well. So, it's a very good business in this environment. A lot of financials that's fairly true for as well. Not all financials, but a lot of them.

So, it doesn't surprise me that in the top five he has Bank of America and American Express. Those are transactional businesses. The more volumes go up, even if their costs go up more than their volumes, they are going to benefit. So, he is focused on companies, when you look at this, that generally do that.

Other commodity businesses do very well, Chevron. I also think the Venezuela thing, if there's one company that majorly will benefit, it’s Chevron. Actually, they’re plugged into Venezuela and that was one of their biggest markets before.

And then the Coca Cola company, people think that that is a product business, it's not. They are a distributor. They’re the middleman. Middleman businesses don't have more cost. If volume goes up, they do well.

And so, all of these, except for maybe Apple, are in that breed. So, he is, in a sense. managing risk and actually trying to benefit from what he believes, if I look at this portfolio, is a rising long end of the curve and, importantly, a steepened curve. Financials do really well, obviously, for those reasons. And I think that's what this tells me. And I think that's a good… at the very least, it's a risk management play on that even though he's not doing the diversification thing as much.

I mean, first of all, let me say that he's done very well for someone who said, by his own words, that he was not a tech investor. I think investing in Apple was a pretty good move. But, and people often get sort of blinded and rightfully so by the 19% compound rate of return that he's had for, I don't know, 50 years or however long it is. It's amazing. But when you do look at the track record, there are pretty steep drawdowns along the way. That's one thing. And also, I think people forget that he does use leverage. I don't know the exact number, but I think it's somewhere between 1.5 and 2 times leverage.

You took the words out of my mouth. So, if you manage risk, these are the big ideas that everybody misses, and in our words of David Dredge (I'm going to keep using his metaphor because it's such a good one), if you can get your risk adjusted returns to a better place, if you have more control in the car, if you’ve got the brakes, it's a stable controlled vehicle, it's not just one lever gas, if you can get to that place where your vehicle is much more under control, you can use the brakes to go around the turn as you can accelerate, then you're in control, there's less risk and you can go faster on average. You can add leverage, you could add speed because the machine is more under control. And that’s the critical idea.

Most people think of risk management as oh, I have to take less risk. And that's why 60/40 exists. Bonds are not a diversifier to stocks. They do not reduce your risk. It is just a matter of taking the speed down of the portfolio. And unfortunately, that speed being taken down means your long-term returns are going to be lower. And, by the way, you still have more risk.

You still haven't really… I mean you've just taken your… The Sharpe ratio is the same. You've just lowered the total risk with your total return.

So yeah, at the end of the day, what Warren Buffett has done, just to put a bow on that is, he is an expert at managing risk relative to return for a long portfolio. He thinks about risk and he does that through quality and understanding, only investing what he knows. Because if you know what your risks are, and you understand it, you have less risk. And by doing that he can then deploy leverage, which he does, which then gets him to a better place on a return basis. If he just managed risk and didn't deploy leverage, he wouldn't outperform the market, he would outperform risk adjusted returns. His risk would be dramatically lower.

And again, this is what hedge funds do, when you get to a 2 Sharpe by diversification or other measures of managing risk, then you use leverage and that's how you get outsized returns.

Yeah. What's interesting, a lot of people, of course, they look at Sharpe ratio as being, you know, the best measure of these things. Even though I think all professionals will say…

Absolutely not, I wouldn’t use that as the most commonly understood, because if I start talking about what he knows, I'm going to lose people.

But one thing I was just going to say to that is that something that we've done a little bit, just to get a different perspective of things, is actually just take people's annualized volatility of people’s investment strategies and divide it by their maximum drawdown.

That gives people sometimes a lot of surprise to see that even though something looks smooth from a Sharpe ratio point of view, or looks safe from a Sharpe ratio point of view, the ratio of max drawdown to that annualized volatility can sometimes be a lot bigger than what you expect.

100%, and actually, because drawdowns are rarer, you have less data on drawdowns, and people can have 5, 10 year track records with great Sharpes that have tremendous tails in the portfolio. You wouldn't know it until it hits.

Right, yeah.

So yeah, Sharpe is… Even Sortino is not way better because it's just downside volatility, to be clear, as opposed to total volatility. Sharpe really makes no sense. But, I agree, understanding the tail structurally, what is your maximum loss and these things, is critical to risk management as well.

You really want area under the curve with some measure adjusting for amount of size as well that punishes an equation bigger losses. And that's really the best measure of risk, in my opinion.

All right, quick update for the people who are interested in a little bit of trend following.

But the jury is still out. The month looks pretty quiet so far, except, of course, for those who are focused on things like silver and other precious metals. I mean this has been an amazing year. Silver is up more than 100% this year, even though most people talk about gold, which is still doing well, up 55% so far this year. But anyways it's very interesting.

The traditional world, MSCI World Equity index down 1%, thereabouts, as of last night, but still up 19.4% for the year. S&P Aggregate Bond index down 32 basis points, but up 6.87% for the year. And the S&P 500 down as of yesterday 1.78%, and up 15.71% year-to-date, but is being helped by a better-than-expected inflation report that came out just before we started recording.

Anyways, let's move on. Before we get to our topics, Cem, we have three questions that came in from Rick from Offsides Macro. He writes, Cem, you often emphasize that today's markets are shaped more by positioning and reflexive feedback loops than fundamentals. How should systematic allocators quantify and integrate the understanding of positioning into models to anticipate regime shifts rather than react to price signals?

Oh, that is the greatest question of all, honestly, if you're talking about trading, maybe not investing. Look, there are structural changes that you need to understand. At the end of the day, markets are just a voting machine in the short-term. They are how many buyers are there versus how many sellers, that's always been the case. I think the difference is nowadays the structural flows of buyers versus sellers is just much bigger than it's ever been relative to other flows. And so, they are more dominant and luckily a lot of them are more measurable because they're structural as opposed to based on an opinion or a data point or etc.

So, it actually favors those that understand market microstructure and these concepts of reflexivity, etc. Positioning, again, going back to Soros at the end of the day, and others, are the biggest understood and countable, measurable supply and demand and wain.

And so, the more you understand that across the board, whether it's in options or whether it's an underlying stock or whatever it is, is the most important thing. So, understand that positioning, understand the effects that that positioning will have as it is either unwound or as hedging to those positioning kind of are done. And then from there I think you end up understanding reflexivity itself much better.

You know, again, reflexivity at the end of the day is a function of how are people currently positioned, what are their needs and demands, and how will they then respond as a function of moves and occurrences in the marketplace. So, I guess to answer the question, you know, reflexivity is the key. Understanding positioning is instrumental if you're going to play in, in these markets, particularly on a short-term basis.

Some of those structural things lead to changes in the distribution more broadly. So, it can also help for more medium-term, meaning one year, even two-year type outcomes as well.

So, that said, everyone looking at 5, 10 years, there's a much bigger story that eventually will play out as a function of those flows generally mean reverting to some reality. And that generally happens as liquidity comes out of the system at some point, which is hard to predict when.

And the actual quantification of these things, is that kind of the secret sauce, the IP of each manager, how they do it? It's not like something you can look up in a specific report, I guess.

Yes, although the process is not rocket science.

Okay.

In a sense it is if you couldn't get to the positioning itself, if you can collect that data and have a good sense of what some positioning is, or broad positioning (you don't know everything), then just simply understanding the reaction function of those positions is really what you're solving for. You can call it secret sauce, it may sound technical, but depending on the products there are pretty clear results. You just have to kind of work backwards from there.

Which, you know, in the case of options, I happen to be an expert in, so you call it secret sauce, but I'm not the only person who understands how options work. You know, if time passes and implied volatility changes, and the market moves, these all have effects on the options. And based on that positioning, that'll tell you then what the reactionary flows should be. That's the case for options which are a little bit more multi-dimensional. It’s less complicated when it comes to stock and less complicated when it comes to other products as well.

Sure, great. Next question is, in environments where traditional hedges become harder, e.g. compressed volatility, crowded hedges, what positioning adjustments do you consider before volatility spikes, especially when positioning data suggest convexity traps?

Now again, I don't know if this gives the full meaning or if this is too close to answer in terms of IP. Feel free to answer how you want.

It's fine, I think. Look, the broad answer is you have to think about (with options in particular, which seems to be the inquiry), you need to both think about the reflexive effects on realized position, which is you know what is likely to happen to the underlying, but then you also have to think about supply and demand to the implied vol itself, which is the secondary part, which is critical.

Generally speaking, the reflexive effects on implied volatility are much stronger, and because they're less liquid and there are less flows other than this relative to the effects of the reflexivity, if that makes sense. So, one of the easier things to do is to predict, based on positioning, the likely paths of implied vol itself.

Now that, itself, reflects effects to the underlying as well as like… So, like the vama and veda, these effects that are tied to the vol have effects on the distribution of the underlying but they're not necessarily the delta effects. The delta effects are part of (those are the vanna and charm effects I talk about) a much broader bigger group of flows that move markets.

They're important for the move, the direction, but during some periods are significantly smaller, and even when they're bigger they are maybe 40% at the best.

Everybody likes to think about direction specifically in the effects of the options and they started with gamma. I've added in vanna and charm and people have largely now absorbed that in the last four or five years and are talking about it more.

But I do think the distributional effects of implied vol compression, and those are much more predictable and much more powerful and easy to use. So, I really like that angle even more. I think that's just something that very few people focus on that I'm trying to talk about a little bit more so people understand.

So, again, there's a lot of details in there. You could probably do a whole episode on this. But those are just general views that might help.

Final question, and I do remember this call a number of years ago. You deserve credit for a call you made on gold vol a while back, if memory serves me. I believe gold was at US$2,500ish. You suggested looking at US$3,000 calls. Both FX and treasury vol remain low. If not there, where else are you smelling asymmetry?

Yeah, we don't always get it right. It was hard to have called that better. I think we called it almost to the week, the low and in gold and the low in gold vol simultaneously.

We did that on here. You can go back and listen to it again, over three years ago, three and a half years ago, maybe four almost. How do we do that? We've had this very clear broad thesis about structural inflation and populism. And again, once you have that view and that's on a straight line, it's going to take time to play out. The best asset to have in that type of a regime, which we haven't seen for 40 years plus, is gold.

And the way it was performing relative to all other commodities was completely out of line with that. And we actually, to be clear, it wasn't a broad call on commodities, it was a call on precious metals specifically. And actually, we said look, you want to sell vol in oil, you want to sell puts in oil, collect that premium and plow it into as many long calls on gold as you can. And I think that education there is that it's not just about direction which is what most people focus on.

You had a zero dollar bet in doing that and actually probably collected a premium in that process and got dramatic exponential convexity to gold and just continue to collect it in oil for four or five years. I mean I cannot think of a better… I wish I'd launched an ETF doing that. It'd be up like 10,000% and, you know, would have $10 billion in assets.

But the reality is that trade, it's not going to work every week, not every year even, but structurally that is what you want to do. And we did a lot of data analysis of the ‘60s and ‘70s at the time. You'll remember we talked about it then and the volatility dynamics. Again, it’s hard to predict direction, general dynamics apply, but predicting distribution, given some very basic assumptions, can be very predictable. You can make these big calls that can last decades and that can make you inordinately wealthy.

Again, if you just knew that interest rates were going top left to bottom right for 40 years, which is what happened for 40 years, if you understood that one dynamic, one thing, you are probably one of the wealthiest people you know because it really drove everything.

And again, if you believe what I believe, and I have believed for four or five years, I think fairly accurately, because you can see it all happening under the hood. I think you're going to be inordinately wealthy in 15 years and I think we've already made people a tremendous amount of money with that view in the last four or five years. And that is that inflation is structural and it's not going away. It can go away for six months, a year. Again, the inflation of the ‘60s and ‘70s had four different bouts. It was not one secular move.

There are cyclical effects and if you look and understand what's driving it and you have that view you are going to make a tremendous amount of money. During ‘60s and ‘70s precious metals were not only the best performing asset, most people know that, but it was the most volatile asset.

And with implied vol, with that asset at its lows relative to other things and its implied vol simultaneously at the lows on a risk adjusted basis, that was one of the most ridiculous trades. And again, if you look at stock vol, equity vol, because it's a nominal asset over that decade, 14 years – ‘68 to ‘82, it went nowhere in nominal terms.

So, talk about implied volume compression. It's not that volatility will be higher and under all time frames for all assets. There is really a dramatic distributional difference between assets in these regimes. If FX vol is the way to go, I've been saying for four or five years, think about how much money in the main FX vol. You're seeing yen carry trades blow out, you're seeing all these other FX moves. So, FX vol, this is why precious metals fall into that category because they are more FX. And then, importantly, bond vol, obviously, is much better during these periods. So, those three categories; precious metals, FX, bond vol, dramatically higher on all time frames.

And then you go look at equity vol, long-term vol in equities is dramatically lower, short-term is fairly in line. So, you still get a lot of stress and geopolitical. But over time, as you head through these periods, it actually that compresses as well because valuation should come down structurally as inflation occurs. Multiples should contract because as interest rates go higher multiples need to contract to stay in line with that.

And then lastly, industrial commodities have a push/pull that happens both from inflation pushing it higher, but general deglobalization and things generally putting a cap on it with minor spikes in between, like we saw during the OPEC crisis in the ‘60s and ‘70s. But generally speaking, you know, structurally, if you're selling out of the money puts it’s a much safer play.

I wouldn't go sell the money calls per se in oil. But structurally, selling puts is a much better play for industrial commodities like energy or things like that.

Hearing you talk about this, and I do remember all our conversations, and I do remember your kind of steadfast conviction about the playbook, but I am actually kind of curious because one could say, well, he's been absolutely right, and it's playing out exactly as he said. But you're comparing to a period where statisticians might say, well, that's a sample size of one, it's one environment. What made you so certain actually? Or maybe you did go back further to see if there were other periods like this. But, what made you so certain that actually, yeah, this is exactly what we're looking at.

Well, we've done a lot of conversations here. I could go through the deep, deep kind of the structural underpinnings. It comes down to that this is not just a sample of one, to be clear.

Right.

This is a structural cycle, the populism is, which is a function of inequality. And inequality is inevitable at some point. The system structurally, the animal, not just humankind, the way the world works, the way evolution works, is it's a survivor bias. It's winner takes all, absolute power corrupts absolutely. If we did not have government, if we did not have man-made structures to help make things more fair, that's really the role of government broadly.

Some governments.

Yeah, that's what it's supposed to be, I guess I should say. It's supposed to… Without that (I apologize) we would have a winner take all system. We talked about this before. The impulse towards fairness only happens in response to absolute power corrupting absolutely. In a democracy, that happens more smoothly because you have a voting mechanism that doesn't allow it to go… I mean, it can go very far, as we've seen, but at least in theory, it allows for a transition back.

And what we've seen in the United States is a very clear cycle. And others talk about this from other dynamics. Our view is complementary to these fourth turning type dynamics that you talk about. They're different, they have underpinnings that really look at a much, I think, broader picture of the why, and not just that it exists, but what drives it. But importantly, it's not just a matter of inequality expanding and compressing.

I think one of the key takeaways is when that expansion happens that it's not equally felt across generations. It is felt unequally because when you are young, you are labor and when you retire you're all your capital.

And so, what happens through inequality expansion is during the times when it happens, which are the majority of the time, by the way. It's probably 40 or 60 out of 80 years, the younger generation becomes disenfranchised, angry. They're also young and have that revolutionary spirit and want change at baseline. And as that generation then moves to political dominance and the older generation dies, then the tide turns. This is why the machine works the way it does. And it's not good for predicting one year, two year outcomes or five year outcomes. But if you're looking at 80 year, 40 year, 20 year, decade outcomes, it's incredibly valuable to understand those dynamics.

And again, you want to be able to do things that you measure. Those are the things that are the best for prediction that can give you great conviction. Go back to the Warren Buffett thing. These are things that you can measure, you can understand the generation, what the inequality has been for that generation, what that's likely to mean for their political views and how that's likely to play out. And so that's the base underpinning. There's a lot more detail and we can dive into all the dynamics that are driving it.

And so, it is in government's best interest, in this environment, to take its pain through nominal pain than it is to have massive market declines. Again ‘68 to ‘82 the market dropped at its peak, after a 14 year window. In real terms, you know, 60%, 55%, 60% but nominally it went nowhere. And that is much more politically palatable. Even though nobody likes inflation, you can hide the inflation a little bit, people feel it, but you can use your talking points and look, the market, you know, just rallied back 75%. Well okay.

And, and so the incentive structures are such that avoid crisis, avoid nominal volatility and so, inflation is really the only way out unless you're willing to accept a crisis in these environments.

We’ve got three things left I'd love to talk about. I'd love to end up with kind of you maybe giving your sort of key takeaways from this year. I'd love to follow that with your following the roadmap we just talked about, you know, what do you see for next year. I know people love to hear that.

But before we do so I'd like to touch on a topic that you talk a lot about at the moment, you think a lot about, and it's super important, and that is kind of how do we build a portfolio for this future or this regime that we are in?

And I just happened to come across a paper, I mentioned it to you before we clicked record, I think it was done by the Future Fund which is a large Australian sovereign wealth fund. And they did a paper about, you know, what portfolio resilience really means.

And I don't know if you necessarily think about building portfolios just to be resilient because obviously people also want them to compound but, as far as I understand, the Future Fund has done very well and beaten its own target, which very few pension funds, I would say, have done in the last few years. When they talk about resilience, and I think this is actually quite critical, because in my world we talk about building robust trend following strategies but nobody really puts words on what does robustness really mean? How do you measure it?

When they talk about resilience, their definition, if they were just going to say it in a couple of lines, is a collection of exposures that achieve target returns through a wide range of future scenarios. That's kind of how they put it into words. But in that, they talk about achieving diversification, that it needs to be able to absorb shocks, it needs to increase the predictability, it needs to guard against sustained underperformance, severe losses. And then comes this word robustness.

I mean, with all the work you do right now, with all the conversations you are having right now, I'd love to hear your thoughts about how you think, in your wealth management business, think about building kind of the portfolio for the future or for this regime.

Why in the world, if 60 out of 80 years, in decades, you make 0% in real terms with a strategy, would anybody do it? They didn't because it didn't work. This indoctrination that 60/40 is how we invest is an artifact of recency bias.

The reason it's been adopted is because it's easy, it has broadly worked for 40 years. And because the Sharpe ratio, for the last 40 years for S&P, is 0.52, and 60/40 is 0.62. You have gotten some diversification benefit. But that's simply a function of interest rates going down and being used as a tool.

Once you see this big picture, and you understand what's going on, again, if you got this interest rates top left to bottom right, then yeah, do 60/40. I get it. I agree. It worked great. You're really wealthy. Do it with leverage. Buy the dip and know that it's coming.

But if we don't know where interest rates are going, it is an incredibly poor way to invest. It's dramatically suboptimal. There is no risk management.

And on top of that, you know, if we think they might be going the other way, which we talked about for four or five years and have been inaccurate, it is a death wish.

And so, I'm not saying interest rates are going up. I have said that separately. I think that's a high probability structurally. At the very base, if they go nowhere… We're still below, by the way, the 60 year average. The 60 year average 10-year bond is 5.8%.

And can I just add one thing which people may not notice, that is that since the first rate cut in this cycle, long-term interest rates are actually up, they're not down.

Correct, which again, we've talked about. We've said, for many years, the steepener is the best trade you can put on, blah blah, blah, blah, when it was inverted. Talk about… In fact, gold trade, the steeper trade has been just as good.

It's important to note that if we stop and think about what drives risk, and what drives returns, and we take a completely agnostic view, just agnostic (this is not a bet on where we are going from now) you can achieve risk adjuster returns and I am not exaggerating, relatively straightforward with diversification, with a little bit of long vol and improving your geometric returns. Some value investing like Warren Buffett. These are all concepts, by the way, that academic research screams. It's not even a question. Simple concepts.

This is not alpha in the sense of oh, I have gutters trading strategy. With these concepts you can construct a robust resilient portfolio, relatively straightforward, that does not outperform a 0.35 Sharpe by 50%, by 100%, not by 200%, not by 400%. Most products in this world, if you do something 25% better, you take over the whole market share. We're talking about four times the risk of adjusted returns over 125 years yet nobody's doing it.

They will do it when the things go the other way. And it'll probably be too late because people just chase whatever worked the last five, 10 years. And 40 years is forever for people. So, to look at a big picture and understand risk is a bridge too far.

But I'm telling you, if this next 20 years does not look like the last 40, the biggest business in the world, the biggest total accessible market of any business in the world, which is asset management and advisory, will look dramatically different, dramatically, than what it looks like right now. And so, this conversation we're having arguably is the most important conversation in business, period. And it's one that's well documented and understood. That's the wild part.

What we're talking about is not a new idea, it's just a little harder. In the words of Warren Buffett, you have to swim with a swimsuit at the risk the tide might go out and nobody's been swimming with a swimsuit for 40 years because it's uncomfortable. But yeah, simple replicable ideas. This is not rocket science. And if you do it, you can achieve dramatically better outcomes.

Well, we've called a few things over time.

Yeah, exactly.

Yeah. Let's look back briefly. There are a couple of really interesting big picture things.

One, we highlighted this in our conversation, actually, yesterday, but I think it's so important is the rise of non-correlated assets for exactly the reason I just highlighted that you have a US$500 trillion long asset world including stocks, bonds, real estate, all the things. Again, how the whole world manages money to draw those two things together.

And then you have these non-correlated diversifying things, or not just things, strategies, a lot of them. Some of them are things, and those are precious metals, let's say, call it crypto, which you can argue are diversifiers or not. You know, people believe it is, which is all that really matters. And then we have hedge fund type strategies. Which I think we all fall in, in some form or another. And then you have structured products or the use of options, whether it's ETFs, payers, things to position in a much more non-correlated way.

That pool of assets has tripled in two years, two and a half years, and tripling consistently (all of those different things) for the same exact reasons, which is a drive towards non-correlation. But again, going from a very low level of US$5 trillion to US$15, and this is why markets are going up. And even though interest rates went up to 4.50%, relatively, in the last year or so, it’s more stable.

So, the big question is, you know, is this the first inning, second inning, where are we? And I would argue, again based on what I just argued, that that if we are happening to go into a period where interest rates do trend higher, and there is worse returns for assets than we've seen the last 40 years and not just for a year or two, I'm talking about for a decade, you should see a dramatic continuation of that. I would argue a lot of these people who are moving to this are early adopters, who listen to our show and think about these things more broadly. Most people don't react until they're punched in the face. And so, I think that's incredible and probably the most important thing that's happening.

Again, if you understand these little things, they can be tremendous drivers of wealth in so many ways. The onslaught of ETFs, particularly non-correlated ETFs in the option space, the growth of, again, structured products, the effects of those structured products in this growth both on the underlying, this would be kind of my second point. So, you now have this thing.

Now the other big takeaway is we saw some dramatic and important changes to how underlying assets move as a function of some of these moves. There is an interaction, we talked about on here, of hedge fund long/short equity which is growing dramatically because of the demand for hedge fund assets with vol compression, which is a function of the rise of structured products, and then those types of ETFs that are driving that vol compression. Now these things are reflexively affecting the underlying.

And this summer there was a tremendous set of in particular, and really interacting with policy and allowing policymakers themselves to make decisions that help drive their goals. I would argue a lot of whether they realize it or not. But the Treasury and Fed had a much easier time with the treasury and driving a positive outcome out of Liberation Day, and this year as a function of the stability that was driven and some of the pain that was forced in hedge funds that were underweight during this window.

A massive part of the structural demand that pushed this market higher was the underweight of equities of institutions having to buy back in and the vol compression that was strong and stable that allowed for risk taking throughout this period. So, that would be my kind of second takeaway is these reflexive effects and the importance of this shift that that's driving.

And then I guess as a third takeaway we talked about, late last year, early this year, about how, almost to the day, that Feb. OPEX was a risky place. We almost called that again within a week of the decline. We thought it'd be a 15%ish type decline and then a rally. We got 20%, we got 25%. But sure enough, it turned in April. We bought that dip and we're aggressive on the rally. So, those things all made sense based on the approach that the administration was taking.

I do think that what became clear though, is the exuberance (and this is where we get into kind of future looking to next year) that we felt, I think we all felt it, even people who weren't pro Trump were like, okay, well, change. This could be really rah, rah, you know, boom, boom, let's go. And there was a real sense of exuberance with Trump coming in.

He was the change agent, as every change agent is, has felt like, okay, we're good, this is going to change things. And as I've said, what's happening here is not political, it's structural. And as I highlight in the ‘60s and ‘70s, again, as a metaphorical, you know, that we had a ‘60 to a ‘62 to ‘82 period, 20 years where we had five presidents. The turnover was every four years, on average, in some form or another, whereas last 48 average is 7.1 years.

That is because of this populist impulse and the political upheaval that's coming as a result of it. And I said very clearly, loud and clear, I'm like, just wait, the pitchforks are going to be on his lawn. Give it six to nine months.

And sure enough, it started with the Elon getting kicked out of the administration, and literal pitchforks and fires in his dealerships, and then moved to now Trump and his approval ratings and broad move and sentiment against Trump. I want to be clear, and I think you're seeing that by the way, with the Epstein releases and his base kind of moving away as well. This is why again, structurally, now we go look at the ‘60s and ‘70s and look at political cycles. Elections matter more in this period, dramatically more than they do during other periods.

Let's start with presidential elections just to rewind to that. Not the midterm. We're going to get to the midterm. This is now looking forward, presidential elections during that ‘62 to ‘82 period, we have five of them. All five are double digit positive with an average return of 21.5%.

Now, okay, people like, well, presidential election years are positive in general. Not true. If you take out that five out of the 25, for a hundred years the average return is closer to 6%, 7%, which is meaningfully under the long-term average. So ironically, presidential election years aren't positive, relative to normal are not positive, except for during populous periods, which is where they're consistent and very positive. So that's a big underlying thing to understand. It highlights how important the period is.

And then also, if you take those five election years out of the 20 years, that ‘62 to ‘82, we've already talked about how poor that period is.

Right, true.

So, the other 15 years combined have an average nominal performance of negative 3%. That's nominal, not even real.

Right.

And that's 15 of the 20 years. So, it's black and white. If you look at other elections, if you look at in its data set, and it makes sense most importantly. We didn't go mining data to find this. We had this big qualitative idea. We went and looked at data and it screams at you.

And then lastly, now let's look forward into midterms.

Midterms, right.

We hadn't talked about this at the time. Midterms, I kind of took those other 15 years of that data set and said oh, they're all bad. But if you dive into those other three years of the data set, it again screams at you. Every single one of those midterm years, four of them (there are actually five), I'm not counting ‘78. So, if you go look at ‘62, ‘66, ‘70, ‘74.

Okay.

All of them were massive down years, and particularly if you start in October, so like Q3 of the year prior. So, let's say we take a 15 month period leading into the midterm. Those periods, if I popped up a chart here that again I could do it. It, again, just screams that you have these peaks that come out of this exuberance and oh, we're going to change things and the world's going to be great to, oh no, our polling is at the worst numbers ever. Things are not working. It’s the same old, same big problems. Nothing's changed. And you get this dramatic drawdown.

The biggest drawdown of those four is 42%, and they get bigger. They start at 24%, 25%, they go to like 30%, you know, and they build. They get bigger as time goes on. And that also kind of makes sense in the sense that people start to recognize the pattern. People start to recognize… They actually start earlier, too, as you go. It's really interesting. They start earlier, they become bigger. And again, the pressures, as they build through this populist period, political dominance become more incontrovertible.

So again, qualitative idea underpinned by big ideas. Dive into the data. And when they both scream with the way they do, you probably should listen. It's not the only thing that matters. But I do think the populism is a political reality and it's what's driving the poor outcome.

But it's unavoidable in a sense, unless we head to pure authoritarianism and circumvent the whole system, which is possible. Anything's possible. But that's the reality and the political pressures. And again, by the way, I'll draw a parallel here to, again, the ‘70s, Nixon came in who was the one I compared the most to Trump here. And what was the first thing that Nixon did? Nixon did massive tax cuts for the rich, tried to roll back the Great Society program. It was his first policy. And by the middle of the midterm year, he was in price controls as inflation picked up.

And so, the move to fiscal spending, which we moved away from this year, and people were like, oh, change is coming, it’s likely. And I've said this now for a while, to come right back, as the political upheaval to these policies.

The pitchforks show up on his lawn and those political pressures cannot be destroyed or turned away is the big idea. And those pressures are the problem ultimately for equity markets…

Yeah, it will be for a dead market as well. And what will be interesting, with that analysis, is also, should it play out as it has done in the past, add to that the rise of passive investments, which we did have...

That's a very good point. You know, last year there were things that helped the administration fight against these pressures to some extent. And so, could it be a situation where those pressures, which are relatively new and reflexive, could overwhelm some of these bigger structural political things? Yes. But these are factors we should both be thinking about that are important to that analysis.

Cem, we're coming up to the hour. This was again, as always, wonderful, so insightful. I really, really appreciate the time, not just today, but actually all the weekly and monthly conversations you have with me or with other guests. I know there's some really exciting guests coming up on your series. U Got Options in the new year, so, I can't wait for that to be released.

I would encourage everyone listening to the conversation here today. If you want to show some appreciation for the time and energy that Cem puts into this, follow him on Twitter, of course, but in addition to that, go and find your favorite podcast platform, iTunes, Spotify, wherever you listen to your podcast, and leave a nice rating and review for the work that Cem does.

Next week we will be releasing part one of our year-end conversation and since we recorded it yesterday, I can assure you it will be worth your time and part two will be the following week.

I think it's very hard for me to put words on the amount of brain power and experience in that group of nine co-hosts that we have and in all kind of slightly different fields, but sitting and just mainly just orchestrating things yesterday and listening to all of you was just incredible. There are so many takeaways from that for them, those conversations. So can't wait to release them in the coming couple of weeks.

From Cem and me, thanks ever so much for listening. We look forward to being back with you next week and until that time, of course, Happy Holidays, Merry Christmas, and take care of yourself and take care of each other.

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review. And be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com and we'll try to get it on the show.

And remember, all the discussion that we have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also, understand that there's a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we'll see you on the next episode of the Systematic Investor.