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Digital Gold and Actual Gold
Anti-System Assets Worth Some Allocation
Good listeners welcome to 2025 and at the risk of offending Larry David and violating his strict 3 day statute of limitations
I gotta wish you a happy new year. I’ll be saying it for another week and then will transition to “wishing you an excellent 2025” so be prepared. Kindness and goodwill may be the one arb left in the world. That of course, and Saylor’s bitcoin buying machine. Just kidding.
As It’s the beginning of a new year, we all ought to be thinking about whether our portfolios are set up to succeed in good times and, less fun but still very important to contemplate, consider whether we are over-exposed to the downside. You’re probably supposed to do that at the end of a year, but I was too lazy to get to it. I was too busy binging Landman. That Billy Bob can act…and Jerry Jones, who knew he could as well? John Hamm, always a favorite. It looks like Paramount Plus will live to survive another year somehow.
This being a markets-oriented podcast, I do have a couple of things on my mind that I want to share in the realm of both risk and portfolio construction. As a fresh year is upon us, there are lots of interesting prices to take in already…a 10 year note of 4.75%, a VIX just below 20, a re-awakening of FX volatility. 8 moves in the SPX north of 1% in just 3 weeks. NVDA even went down 6% in one day. I didn’t know that was possible. I ripped through Landman, as mentioned and I’ve also been on a binge of Succession – again – and gotta bring in Logan Roy – again. As he would often say, “let’s get into it”.
Diversification, Risk and Sizing
The main subject at hand is diversification. What composition of assets yields a favorable return with bearable drawdowns? After two straight years of 25+ percent returns on the SPX with just 13 vol, portfolio construction might be considered an open and shut case. “I Buy SPY” said the robotic indexer savoring the Sharpe ratio above 2 and noting that realized vol on down days was just 13% in 2024. Hard to argue with.
Risk can be characterized in a number of ways. It’s clearly related to volatility, but many in our profession draw a rather sharp distinction between the two. For me, the notion that risk is the scenario in which you are forced into making decisions you don’t really want to has always resonated. That is, unwinding exposure to limit further damage because the potential losses from inaction are deemed too costly. And that ultimately comes down to some combination of improper sizing and portfolio construction. “My portfolio is more diversified than I thought it was,” said absolutely no one amidst a correlated risk-off event.
There’s a tangential theme here that comes to mind and that is the notion of mark to market risk. There are few, if any, truly mark to market insensitive investors in the world. Perhaps it’s a large pension fund. Maybe it’s Warren Buffet who sold an absolute truckload of SPX vega before the global financial crisis and marked it wherever he wanted to over the exceptionally turbulent period that followed. 10 year SPX vol is at 38 in the month after the 2010 flash crash? Warren’s got it marked at 21, basically where he sold it.
For the rest of us, mark to market risk is the definitive risk. And even entities with unique ability to ride out a storm are paying some attention to the value of their assets at a given point in time. Remember all the discussions around under-funded pensions circa 2020 as rates and stock prices plummeted? Equable estimates that the average funding got as low as 72% around that time. As I sat on the investment committee of the board of a charity, I can say that the unwelcome exposure to low rates and the burden they imposed on discounting future liabilities was a very active topic of conversation. Even long-term pools of capital respond to the prices they see. Rates are lower than they’ve been for a 100 years? Who is to stay they won’t go lower still?
Last year, inspired by some of the work of Cliff Asness, I did a podcast called “Vol Laundering and the Portrait of the Perfect Hedge”. Here, I explored the value of optionality in creating exposure that embraced rather than ran away from mark to market risk, turning vol laundering upside down in the process. Check it out if you’ve got 15 minutes to spare.
3 Portfolio Tweaks
Speaking of 15 minutes, in the time that follows, let me make the case for a few simple portfolio tweaks that I think are worthy of consideration. I like adding 3 assets with quirky distributions to a base exposure to the S&P 500. Specifically, while one might surely advocate for being over or under-weight the implied sector allocations that result from owning the index, I’m not here to do that. History has shown that it is just very difficult to manufacture alpha this way. I’ve said it before, the SPX is one beast of a benchmark. The folks at Standard and Poor’s might contemplate charging 2 and 20. On the Spider front, the folks at State Street charge zero and 10. Ten basis points, that is.
Let’s leave the index alone. It’s massively over-allocated to tech, of course. And its valuation multiple speaks to expectations that the rampant profit growth of the Mag7 will continue. It’s also, however, experiencing a unique, and I will continue to strongly argue, unsustainable run of low correlation. “You want details?”, as Ben Affleck said in Boiler Room? One year realized correlation on the SPX is 12%. Now is that right time to repeat something I’ve said so many times, to colleagues and clients, to my wife, kids, my dog Griffin and anyone else who might listen. “The very same set of uncertainties that cause stocks to become more volatile also cause them to become more correlated”. It’s not rocket science.
Contemplate 4 sources of risk. Economic, financial, monetary and geopolitical. These are sufficiently macro in nature as to impose themselves on markets from the top down. So, what we see in episodes of macro uncertainty – and it’s unclear if this is a cause or an effect or, more likely, some combination - is a material gravitation of investors to index products. The “market” in quotes, becomes a single stock. When correlation is north of 75 as it was during the GFC or the 2011 Eurozone crisis or during Covid, there’s no differentiation among stocks by style factor, sector or geography. You don’t need single name equities when the SPX is realizing 45+.
The old adage “don’t put all your eggs in one basket” is certainly good advice. But even diversifying through a basket of stocks, timeless and sensible as it is, nearly always proves less a risk mitigator than we expect it will be when a market stress event materializes.
In 2023, the SPX was up 26% on a 13 realized vol. In 2024, in a sequel on par with 22 Jump Street, the beastly benchmark was up 27% on a 12.4 realized vol. As I said, the thousands upon thousands of pages devoted by the Street to the 2025 outlook notwithstanding, the portfolio construction question could reasonably be considered open and shut. If it ain’t broke don’t fix it, I say. Stay with what’s worked – and, critically, what’s low cost and liquid. The SPY checks all of these boxes. But markets are a never say never business. And sadly, risk management suffers from the failure of our imaginations. What could wrong? Just about anything, history tells us. Sadly, we are seeing a natural disaster play out in real time.
Long Insurance
Listeners to the podcast will recognize that I think it’s perfectly ok to simultaneously believe in the VRP, the vol risk premium, AND to embrace the value of optionality. Let me explain. First, it’s difficult to get away from the empirical observation that there is excess premium to be earned, over time, by providing options-based insurance to those who want it. Geico and State Farm don’t sell insurance for free, why should Goldman Sachs? Second, I believe in the value of owning convexity – certainly not all the time and certainly not at any price. But at a good price, vol is on the only anti-fragile asset in the world. When everything else is breaking, vol is quickly strengthening. That is really unique.
So, the first portfolio overlay I believe is sensible in the current environment is owning some options-based protection on the S&P 500. We are sitting here with the VIX flirting with 20, so it’s difficult to jump up and down on its nominal cost. So, I am going to stay with the trade structure I’ve been recommending for a bit now, and that’s a 3m 95/80 put spread on the SPX. Your protection begins at down just 5% from the current level. And you are protected for the next 15%. A couple of thoughts to add here.
8 of the last 15 sessions have featured a 1% move or greater in the SPX. 1m realized in the SPX is around 18 now. It may be too early to say we are in a new vol regime as we could easily settle back to 10 realized. But these transitions typically happen in broad daylight…the 50 basis point daily SPX moves are replaced by 1%ers…and then you throw in a 3% shock and then the moves themselves become the topic of conversation. All big risk-offs start as small ones, I like to say.
This 95/80 put spread will cost you about 100 basis points. I want to be sensitive to the institutional straight jacket that is imposed on risk-takers in our industry. Benchmark hugging, to borrow from the great Howard Marks, is such a real thing and it means that underperforming the SPX is riskier than outright poor performance. This is to say that the 100bps I think is easily worth it is difficult to come by in a world in which relative performance becomes such a driver of the asset allocation process.
What you get for parting with the option premium is some version of anti-correlation. That is, an asset that gains value as your base exposure is losing it. Price is always key – I call it CALC, convexity at lowest cost. Insurance is always about the price. And I’m here to say that outright long vol is not a slam dunk to me, but set against the aforementioned increase in realized vol as well as a skew that remains in an elevated percentile, put spreads are well worth consideration. I especially believe this because of my beat a dead horse campaign that the unsung risk is diminutive realized correlation.
So throw some put spreads on top of your SPX exposure. Don’t sell the out of the money call to fund them, however. Pay for those puts yourself and enjoy the upside in an unbounded way should it materialize. Remember, the put spread collar is effectively a long put funded by a short strangle. Acknowledging fully that it has worked over the past couple of years, I don’t like being short that strangle right now.
Gold and Bitcoin
Let’s turn to gold and its digital equivalent, bitcoin. I’m not so sure it’s fair to call bitcoin digital gold, to be honest. I’ve done some poking around on how these behave and I’m concluding that there are similarities, but also important differences. Let me give you the TLDR: gold is considerably more durable to SPX shocks than bitcoin is. But both share return distribution characteristics that allow them to enjoy episodes of “asset up, vol up” and, related, both seem to capture a growing skepticism of the fiat currency end-game. I like having small allocations to both gold and bitcoin on top of your SPX exposure. Let’s run through some numbers.
It was 100 Years Ago that John Maynard Keynes coined the phrase “barbarous relic” in describing the gold standard. A century later, while you still can’t (really) take it with you, gold is an asset with important financial properties. It is a decidedly psychological asset that has value because we say it does. It can become VIX-like during crisis times.
The GLD delivered a 26% return and a Sharpe of around 1.5 in 2024 even as the DXY was up 5%, Gold serves as a consistent diversifier and the GLD was just 26% correlated to the SPX last year. It’s difficult not to stay with what is working.
You can quickly learn a lot about an asset by simply asking the question "how does it do on the best and worst days for the SPX?“ That’s a great short hand. I looked at the 3+% down moves in the SPX since 2017 and the performance of Bitcoin, Gold and the TLT on each day. Gold is down only 70bps on average for these big down days. That is critical. There are not a lot of assets that can do that. The TLT for all of its “risk off-ness” is up only 50bps on those days. Gold is durable to large shocks. Not every time as a put option is, but broadly.
The characteristics of the distribution of daily returns for Bitcoin are still being developed. Bitcoin is, for now, more a risk asset than anything else. On those down 3% SPX days, Bitcoin is down 9x what gold is, averaging -6.1%. When the SPX fell by 10% on March 12th, 2000, bitcoin fell by more than 27%. On Volmaggedon – Feb 5th, 2018 as the SPX swooned by 4% and the VIX skyrocketed, bitcoin fell by 12%. Gold was up small. Gold was 26% correlated to the SPX in 2024, bitcoin was 39%. However, if we limit the sample to just down days in the SPX, that correlation rises to 46%.
But, as I covered in a recent podcast on bitcoin options “IBIT…The Hottest Option on the Planet”,
the daily return profile of bitcoin has some truly compelling attributes. Specifically, while it remains a risk asset, it’s also an upcrash security as well. That is, the realized vol on up days is mostly higher than the realized vol on down days. An important corollary to this is that the asset and its implied vol can be positively correlated. Assets like this are rare. Typically, when an asset rises, its vol declines. For bitcoin, rallies see an increase in implied volatility. Think about what’s happening here. As the asset increases in value, the implied probability that it can run further – perhaps decidedly so – increases. The far out of the money calls get very well bid. Gold, of course, much more mature than bitcoin, also has this characteristic. The correlation between the GLD and the GVZ, the gold VIX, is consistently positive.
These are highly convex securities. They are options. And they have been going up. I want to be clear, that these are not sources of portfolio protection. But they do have very unique return profiles, often times having nothing at all to do with the Mag7. I think that both gold and bitcoin are important to own at a time when evidence that the US fiscal situation has so much agency cost and there doesn’t seem to be an adult in the room or a business plan is growing. Paul Krugman used to call people like me deficit scolds. I will proudly take on that moniker.
Gold and bitcoin are assets with a certain psychological value proposition. They are some version of anti-system. And I worry quite a bit that our money system is being exposed for succumbing to the exorbitant privilege. The fiscal path projected by the likes of the CBO points to debt to GDP ratios that approach 200% over the coming 2+ decades. Is it reasonable to think that a financial accident is not in the making?
As I type these words, it is Friday, we just had a solid payrolls report which, of course, hurts the SPX, down almost 100 handles and 1.5%. The 10 year has breached 4.75%. The dollar is up 40bps. The GLD mostly vulnerable to higher rates and a stronger dollar found a way to rally by a percent. Bitcoin rose by almost 3%.
Alright, that’s it for now, but we’ll be following up with more. Something tells me 2025 is going to be really important from an investment perspective. And, while I’m a big fan of Larry David – and especially his side kick Leon – I want to wish you a happy new year as well. Let’s make it count, together. Until next time.