Greetings and salutations loyal listeners, risk enthusiasts, vol geeks or to those who somehow were looking to trade crypto and came across the wrong Alpha Exchange. The AE is a big tent, and I say that you are all welcome here for what promises to be another exciting addition to our “Sayings on Vol and Risk.” To set the table, last year, I did a 5-part series with 25 Sayings. These are concise statements I’ve wound up using many times over during the course of my career to help myself and others think about market risk. These pitchy proverbs are market maxims that explore the drivers of unanticipated change in asset prices. They aim to help us contextualize how and why markets and securities behave the way they do.
With the first 25 saying completed in 2024, I recently added 5 new ones, getting us to 30. Over the next 20 minutes or so, I will share 5 more. What ties these 35 adages together is more than 3 decades of cumulative observation of both the behavior and misbehavior of markets and the humans that populate them. What do we learn from prominent risk events? From the vulnerabilities that inevitably result from our inherent biases? How do institutional considerations like benchmarking and the risk of being wrong impact how investors choose risk exposures? When and how do trading strategies morph from a good idea, to overconsumed and likely to sew the seeds of their own demise? These are all wide-open questions without truly definitive answers, but our sayings are meant to help think through these complexities.
You’ve heard me rattle on about Succession often. The writing and the acting keep drawing me back in. There’s a great scene between Logan Roy and his daughter Shioban as she seeks to get more involved in the family business. Complaining that without his backing, she will lose internal support, she says, “Dad, there’s a line”… he interrupts and says “Nothing is a line. Everything everywhere is always moving forever. Get used to it." I think that’s one way to think about markets. Clearly prices are forever moving. But markets are too, not just because prices are, but because change is constant – in regulations, in technology, in the economy, in trading strategies and so on. So, as Logan Roy suggested, let’s get used to it.
We’ve got 5 new sayings for you, starting with the statement that “risk management suffers from a failure of our imagination”. What do I mean? Well, who had the Meme stock episode of January 2021 and the way in which individual investors sought to move stock prices by trading – or in the case of diamond hands, not trading, in unison? Who had year over year CPI peaking at 9% in June 2022? After all, two-year break-even inflation was 68bps in June of 2020.
Who had the speed with which capital ran from SVB in 2023 as a possibility? The Fed certainly did not. Nor did the hedge funds that got carried out on rates falling, not rising in the aftermath of SVB’s downfall in March 2023. Let’s review this for a second because it speaks to the notion of the butterfly effect in markets. From early Feb’23 to early March, the 10 year yield rose by 70bps. The 2 year moved up by 100bps. There was significant concern around not just SVB but whether there would be a broader depositor run on the banking system. The Fed got involved, guaranteeing deposits. The market saw a big change in monetary policy coming and the two-year note yield fell by 130bps in just 2 weeks. Hedge funds, believing that “higher for longer” would prevail, had sold call options on two-year note futures. The massive rally in this security and explosion of vol that came with it, caused huge losses.
You had to have quite an imagination to piece this one together in evaluating whether being short calls on two-year note futures was going to prove especially risky. First, you had to envision that Silicon Valley bank would be exposed for its lax risk management protocols and for getting long duration at the wrong price. Next, you needed to anticipate that an electronic bank run would quickly ensue, perhaps following Peter Thiel on Twitter. Next, you saw that the Fed would be forced to act. Then you’d have to link the Fed’s playing the systemic risk card with a giant rally in the front end of the curve with the expectation of meaningful Fed policy easing. And the Twitter grifters say that investing is easy! Note, the Fed wound up not easing at all in 2023. A big fat never mind in market prices as the two-year note which got to as low as 3.7% in yield in late March 2023 was again yielding 5% by August.
Risk Management does indeed suffer from a failure of imagination. I’ve been re-rereading books on the financial crisis. I read House of Cards on Bear Stearns. Now I’m onto the Big Short, featuring folks like Michael Burry and Steve Eisman who profited handsomely betting against mortgage derivatives. Also featured in the book is LibreMax founder and CIO Greg Lippmann, then a trader at Deutsche Bank. There’s a great chapter in the book in which Lippmann pays 28bps to buy credit protection on the senior tranches from Morgan Stanley’s Howie Hubler. In coughing up the premium, the DB trader says “we both know there is no risk in these things”. Even Lippmann, on the right side of the epic unwind and with a keen understanding of just how misplaced the credit and correlation risk was, could not imagine that what he was buying was actually really worth something.
And that leads us to Saying number 32 and that is that “markets are a never say never business.” The text books teach us that markets are efficient and that price discovery takes place at every instant. Markets can accommodate what you want to do at all times and in any size you like. But what we see is that prices are simply where two counterparties happened to transact at a given time. For the most part, buyer and seller exchange money for an asset in the context of market conditions where the price is within the realm of fair value. Clearly, the two parties wouldn’t trade without a difference of opinion, but it’s generally the case that prices are linked to some economic value. There are exceptions. Many more than you’d expect.
Market prices can do really strange, almost inconceivable things. They can stray so far away from equilibrium levels. For example, crude oil in 2020. How about GameStop in 2021. How about Nickel in 2022. Three years, 3 distinct assets and each of them showcasing prices that any model of underlying price distribution would struggle to accommodate. These prices are the result of a protracted imbalance of supply and demand. There’s nothing more dangerous, because when there is no capital left to buy or sell, arriving at the clearing level will require a massive change in price.
How about two recent, related examples, the VIX and NKY in early August of 2024? The VIX closed at 23 on Friday, August 2nd. It would reach 66 in the morning session of Monday August 5th, as the SPX options market, the calculation engine for the VIX, lost its way, breaking down from a liquidity standpoint. How about Japan’s Nikkei 225 index? It fell by 12.4% on August 5th and rose by 10.2% the next day. Up until these enormous swings, the Nikkei was roughly a 16 vol index, moving around 1% per day, up or down. While we know that the normal distribution fails to capture the “fat tails” of equity returns, consecutive 10 standard deviation moves? That’s serious stuff. Never say never.
Because risk management suffers from a failure of imagination and because markets are a never say never business, it turns out that markets break, on occasion. And, in the words of Mike O’Rourke from Jones Trading, “broken markets break down.” That’s our saying number 33 and I appreciate this one not just for its wonderful brevity but because it captures a vulnerability unique to asset markets. There are some exceptions, but crashes do not come out of the clear blue sky. They are an outcome of a process in which risk takers have already sustained losses, losing both wealth and confidence along the way. Think of market wealth as one’s chip stack. With a string of successes and a big stack in front of you, taking the inevitable loss on a hand won’t hurt that much. But should the stack erode over time, your effective leverage rises along the way. In markets, losses typically coincide with conditions that have become more volatile, further amplifying your effective leverage. You wind up with less chips, and being forced to play in a looser game.
Thus, while there are risk events that can materialize quite suddenly – an awful event like the 9/11 terrorist attacks or the 2020 pandemic – it’s more often the case that asset markets that have already experienced a meaningful drawdown become more vulnerable still. Losing confidence and capital, investors may be on the wrong side of trades that sought carry but are exposed to a pop in volatility. Margin calls may be made and mark to market collateral may be demanded. If liquidity and volatility are some kind of inverse cousins of each other, faltering markets can become more difficult to trade, with less visibility on whether trades can be implemented or unwound.
“Nothing bad happens above the 200 day moving average”, is a statement generally attributed to Paul Tudor Jones. My vol nerd equivalent is that “nothing bad in markets happens when realized vol is below 15”. In some ways, these are the safety zone corollaries of Mike O’Rourke’s “broken markets, break down.” All 3 reflect the idea that assets become more or less vulnerable based on their price history and the wealth created or destroyed in the process. Recently, the SPX crossed its 200 day moving average on March 6th. Over the course of the next month, it would lose 13%. This may be a cherry-picked example, but the point is that from the Feb 19th all-time-high in the SPX to March 6th, the SPX was down 6.6%. From March 6th to the April 8th low, it would fall another 13%.
Next on our Sayings on Vol and Risk is the statement that “this is not your father’s ETF market.” No-siree-bob. There are, apparently, a lot of things that are not your father’s. This is not your father’s Oldsmobile, or root beer. There was a “not your father’s podcast”, but it’s no longer. I guess it’s no one’s now, including your father’s. Joe Biden – remember him – told us in 2022 that this is not your father’s Republican party. I guess I see his point, though I’m not sure he could make it today.
This is not your father’s ETF market is a nod to all the new flavors of exchange traded vehicles that continue to be created. Today’s ETF world increasingly consists, as Alpha Exchange guest Eric Balchunas calls these products, “hot sauce”. First there was SPY. TLT and GLD came along. VIX products – both long and short – were launched and then imploded. Today’s world of ETFs are on discretionary baskets with various new themes like AI, water, genomics and cyber security. They sit atop totally new assets like bitcoin, Ethereum and Ripple. They provide access to private credit.
They embed optionality, both vanilla and complex forms. They have daily resetting leverage features, both on the long and short side. I’ve done a series of podcasts on the leveraged ETF universe that I’ll point you to. Check out episodes with Rocky Fishman of Asym 500, Mike Green of Simplify and Victor Haghani of Elm Wealth. Each does a fine job discussing the mechanics of these products, with specific attention to those with MSTR as the underlying.
Big picture, and back to Logan Roy, “everything is moving, always.” These new products introduce new dynamics into the market. There’s no one at the helm of MSTU, the 2x levered long ETF on MSTR, that has much to say about Michael Saylor. The Portfolio Manager of MSTU is there to deliver twice the daily return of MSTR, for better or worse, each day. That’s it. But, as we’ve covered extensively on the Alpha Exchange, the hedge for this product requires said PM to buy on days when MSTR has risen and sell when it’s fallen. And, while it’s counterintuitive, the leveraged short ETF does the same thing, also reinforcing a price that is rising or falling. Taken together, the leveraged long and short daily reset products act like the delta hedging of a short straddle.
Mechanical trading strategies that require a rebalance each day that go the same way as the underlying asset are worth paying attention to. There are instances when the leveraged ETFs are large enough relative to the liquidity profile of the underlying asset that they exacerbate the volatility.
Some of these new ETFs also come with embedded optionality. There are risk managed products that utilize collars, seeking to create a “defined outcome”. There are overwriting strategies that generate some option premium by sacrificing upside in both indices and single stocks. NVDL, for example, sells calls against NVDA. It’s got nearly $1.6 bln in assets. We are seeing ETFs with OTC swaption and barrier options tucked inside them as well. For potential users of these products, it’s really important you understand what you are getting. I’ve seen one product nominally called an inflation hedge that did poorly in the post pandemic inflation surge.
If you have a Bloomberg terminal, hit up the ETF and run the MHD command to see what the portfolio is composed of. You can often see real specificity, even on complex OTC options. You want to be convinced that this additional kind of exposure is serving the right objective and at the right price. Please, please please, don’t be like Congress passing a 1,000 page piece of legislation without reading a single line of it. On the investment side, do have a look at the prospectus. On the leveraged ETF front, it’s remarkable how clear the prospectus makes it that holding these resetting products over time is not wise and yet, many do anyway.
Alright, we are set to close out these new addition to our sayings on vol and risk. We started with “risk management suffers from a failure of imagination.” We added “markets are a never say never business” and then added “broken markets break down.” Now that we know that this is “not your father’s ETF market”, we conclude with an old standby from Voltaire himself. “Doubt is not a pleasant condition, but certainty is an absurd one.”
Lots of wisdom here as applied to markets. First and foremost, investing fits in the category of various disciplines that requires decision-making under uncertainty. Try as we might, there will always be more that we don’t know than we do. The work is about reducing that ratio, but always respecting there’s only so far it can be reduced. The list of unknowns in markets - emanating from all corners of the world, from geopolitical risk, monetary policy, technological innovation and so on – is a long and formidable list. Doubt is unpleasant. In markets, we might call it humility and it’s an essential part of the first rule of risk management: don’t die.
And while we haven’t met, I gotta concur with Voltaire on the second part of his statement as well: “certainty is an absurd condition.” Taken literally, Buy 0 and Sell 100% odds all day long in whatever size you can. Certainty in markets can be a bad thing. Joe Cassano of AIG Financial Products was clearly certain. In August of 2007, about his desk’s enormous exposure to sub-prime, he said, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
Michael Saylor is today’s version of certain. There are few better salespeople, probably because he is so entirely convicted. He once said, “only buy bitcoin with money you can’t afford to lose”. What a fabulous turn of phrase. There appears no price at which he would decide to take profits or cease his buying campaign. Like Joe Cassano in the 2005 and 2006 era, Saylor has been dead right so far. And, that becomes the problem. The “up and to the right” path of bitcoin’s price, is an intoxicating “I told you so.” It clearly reinforces his own thinking and enables him to rev up his sound machine, seeking to bring in fresh buyers.
It’s working remarkably well. He just has no business being so certain it will continue to. There’s nothing about bitcoin that should leave Saylor so entirely convinced it’s going so much higher. Recently, he suggested it would hit 13mln by 2045.
To be clear, I’ve advocated pretty strongly for exposure to bitcoin as some part of the portfolio. It’s got a very unique distribution of returns and, given the total budgetary irresponsibility of our elected officials, both gold and bitcoin serve a purpose. At the same time, we should take note of those peddling the “sure thing.” Remember when Bud Fox said to his boss Lou Manheim in Wall Street, “I’ve got a sure thing” to which his boss responds “no such thing only death and taxes”. I might add never ending and large auctions of US Treasury securities to that list. But that’s about it.
We’ve now completed 35 sayings on vol and risk. To be sure, there are plenty of overlapping elements among them, but I am hopeful they provide you with some insight in thinking through this high-contact sport called financial markets. Until next time, have a wonderful week. Be well.