Sayings on Vol and Risk...A Fresh Five

Hello listeners and welcome to what was originally a series called 25 sayings on vol and risk. In this 5-episode podcast (on Apple, Spotify, etc.), I shared a number of pithy proverbs I had developed personally or utilized with full credit to the author as a way of understanding how markets work and the lessons they teach us.

Our relationship with prices is a complicated one, to be sure. They make us wealthier, or less so. They motivate us to move and always force us to think. Above all, markets provide us with feedback. And feedback, according to Ken Blanchard, is the breakfast of champions. I’m just finishing reading “The Fund”, the book from 2023 on Bridgewater. And with this in mind, I can state unequivocally that Ray Dalio consumed his share of Wheaties. A unique culture they’ve got at The Fund, to put it mildly.

What follows are 5 new sayings on vol and risk. And I will follow up with 5 after that, getting us to 35 in total. I speak my own book, of course, but there’s a lot of risk philosophy shared here. What ties everything together is an appreciation for the reflexive nature of markets, where feedback matters. And, so, too, do the undeniable biases that we humans experience. We put too much emphasis on events of the recent past, extrapolating a future that will look much the same. Conversely, we forget that which happened longer ago. Time passes and our appreciation for history is dulled.

Ray Dalio may have the Principles, but we’ve got 25 (and counting) sayings on vol and risk. So, let’s explore the newest 5, shall we?

Let’s start by riffing on none other than Sir Isaac Newton himself and his second law of gravity. When applied to markets, it reads “financial objects at rest tend to stay at rest”. Perhaps this is Dean CurNEWtons law. Where am I going here?

When markets become especially stable and volatility especially low, the set of factors that played a role ought to be respected. Many, me included, have illustrated the correlation between low market and low economic volatility. Take the “2-2-2” economy that often was used to characterize the post GFC, pre-Covid era. Inflation, the 10 year and GDP all were consistently in the neighborhood of 2%. There were, of course, periodic risk-offs like the China FX repricing in Aug 2015 or the VIX event of Feb 2018 but in general, very low realized vol of these macro variables coincided with a sanguine backdrop for market risk. When the economy is stable, so are corporate profits. Again, we can easily illustrate that when earnings for the S&P 500 experience smaller fluctuations, the volatility of the index is low.

And this is where the feedback from markets comes in. We all read the same TOP page on Bloomberg or the Investing Section of the Wall Street Journal. The same talking heads pontificate regularly on CNBC. I may be one of them. Just curious, Does Wall Street Bets have a macro sleeve? Anyway…

We consume an impressive amount of content, most of which leans into a “consensus” view. A consensus view becomes one because the data – both economic and market – forces it upon us. It’s difficult to bet against something that has been happening with such consistency. The trend is your friend, they say. We become convinced that the consensus state of the world and of market prices will hold. And here’s the feedback loop part: we build trades around this idea. We short vol. “Sell the straddle and go to lunch”, as the saying goes, is a nod to getting fat and happy by betting on stability.

What matters, in this process, is that as vol is sold, it can reinforce the stability already in place. I’ve covered this quite a bit, but in simple terms, a short straddle on the SPX, purchased by a Goldman or Morgan type who hedges, will create index delta supply as the market rises and index delta demand as it falls. Voila. A “gamma well”, as it is sometimes called, in which the index just gets stuck in a narrow range due the just described manner in which the hedger buys and sells to rebalance.

It's always difficult to disentangle the why of market moves – or in the gamma well case – lack of them. I can say that around August of 2017, with the 30-year anniversary of the 1987 stock market crash soon approaching and with the SPX realizing 5 or so vol, I asked 25 clients what their forecast was of realized volatility over the next 1 and 3 months. Suffice it to say, these were very low expectations. But most telling was the expectation of SPX realized vol over the next week. The average response was 5.8%. And guess what, the realized vol over those ensuing 5 trading days wasn’t much different from that. Financial markets at rest did indeed stay at rest.

Ok, let’s keep this list moving. Related to this observation is saying number 27, which is that “realized vol rules the world”. Everything in markets - and many things in life - are a response to realized vol. Our thinking, our behavior, and the choices we make are always informed by the actual or perceived uncertainty of outcome. And past uncertainty of outcome maps directly to what we expect about the future. Drive into NYC and experience nightmarish traffic? You’ll think twice next time. Find your car ticketed after just a quick run into Starbucks? You are set back not just the 25 dollars for the violation but 8 for your salted caramel frap. You’ll think twice next time.

For option markets, realized vol truly rules the world. The machines that set the prices of the millions of put and call contracts flickering in real time couldn’t possibly establish and refresh levels without a heavy helping of math. And, at the heart of the price setting algo is realized volatility. Run a scatter plot of the 500 stocks in the SPX connecting realized and implied volatility for each. You will see a pretty tight – certainly not perfect – but impressively consistent relationship. The higher the realized vol, the higher the implied vol. Of all the factors that impact option prices - carry as we call it – the relationship between realized and implied vol – matters the most.

The marginal price setter of an option is the investor seeking to replicate it through a dynamic trading strategy in the underlying asset. When realized vol gets especially low, the prospects for monetizing the trading strategy are poor. It means the option isn’t worthless, but it is indeed worth less.

A good example of this is in the behavior of credit spreads and options on credit in 2024 and into early 2025. The CDX IG averaged 52 from the start of 2024 into Feb 19^th of 2025, when the SPX hit an all-time high. Incredibly, the IG price was contained entirely in a range between 61 and 47. Is it any wonder that the CBOE’s VIX IG index averaged just 26 over this time frame?

Saying 28 moves away from realized vol, but stays with the theme that we humans are prone to miscalculations, often resulting from our overconsumption of pricing data. In this little number on vol and risk we learn that “my portfolio is more liquid and more diversified than I thought,” but then in ironic twist, add said no one, ever.

It’s literally never the case that we find our portfolios more durable to a shock than we expected them to be. Even hedges themselves – built on that one asset in the world that is truly anti-fragile – vol – can be difficult to unwind when the opportunity to do so strikes. Just ask VIX call owners about the morning of Monday August 5^th. Turns out buying something from someone for a dollar and looking to sell it back to them at 8 just weeks later sometimes causes a problem.

Liquidity in markets can be, in the words of Mohammed El-Erian, a mirage. I decided to re-read one of the books on the GFC, “House of Cards” by William Cohan. It’s a story about the downfall of Bear Stearns. And in it, we learn of one of the earliest cracks in the system, the downfall of BSAM in July 2007. The fund’s chief, Ralph Cioffi, has most of the capital in subprime CDO’s, which for financing purposes, he has repo’d to the likes of Goldman Sachs. The prime brokers have been dutifully marking this very complex and highly illiquid paper pretty close to par over many months. Suddenly, Goldman has the paper marked at 50-60. Whoops. And that, basically, was the onset of a very fast lights out for BSAM.

Marking to model is one thing, if you have luxury of doing so. But true marks that reflect where an asset can be disposed of, or in the case of a short, covered, are altogether different. I often say that diversification is an elusive pursuit. Assets become more correlated and volatile at the same time. Take the Quant Quake that occurred just a month after the Bear hedge fund imploded. A big part of the crowded, factor-based exposure underpinning the August 2007 unwind was the expected diversification resulting from joint exposure to value and momentum. The speed with which that de-risking would take place flipped the correlation entirely, leaving quant portfolios with much more risk than contemplated. One of the quotes coming out of the Quant Quake that I always loved was from Goldman’s David Viniar who said, “We were seeing things that were 25-standard deviation moves, several days in a row.” Boy, I suppose that is surprising when you think about it.

Now, I can’t help but finish this bit on market liquidity with some reference to all of the growth in private credit. There’s nothing about the expansion of this asset class that is bad, it just needs to be thought of in the context of how quickly one can convert the exposure back to cash. My view is that investors consistently overestimate their time horizons and, as a result, over-allocate to the “hold to maturity” bucket. I’m reminded of the scene in Casino when Joe Pesci’s Nicki Santoro tells the banker, “I think I want my money back”.

The next item on our list is a function of a new risk dynamic in markets and it leaves me believing that “the 10-year Treasury note, not the SPX is the risk asset”. Let me explain.

In remarks delivered on May 5^th, Scott Bessent invoked the anti-fragile term in reference to US markets. The equity market can hardly be bullet-proof when the US government bond market - one of our most important assets - is anything but antifragile. There's no business plan for right sizing this complex or stabilizing the debt. Only an extension of the debt ceiling, for now. When one thinks of antifragile assets, the notion that an "X Date" beyond which the borrower is in some version of default, doesn't readily come to mind.

Unfortunately, the back end of the US bond market, long an “insurance asset” that rallied on a flight to safety, has become a threat. Higher yields are the market’s way of saying “no mas” to debt and deficits. Even Elon Musk has gone scorched earth on the “Big Beautiful Bill”. The Trump / Musk bromance was bound to end badly.

I talk a good deal about stock/bond correlation on the Alpha Exchange. We've certainly seen instances when stock and bond prices go the same way. 2022 is a prime example, and it caused a sizeable drawdown in the 60/40 portfolio. But that did materialize during a tightening cycle when the Fed was clearly behind the curve and the short rate was rising fast. The back-end followed the front end higher in rates as this occurred.

The recent dynamics are altogether different, as the long end is under pressure even as a Fed easing cycle is being discussed. The recent dynamics are about a risk premium emerging in the back end of the US bond market. It’s an irresponsibility tax. Sadly, this is well-earned.

In stating that the Ten-Year Note, not the SPX, is the risk asset, I am reversing the causality that investors have long been accustomed to. In the era of risk on/risk off, the bond market would rally as a RESULT of a stock market sell-off. Now, it is the bond market – and higher yields for the wrong reasons – that serves to threaten the stock market. Hopefully Scott Bessent is channeling some of his old boss, Soros, on the notion of reflexivity. Market prices don’t just react to fundamentals, they shape them. The ultimate systemic risk is one in which the US bond market badly malfunctions.

We are set to close out this addition to our Sayings on Vol and Risk, getting us to 30 in total. We’ll finish with the recommendation to “shake hands with the government and sell what they’re selling.” This is a play on a statement Bill Gross made repeatedly in 2008 as the GFC was set to intensify and there were questions about the soundness of Fannie and Freddie. Broadcasting his positions on CNBC, Gross said, about his ownership of GSE debentures, “shake hands with the government and buy what they’re buying.” It was a compelling PR campaign, and it worked. My twist, to shake hands again, but sell what the government is selling, is a nod to the reality that the Fed and Treasury simply cannot allow the VIX to go too high.

As it surpassed 50 in the days after Liberation Day, the VIX was quickly becoming a problem for Bessent. As I’ve said before, the precedent for a north of 50 VIX ain’t promising – it’s 50 on the way to 80 as happened both during the GFC and Covid crash. The higher the VIX went, the more destabilized markets would become. Anticipating the policy response amounted to recognizing that Bessent would need to sell the VIX, doing something that amounted to forcing it lower. And that, of course, is just what happened on April 9^th, when Trump reversed course on tariffs.

There are certainly other times when a surge in risk premium is extreme enough such that we can reasonably expect policymaker intervention. The all-weekend summits in the Fall of 2011 featuring finance ministers across Europe certainly had a “how do we lower sovereign spreads to Germany” theme to them. These folks didn’t like markets very much, but even they understood the risk of doing nothing.

In general, whether buying or selling what the government is, the general idea is to try to understand the policy response, its degree of urgency and its ultimate impact on asset prices.

If we go all the way back to 1994 and consider the Mexican peso crisis, we can remember that the U.S. initially extended a limited dollar swap line of $7 billion. The crisis worsened, and lines of credit from the U.S. and other countries were established. Another month passed, and the crisis deepened still. A loan package of $50 billion from the U.S., the IMF, and a consortium of banks was arranged. It was not until Mexico adopted stringent austerity measures in March of 1995, two months after the loan package, that the peso stabilized.

The big picture observation is that while tail risk events rarely play out as anticipated, an important cross-current to these occurrences is the specter of policy response. In seeking to stabilize markets and forestall crisis, authorities implement various programs that directly impact the market price of risk.

Well folks, that is all I’ve got for now. As I speak these words, we are 2 months past the short-lived but intense risk-off that hit the market after April 2^nd’s Liberation Day. There’s a good deal to be learned from this event – about the speed with which market prices sometimes need to incorporate a new state of the world, about how correlations can surge in a crisis, and about how policymakers need to be watched closely, because try as they might, they simply cannot ignore the misbehavior of market prices.

I look forward to coming back in short order as we build out our Sayings on Vol and Risk Series. I hope you’ve found this interesting and useful. I wish you a wonderful week. Until next time.