Benjamin Bowler, Managing Director and Global Head of Equity Derivatives Research at Bank of America

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:19] As Global Head of Equity Derivatives Research at Bank of America Merrill Lynch, Ben Bowler is helping the firm's institutional client base understand the complex risk dynamics that impose themselves on today's markets. His process often leads him across asset classes, looking for linkages and developing stress indices that may provide early warning signs for U.S. equity markets.

[00:00:42] Our discussion first considers the recent S&P Vol event, which, from a short-term severity standpoint, Ben puts in a category with the GFC and COVID. He further makes the point that since the tariff uncertainty was self-imposed, it was as if we were in the midst of the COVID crisis but already had the vaccine in hand. We then explore the work that Ben and his team have done on the concept of fragility.

[00:01:07] Here he argues that the speed and magnitude of vol spikes, flash crashes, and tantrums in markets has increased. In fact, in U.S. single stocks, he suggests that fragility is at an all-time high, with the reaction to earnings faster and more violent. Two factors may be playing a role. First, there is substantial crowding in certain risk exposures like large-cap tech.

[00:01:30] And second, liquidity provision, increasingly electronic in nature and sometimes rapidly withdrawn during times of stress. Lastly, we discuss the history of innovation and how investors have generally pulled forward the benefits of path-breaking new technologies, leading to asset price bubbles. Here, Ben is thinking about right-tail risk and how important optionality may be in hedging the risk that the AI bubble could inflate substantially from here.

[00:01:57] I hope you enjoy this episode of The Alpha Exchange, my conversation with Ben Bowler. My guest today on The Alpha Exchange is Ben Bowler. He is the Global Head of Equity Derivatives Research at Bank of America Merrill Lynch. Ben, it's a pleasure to welcome you back to The Alpha Exchange. Thanks, Arnie. When the VIX was in the 40s, I thought about reaching out. And when the VIX got into the 50s, I knew I had to reach out.

[00:02:23] And I was looking back at our first podcast, which was episode 17. It goes back more than five years. I think it's actually even before the COVID shock. Lots has changed since that period. We've had some big bursts of volatility in markets. We've had some pretty quiet times as well.

[00:02:44] As we get our conversation started, I just thought it would be a useful jumping off point just to have you reflect a little bit open-ended on the market chaos of the last, call it 60 days or so. There's just not a lot of precedent for a VIX closing north of 50. You really got to put yourself into episodes of crisis like COVID and the GFC. And now we're sitting here with the VIX at 17.

[00:03:14] So get us going by just looking back a little bit on this last period. What, if anything, have we learned about markets through what has been an unbelievable risk off and an unbelievable risk on? April was historic, as you said. I mean, we could put that in comparison with the COVID crash or the GFC or 87 in some sense.

[00:03:39] We, for a long time, have talked about this idea of market fragility, this idea that we're having a more frequent occurrence of flash crashes or tantrums in markets. And, in fact, if you look back to 1928, April recorded a noticeable blip in the almost 100-year chart of U.S. equity fragility. It was pretty striking.

[00:04:08] Within the span of the week, we got two consecutive 4% down days, which was, I think, only the fifth time since World War II on the 3rd and the 4th. We had remarkably 133% intraday realized vol on the 7th, which was the 3rd highest since 2004. I think trailing only one day we had in COVID. And then a 9.5% up day on the 9th.

[00:04:35] So, yeah, I mean, I think, but, you know, if you really peel it all back to me, one of the, you know, really critical things that happened, and I think we'll probably get into this more in the discussion, is what happened from the outside in U.S. investors' perspective. So, this is perhaps something that's not as well known or understood.

[00:04:54] But if you were sitting outside the United States and you were measuring the return of U.S. dollar, treasuries, and U.S. equities, you know, you experienced in April the largest shock we've seen since the 1987 crash. I think it was even more stressful from an outsider's perspective than it was sitting inside the U.S. And that's because we had a joint drawdown in not just the stock and bond markets, but also the dollar? That's right. Yeah.

[00:05:24] I mean, obviously, treasuries had already been, you know, struggling to provide the kind of risk off that they historically had done in the last couple of years. But I think the weakness in the dollar was particularly notable.

[00:05:37] And again, it's probably not as noticeable for those sitting inside the U.S., but for those outside, which comes back to, I think, a, you know, kind of a really important bigger picture point here, which is just this increasing loss of confidence in the U.S. from, you know, outside investors' perspective. And yeah, I mean, I think it's, you know, again, I think hard to quite appreciate just how dramatic probably the shock felt from their perspective in particular.

[00:06:05] When you were inside that period, you know, call it April 2nd, Liberation Day to, you know, April 8th and to the early morning of April 9th, and you start to get these correlations that run amok and specifically the rates up even as the dollar is selling off. Some others have pointed out that this is kind of a list of risk, right, U.K. pension hedging debacle of, I want to say, 2022.

[00:06:34] What was that like for you? And just in terms of client conversations that dominated the most protracted part of that risk off, those kind of four or five days post-April 2nd? There was a lot of concern.

[00:06:50] I think the way we looked at it, though, which was quite important, was that, you know, the and I think one difference from what we saw in the U.K. LDI crisis, the Liz Trust moment that you were mentioning a few years ago, was a couple things. One is, you know, I think in some sense we can't forget that this was man-made. There was someone in control, essentially, which was the U.S. administration who could, you know, reverse course.

[00:07:19] And ultimately, we saw that they did. And I think we also learned what the pain point was, you know, which they, you know, which the administration was willing to back down. But I think that was a critical aspect of this risk off. You know, I think some people had said it was almost like, you know, kind of COVID, but, you know, knowing that we had the vaccine in hand, it was just a matter of, you know, when it was going to be made available. And so that aspect of it was pretty important.

[00:07:48] I think another key component to this is that going back to the – so we were very concerned, actually, during the U.K. LDI crisis of something that was quite problematic in the sense that the Bank of England at the time, if you remember, essentially said, hey, we're going to do everything it takes.

[00:08:06] But for a maximum of two weeks, right, because they were really stuck between this point of pain between trying to support the market at the same time, not allowing inflation, obviously, to, you know, to get out of hand. And so they kind of gave a time limit around how long they would provide that central bank put. And luckily, the market came around and they got things under control and they didn't need to be tested on that time limit.

[00:08:35] But this is kind of a broader point around policy puts, but I think a very important one, which is that at that point in time, when inflation was as high as it was in the U.K. and also in the U.S., we were very concerned that effectively this central bank put that has, you know, I would argue been the most influential factor, feature of financial markets in the last 100 years, you know, in terms of putting that left tail protection in,

[00:09:02] that we were without that for the first time really since Alan Greenspan invented it in 1987. And we were without it while inflation was running at those really high levels, which was exactly when we had that LDI crisis in the U.K. So I think one major difference today is that, you know, with inflation back down to as low as it is, sub 3% in the U.S., closer to 2%,

[00:09:27] that, you know, we do have the central bank put back compared to where we were a couple of years ago. That actually is quite comforting compared to the situation, I would say, if we were having this conversation just, you know, two, three years ago. And on top of that, of course, we saw the Trump put in action. And I think seeing the contours of where that put kicked in, seeing the pain point at which the administration was willing to back away

[00:09:54] became really important in understanding how this, you know, this risk event would eventually unfold. I've introduced you as Global Head of Equity Derivatives Research, and we've talked a little bit about the VIX, but we spent most of our time talking about FX and rates and the path of Fed policy. And so your work and your team's work brings in a very cross-asset approach.

[00:10:23] And one of the things I think you guys have done especially well is develop these global stress indices, which have a number of subcomponents. And there was one part of what you wrote that really caught my eye was that one of your stress indices kind of flashed yellow, yellow to red in the, you know, couple of days before this thing really flared up.

[00:10:45] And I'd love for you to just to, you know, first lay out the way in which the Equity Derivatives Reach product takes in cross-asset information, maybe, you know, referencing these stress indices and, you know, kind of the interaction between the VIX and all of its cousins and how you guys make use of that. Yeah, I mean, as you said, Dean, I've been doing this for a long time. It's the 27th year of, you know, being in research focused on ball.

[00:11:15] And I guess partly because I've been doing this for so long, about 15 years ago or so, coming out of the GFC, when we were in a very macro-driven environment, we kept getting questions from clients around, well, hey, look, you know, we're in a macro-driven world. I'm concerned that we're going to see another resurrection of macro risk. I'm trying to figure out how to hedge this, but how do I know whether I'm better off buying, you know, puts on copper, calls on the dollar, or puts on equity?

[00:11:43] And how do I compare and contrast the value of those opportunities in a world where correlations, you know, go to one in a shock, whichever one I'd experienced? And so we started a process in late 2009, early 2010, in building a number of tools for understanding risk on a ball, on a cross-asset basis. And we, in 2010, developed something called the Global Financial Stress Indicator,

[00:12:09] which is our flagship tool for measuring and monitoring risk on over 40 factors covering five asset classes. And that's kind of our way of sort of peering into what cross-asset risk is saying on a regular basis. But we had noticed when we first developed the index that if you could identify thresholds at which cross-asset stress started to build up momentum,

[00:12:37] it was actually a pretty good indicator for where risk would continue to cascade higher, where the momentum would continue, and where risk assets would sell off. And so we developed this thing called the Critical Stress Signal in late 2010, early 2011, that basically was this threshold marker of cross-asset risk momentum. And it worked fairly well in the early days, as it did in historical back tests.

[00:13:06] But what became really remarkable was in 2013, beginning with the taper tantrum, when Bernanke, if you remember, kind of walked the market off the ledge, you know, talked the market off the ledge by saying, hey, look, there's no risk to see here. This indicator actually started to become incredibly contrarian, meaning it seemed to represent the stress threshold at which policymakers started to panic

[00:13:32] and, you know, were willing to step in and provide that proverbial put. And in fact, it's become even more successful in live action since 2013 than it was even prior as a momentum indicator. And sufficient that we had the last signal we had was on the 7th of April.

[00:13:56] The last eight signals, which have all happened since 2020 in the last five years, essentially 100% of them have marked within 3% of the low in the S&P 500. So I think initially, we kind of started to joke that we needed to take Bernanke and then Yellen and, you know, later Powell off our distribution list for this indicator, because it seemed to be it was exactly the point at which they would step in.

[00:14:24] But of course, you know, at some point, they didn't need to step in anymore, because markets learned that at certain stress thresholds, you buy the dip, because it works, you know, every time. And so there is, I think, element of self-fulfilling by the dip that's actually coinciding with this stress threshold. But again, just remarkable that it seemed to be the point of pain in which the administration, in this instance, just couldn't stand it anymore and, you know, pull the plug and put a floor in the market.

[00:14:55] There seems to be, especially with this one, some version of trading the policy response, or in this case, just trading the undoing of April 2nd. And as you noted, I think that it's easy to look back, but it really did feel like that pain point, especially, you know, with the VIX in the 50s, high 50s intraday, and the bond market selling off in tandem, that you had to think Scott Besson's phone was ringing off the hook with all his,

[00:15:23] you know, contacts in the markets business. And he very likely finally got to Trump. So look, this was a very correlated, you know, risk off. Every vol across every asset class, perhaps lean hogs wasn't in that. But, you know, just about every macro asset class really saw a very big spike in vol, including credit. You know, credit spreads and credit vol finally participated.

[00:15:53] I would love for you just to maybe compare and contrast this VIX pop to what we saw on August 5th of last year, which felt more technical. It felt like more of a shortfall of liquidity. I'm just curious if you could just review that one for us, because that was really interesting, even though it was very short lived, didn't really require a policy response. But what did you make of the action last August 5th?

[00:16:22] Last August was, you know, largely a classical fragility shock in the context of vol. So, you know, we had, I guess, just almost 10 years ago in late 2015, put out our year ahead outlook that year, arguing that we were entering a world of higher fragility risk. And the arguments we put forward for why fragility was on the rise was,

[00:16:51] first of all, we saw an increase in positioning risk largely coming from trade crowding. We actually argued that, interestingly, I think there's a connection between this central bank control or dominance of markets and fragility in the sense that we argued at the time that as central banks took more control over markets, they slaved the markets to a narrower set of policy factors.

[00:17:19] That, by construction, essentially starves the market for alpha. You now have too big a supply-demand imbalance between too much capital chasing too little alpha. You get crowding, which has been a big problem, of course. And when everyone's crowded into the same trades and they try to, you know, the tide turns and they no longer want to be there because the trade's no longer working, they all try to exit.

[00:17:44] But, you know, the door to exit is effectively as narrowing at record speed as stress rises, namely because high-frequency traders that control the vast majority of liquidity in agency electronic markets are also short fragility. And they have an incentive to, you know, they're faster than everybody else and they have an incentive just to walk away and effectively that narrows the exit door. And so that dynamic, you know, I think has largely been in play in the last decade.

[00:18:11] Again, we've seen effectively since 2008 a five-fold increase in the frequency of flash crashes and tantrums or fragility events in the S&P. It's actually happened cross-asset as well. It's not just an equity phenomenon. You know, we've seen it in rates. We've seen it in commodities. We've seen it in treasuries. We've seen it in credit. And it's right now actually hitting its peak in U.S. single stocks.

[00:18:39] So U.S. single stocks right now are the most fragile that we've seen ever in history, even including the peak of the 2000s tech bubble. So going back to last August in terms of the VIX, again, by some metrics, one of the biggest fragility events we've seen in the VIX itself. And we largely trace that back to a massive liquidity failure, you know, pre-U.S. open overnight, you know, as the end carry trade unwound and extremely wide bid-ask spreads

[00:19:07] in S&P options. And ultimately, it was a liquidity failure, you know, very similar to what we've seen in many other markets. You know, positioning, of course, you know, also played a role in that environment last August, maybe perhaps less so in this event. And maybe that's the biggest difference, I would argue, between past VIX shocks. And this one is, I feel like positioning risk was probably lower this time around, because

[00:19:34] recall the S&P was only down, you know, sub 5% in the event last year. Obviously, much bigger damage in S&P this time, but not as high as VIX. So that was also, I would say, a difference between the two. When I think of the term fragility, the way I think about it, and I'd love for you just to be very specific on it, I'm thinking of a kind of a shock to realize vol.

[00:19:58] That you have an asset that's got a vol profile, maybe it's 15, you know, on average, and then suddenly, you know, it experiences a 5% or 10% move. It's just totally outside the boundaries of what you'd expect. Is that how you think about it? You know, how can folks think about measuring fragility? The classic way that we think about fragility, essentially, is you kind of think about it like a value at risk outlier.

[00:20:26] So if volatility is telling you that the forward-looking distribution of an asset is defined in a certain way, and then you're seeing very large fat tails relative to the trailing distributional projection from volatility, that's essentially what we're calling fragility. In other words, to make it simple, if vol is saying that, hey, less than a 2% move should

[00:20:53] happen, you know, less than 95% of the time, and you see a 4% or 5% or 6% move, obviously, that's a very fat tail. And it's a fat tail relative to, let's say, the trailing one month or three months of volatility to inform that forward-looking distribution. So think about it in terms of fat tails on a rolling basis, right? Like the rolling is whatever volatility, most recently, it's telling you is most likely to occur.

[00:21:20] Now, formally, we like to measure it in two ways. We like to measure either in terms of what we call sigma moves. So again, you know, the trailing volatility should say that, you know, on average, you should maybe expect a 1% return. And if you get a 5% return, obviously, that's five sigma. The more formal way to measure it is just in terms of the kurtosis of asset returns, which standard statistical metric of the fourth moment, that's kind of one of our favorite

[00:21:49] measures, but essentially measuring the same thing, the fat tails relative to the recent environment you've been in. One of the charts that you've published is around the concentration of realized vol in single stocks on earnings days. Of course, earnings is a special day four times a year. I think I had ballparked it that the earnings day realized vol was, I don't know, three to five times that of a non-earnings day, typically.

[00:22:18] But what you're showing on a time series basis is that that extra amount has gotten even more extra, even more significant over time. So talk to us about what you found there. And then I'd love to explore what you see. Is that a, that's just another manifestation of crowding? How do you think about, is that a liquidity backdrop with market making, you know, capital being relatively thin? How do you think about the explanations?

[00:22:48] So we're trying to unlock, you know, why it is that we're seeing record single stock fragility. And I think anyone, you know, who's been following U.S. markets has felt this in the last, you know, 12 to 24 months when you have, in particular, large stocks, you know, trillion plus market cap stocks that on earnings or maybe even on another stock's earnings that are related in the same sector, you get, you know, 10, 15% moves wiping out.

[00:23:18] Or in some cases, adding hundreds of billions of dollars of market cap intraday sometimes. And so that's the dynamic that we're trying to explain. Why is this happening? Why are single stocks so fragile? Again, part of it, I think, has been crowding as, you know, in the large cap tech terms, you know, those stocks have become, you know, incredibly popular in the last, you know,

[00:23:47] Mag7, et cetera, in the last couple of years. Part of it, I think, is still this evacuation of liquidity during periods of stress, you know, from the market maker community that's controlling, again, the exit door. The earnings dynamic is interesting. And it actually, what we notice is this faster reaction to earnings, which you could argue is actually an indication of perhaps greater efficiency, right? That stocks are actually pricing in information more quickly than they used to.

[00:24:18] But, you know, you will appreciate this, Dean, from a vol standpoint. You know, if you price information into an asset more quickly, put it all in the asset in a day instead of in three days or five days, by construction, you are increasing the volatility of the asset, right? Simply because of the squaring or nonlinear nature of how volatility is calculated.

[00:24:41] So that's kind of an interesting mechanical component to this increasing volatility around earnings. Ironically, perhaps ironically, as a function of greater efficiency. So market structure is a fascinating and ever-changing dynamic that matters. The setup, we've talked about crowding. I think that's a fascinating topic. You know, we'll never know how to disentangle, right?

[00:25:07] The extent to which the new news was so significant that the market had to adjust perhaps massively versus the setup. We know, of course, and you and I have talked about this many times, that the setup going into early 18 was one of a massive and very vulnerable VIX complex, right? That basically sowed the seeds of its own demise by being so large and, you know, so mark-to-market sensitive.

[00:25:34] I'm curious what you think about the role of maybe some of the new ETF complex, perhaps the ever-growing presence of seemingly very innocent strategies like passive investing, right? The big get bigger in a passive investing environment. Do those play a role in this fragility concept that you observe? Yeah. So there are quite a few technicals that can be at play.

[00:26:03] And, you know, you think about even the classic ones that have been discussed, whether it's volatility control, in particular, on top of risk parity. If you remember the 2015, August 2015 shock that happened after the China deval, that was a hot topic back then. And we've heard for years that zero DTEs were creating material risks, CTAs. I mean, you name it, passive.

[00:26:32] You know, there's a laundry list of technicals that people have pointed to over time. And, you know, our team has done work on pretty much all of these and continues to do ongoing work. And what I would say to you, Dean, at a high level is that oftentimes we find that the effects are more icing on the cake than the cake itself.

[00:26:58] And that's a bit of an anathema to say that as a derivative strategist, because I think derivative strategists love to try to argue that the tail is wagging the dog and pay attention to the areas that, you know, we're experts in, because we can tell you, you know, when the market is about ready to be thrown around by the derivatives market. And look, at times we find material impact. Usually it's relatively short lived.

[00:27:26] But at a high level, what I would say is the cake is largely what's driving the underlying markets. It's the players, it's their incentives, it's the liquidity environment, as you mentioned, the market structure. That to me is oftentimes, it's the central bank, it's the Fed put. You know, most recently, it's the Trump put.

[00:27:53] Those are the things that I think really matter in, you know, much more most of the time than the product influences, especially for short term measures. Like if you get into the longer term space, sure. You know, longer term ball space, sure. You know, you see structured product influence and so forth. But I don't know. I would just say that, you know, we have tried to, I guess, call a spade a spade within our research and be as honest as we can.

[00:28:21] And sometimes it's telling people that, look, this stuff is actually, you know, not as meaningful as you may fear. I'm sure you've come across folks who characterized implied vol as some forecast of realized. And I never loved that. You know, I just think about the implied vol is a it's a clearing price. That's where two people met to agree to do a trade.

[00:28:44] And sometimes that price can be impacted by some overwhelming supply, some overwhelming demand. There's structural friction sometimes. And as you and I discussed beforehand, you had asked a question. And I think it's a question you're actively having with clients is. Why can't vol markets really sort of see the full picture? And I found that to be a really interesting question.

[00:29:14] And I'd love to understand a little bit more of where you're going with that. And then, you know, what are those factors that might be preventing us from seeing the big picture through vol? As you and I were talking about just before we started today, that, you know, one of the challenges with volatility is, first of all, it's an incredibly complex asset. It's a dynamic asset. You know, it's not static like, I don't know, the P ratio of a stock is, for example.

[00:29:41] It's a function of fluidity and movement. And so that in of itself complicates things. Because of it being so technical, I think also, you know, it's very easy to kind of get down into the weeds of, you know, of markets and these lower level dynamics to try to explain or argue, you know, why it's doing what it's doing. But I mean, largely, like the risk of oversimplifying things, right?

[00:30:10] Largely, as you said, you know, if we look at short term implied vol, it's really slave to realize vol and realize vol is a function of, you know, how much markets are moving up and down. And that's a function of, you know, the supply demand among the players that are trading markets. So, but I think there are some kind of interesting dynamics here, you know, around not just, you know, quote unquote, the vol market, but why don't markets in general see risk, which seemingly is right in front of them?

[00:30:39] Or why are they slow to react sometimes or hesitant to react sometimes, right? We saw that in COVID, right? I mean, if you recall, in February of 2020, we're sitting here saying, well, look, this virus is in Europe, what's the probability it's not going to come to the US? It seems pretty low. It's not going to come here. But yet markets were just grinding higher on high sharps and low vol, if you remember. And that was actually another time we had the critical stress signal tell us that, hey, look, you know, there's a problem here.

[00:31:08] But so I think a couple of things. One is like going into this year, what was most remarkable to us was that we kept hearing from investors last year and early this year that their biggest fear, vol investors, was that we were going to see a 2017 repeat. And right, 2017, if you remember, was, you know, I know you remember, but for the audience, was a really unusual year, right? I mean, we had the lowest realized vol since 19, second lowest realized vol since 1928.

[00:31:38] You know, the VIX traded, I think, 52 times below 10. It was a record. It was a very painful year to be long vol. And a lot of people thinking, OK, this is Trump 2.0, Trump 1.0. We, you know, we maybe expected more volatility, but it didn't happen. You know, we got fooled once. We're not going to be fooled twice. And then you had a lot of people also focused on the supply of volatility from, you know, the overwrite funds and other strategies which are trying to sell volatility.

[00:32:06] And it's all very kind of micro and technical. And we were sitting here saying, well, look, let's take a step back. Let's zoom out. And we have, you know, two mega forces at play here, right? We've got what Trump's telling us. You know, he wants to inject the most radical policy proposal we've seen in a century, drawing on the playbook from the early, you know, 20th century with income taxes, replacing tariffs, you know, drastic government cuts via Doge and shaking up almost every industry.

[00:32:33] The administration was surrounded by big risk takers, including the techno-optimist crowd, whose mantra is to kind of move fast and break things. You know, little admiration for things that have come before, even disdain, I would say, for the past. And bold policy experimentation, you know, that was the promise and one of which they delivered on. So, you know, I think that to us was, you know, fairly obvious.

[00:32:59] In fact, we saw as early as February or early March, policy risk indices were actually at 35-year highs vis-a-vis the VIX, again, as early as late. They started to move up actually in November. So that's one piece of it, right? And the other piece is this, and something that we've been talking about for the last year, which, you know, kind of nobody has on the radar screen, I feel like, at the moment, which is this brewing AI bubble.

[00:33:26] And, you know, look, we wrote this piece last summer. Basically, if you go back to the last several hundred years and you look at periods where you have major injections of productivity enhancement in economies, history says markets that are free and compete against each other, want to pull forward that future productivity in the form of an asset bubble. And asset bubbles that are bigger than what we've seen so far in this instance.

[00:33:56] Capably, asset bubbles coincide with vol-up, spot-up, right? It's one of the best indicators of a peak in the asset bubble. So to us, we have these two megaforces at play, right? From 2.0, the most radical policy we, you know, were promised the most radical policy in 100 years, plus this emerging AI boom, which we felt still had a lot more room to drive more volatility into stocks before it burst.

[00:34:22] And yet, you know, the common refrain was, we were hearing was, we just don't see the risk. And so, again, I think partly what was going on here at the broad level was what I call the dispersion illusion, right? So all the last 35 years, if you look at real-life correlation, you know, going into this year, it was essentially almost as low as we've ever seen. Almost 35-year lows. Cross-asset correlation also pretty much on multi-decade lows.

[00:34:50] So low correlation dispersion itself was masking a lot of, I think, risk under the surface, number one. And number two, look, I think a lot, the way I try to think about markets a lot of times is where is the cognitive bias? And there's many cognitive biases that creep into investor psychology. But one of them is, sometimes when uncertainty is so high, you just don't know what to make of it. The tendency for investors is to sit on their hands and do nothing.

[00:35:18] And ironically, by doing nothing, you're basically not trading. And by not trading, you're not generating realized vol. And by not generating realized vol, you're not generating implied vol, right? So I think it's some of these, you know, bigger picture dynamics that can cause effectively, you know, us to sleepwalk into risk, which I think we did in COVID, you know, and I think we did yet again this year. So those were some of the factors I thought that were interesting about volatility sort of missing the big picture.

[00:35:47] I think markets are incredibly efficient. You know, if we're honest, they're very humbling. It's a tricky, tricky business trying to safely generate return and evaluate risk. You did say something that I just wanted to run with a little bit, which is on the COVID, right? So in the later period of February 2020, I think you still had the VIX at 13 or 14, credit spreads, credit vol, super low.

[00:36:17] You know, Bill Ackman was in the process of putting on his big short, his version of the big short. And as you said, you know, there was lots and lots of discussion. And I like to look back at New York Times front pages. They make those available every single day. You can look back and I'd look at the Feb 20th of 2020, the New York Times front page, and you start to see, you know, the COVID story move to the front page.

[00:36:42] And so for a short period of time, that convexity was there and it felt like the market was just kind of missing it in plain sight. We can kind of say the same about the GFC almost even from a longer timeframe. But in a similar way as 2017, you know, boy, that VIX was low and going lower. And even at a, as you mentioned, you know, closing below 10, it was tough to carry in real time. You know, where, as you said, implied are a slave to realized.

[00:37:12] And so if the market's not reacting, boy, it makes it really difficult to get, you know, conviction to put something on. I'm not saying that even if you foresee that markets are mispricing risk, it's trivial to know how to put a position on that carries efficiently and so forth. But history does, maybe it doesn't exactly repeat, but as they say, it rhymes. And I think we keep saying the same kind of, you know, cognitive errors or biases at times creep in for similar reasons.

[00:37:40] And part of it is reflexivity too, right? I mean, it's part of the challenge with investing today is that most people are being held to a very short time, time dimension. You know, they can't afford to be wrong for too long. And that, that I think prevents you from being able to hold some of these positions. But the bottom line for us is that, you know, options, volatility, right? At the end of the day, why you trade it at all? I mean, if you're trading options directionally, you're basically

[00:38:08] paying for the right to not have to get the timing correct, right? That's what you're paying for. The key is how to pay the least for it. So, you know, how do you try to mitigate timing risk, have your cake and eat it too, but not pay away so much that you can't afford to carry it for long periods of time? Because the key is obviously, you know, mitigating the timing risk, which is, it's tough. And so that's where we, you know, we're constantly through our day-to-day work trying

[00:38:37] to figure out, well, where is the distribution of, you know, risk mispriced? You've got to generally sell something somewhere to fund vol positions. I mean, most recently we were arguing, again, going back to this idea that this crisis was man-made, that there would be a pain tolerance at some point, and that that trump put effectively meant that, you know, you could afford to sell some of the

[00:39:03] extreme fear on the left-hand side to fund, for example, upside vol or fund upside calls or even fund hedges that would protect you against a further grind lower. So, you know, inevitably you've got to sell some risk you think is overpriced in order to own, to buy the risk you think is underpriced. But I do think that without the tools of optionality in your toolkit, it's, you know, timing is so

[00:39:29] difficult with these two mega forces at play that are ultimately, you know, going to drive bigger booms and bigger busts in our view, or maybe the reverse order so far this year, right? Bigger bust followed by a bigger boom. But again, without optionality, I think it's really hard. With optionality, it's still hard, but I think, you know, with some work, you can get closer to a more optimal solution.

[00:39:54] Just going back to what you said about the feedback from realized to implied, I always say the marginal price setter of an option is not directional. He or she is really responding to, you know, what the trading strategy is able to allow them to pay for options via, you know, rebalancing a delta hedge,

[00:40:15] and that's a function of vol. But there are times when some overlay of either oversupply of vol or undersupply of vol, the latter of which I really thought was the case in kind of 2021, you know, post all of those losses in equity options during COVID, the market really took a while for that vol

[00:40:39] risk premium to start to come back to something normal. Maybe it was by late 2021 or early 2022. How would you size things up now? You know, we've talked a little bit about overwriting. We've got, you know, the demands that come from investors that just absolutely must own the MAG7 to some degree. I mean, the S&P is extremely top heavy, as top heavy as we've seen it. And so that

[00:41:07] creates a certain amount of momentum effect. What are the kind of balances of, you know, supply demand? And does it lead you to believe that vol is clearing at an especially high or low rate relative to where it otherwise would? Depends on where, right? Right now, we're recording this on Tuesday, the 13th. So

[00:41:31] just a day after the big up move in markets post the deal, the deal between US and China and the, you know, 4% update in NASDAQ yesterday and VIX coming in pretty hard. You know, right now, we actually think that, you know, we're probably closer to the lows in VIX given what is, you know, we've argued an increasing floor that's been building for all the reasons I mentioned in terms of these megaforces,

[00:41:58] you know, injecting more volatility into markets. So, you know, we're actually of the mind that, you know, there's probably more upside in markets than there is downside in vol. And so we like that asymmetry at the moment. But let me just go back to one other, because you sort of mentioned this concentration risk and so forth. I think this is a really important point. I started off by saying that, you know, early in the conversation that from an outside investor's perspective,

[00:42:22] a big threat to this US exceptionalism trade was dollar down with US assets down. And we have seen non-US investors, those outside the US really become much more risk averse to the US exceptionalism trade because of the, you know, extreme concentration in equities. You know, we've never seen more risk concentrated in stocks ever in history. US equities are 70% of global equities, sure, as you know.

[00:42:52] The risk here is that while we have really since DeepSeek been hearing a lot of rhetoric around end of US exceptionalism, we need to assign a higher risk premium to the US. There's just too much risk there given the current administration. But what I think the risk is, is that you can't separate US exceptionalism from the AI trade, right? And as I argued earlier, I think we're at risk of a multi-year,

[00:43:19] you know, hard to time, but in the next five years, three, four or five years, we're at risk of a much bigger bubble forming. And so that presents a lot of risk for, you know, trying to abandon that US exceptionalism trade. Because if AI kind of comes back as, you know, US tech is up more than any other major market since the Liberation Day lows, you know, that is the pain trade right now for investors.

[00:43:46] So to give a very practical example, you know, that's a pain trade that I think people have to be very wary of hedging. Because I think part of the challenge of investing in today's environment, we're in a world, I mean, obviously, a very, you know, polarized world of, you know, culture wars. And I think one of the cognitive biases, I keep talking about cognitive biases, but one of them,

[00:44:12] I think is, is actually conflating one sort of political views with their sort of objective economic outlook. And I feel like with US exceptionalism, you know, being kind of at a peak earlier this year, and then with the administration really frustrating a lot of the rest of the world, that there's been a very strong swing, you know, towards negativity to the US

[00:44:40] potentially remaining exceptional, a lot of skepticism and doubt, again, biggest underweight we've seen from our FMS. And I think the risk is becoming overly negative, and not being able to, you know, hedge that right tail risk accordingly, which I think is, you know, even as we speak, is starting to feel really painful. So it's another example of where, you know, if your core view is an outside investor is, hey, we need to take our risk down. Hey, if we're wrong, it could be very painful,

[00:45:07] particularly given the concentration you mentioned. So, you know, again, another area where I think people really need to be hedged against, against the risk of US exceptionalism not being over, as so many people have been arguing in the last several months. Now, are there ways to express that, that, you know, the market kind of hands you a price as a function of just supply demand that might be

[00:45:33] especially favorable? I know that we talked a little bit about, you know, you thinking that there's more upside to the market than maybe downside in vol. I know you've done a lot of work and your team has done a lot of work on dividends. Where is the, you know, kind of clever way to express that view on the long-term, the exceptionalism not being something that's, you know, ready to come undone real soon?

[00:46:03] The longer-term idea of all up, spot up, I think is still interesting. And again, you know, as I said earlier, they're selling extreme left tails, perhaps because we know, we've seen the contours of the Trump put, we know there's a Fed put there somewhere, although I would argue it's, the strike is lower than normal because of the extreme uncertainty in the economic outlook that, you know, Powell has admitted over and over again as well. But it's still there, right? It's not, this is not the Liz Truss environment,

[00:46:32] right? Where, where inflation is running so high that we're really at risk of the Fed saying, hey, sorry, we just can't back you up this time because our statutory mandate says we've got to contain inflation. Luckily, you know, we're not in that situation anymore. And I think that's very positive. Arguably, we do have, plus we have a market that's very in tune to buy dips. So I think selling some of the extreme left tail risk, that's still fairly bid, although it's been coming in

[00:47:00] pretty quickly in the last couple of days, you know, to fund upside ball and, you know, kind of like up far, up ball kind of strategies are interesting to us for a true bubble developing. Again, as I was saying earlier, you know, even with this higher floor that we believe is building in ball, you know, selling, maybe selling the downside in the distribution of all to fund the upside in equity, which

[00:47:27] to us looks like a reasonable trade-off right now, you know, given how much ball has come in just, just, you know, yesterday in particular. So interesting. And I think, to me, the downside part of the VIX distribution has always been, everyone obviously uses calls as the hedge, but I've always really liked thinking about, you know, I call it small ball of just selling puts, trying to, you know, in some sense, call the

[00:47:54] floor. You're not going to get rich or poor on these trades, you know, selling VIX put spreads, gain a little bit of premium. But sometimes when you get into that, you know, to me, it's like pretty close, the 17, 16 area. And, you know, if realized vol can hold up around 13, VIX is three over-ish, you know, you're probably going to hold it at 16. Never say never, of course.

[00:48:18] Last thing I just wanted to ask you, and, you know, just in the cross-asset framework that your team employs and, you know, Bank of America is a institution with expertise across all the asset classes. There's certainly some conversation about the, you know, reignition of higher yields. Some of these are, you know, the risk off of the tariffs is going away, but I think the 30-year is now sort

[00:48:45] of approaching 5% again. 10-year is about to hit, you know, four and a half. How does that figure into the equity vol risk outlook in a world where 2022 happened? You know, the VIX traded into the 30s on higher yields. This last episode, we might argue that that's what brought Besant to Trump. Maybe it wasn't the VIX, but it was the bond market. How do you look at the rate side of things

[00:49:12] as a risk for the equity market? The big risk is just the breakdown in correlation, right? The fact that bonds are no longer the hedge. They used to be, they've been a bit better this year, but the last couple of years, obviously, in the higher inflation environment, they've deteriorated materially. So that's a real risk, I think, for everyone. And, you know, all else equal, you know, that kind of pushes people into using contractual hedges, you know, given the lower

[00:49:37] efficacy of statistical hedges like bonds, you know, using bonds. Again, from the outside investors' perspective, you know, the dollar plays a similar role. So I do think, you know, I mean, we came into this year saying basically that the risk of bond vigilantes pushing back was the biggest visible tail risk. And I still think that's, you know, that's a real risk, which is exactly why, as you said, the administration is so adamant to try to get yields lower, because it's

[00:50:03] probably the fastest way to get the US back on firmer financial footing. So it is a risk. And timing, again, is difficult, right? I mean, obviously, we've seen, you know, other sovereigns in different situations. But, you know, Japan comes to mind as, you know, being in kind of precarious positions for long periods of time, you know, dynamics are slightly different there. But

[00:50:30] so the point is timing is tough. But I think it is a non-zero risk. We, you know, we actually, talking about earlier, the low correlation, cross asset correlation, you know, this year earlier, this year in particular, you know, we were quite, quite fond of using the low correlation to reduce the cost of, you know, downside equity puts through hybrids as one example of a way of, you know, again,

[00:50:56] hedging that kind of bond vigilante risk rates going higher, pushing equities lower. Another example of, you know, I think how the smart use of optionality can actually protect you contractually protect you when the statistical protection of bonds has been fading. What is just most top of mind for you from a research standpoint? If it's, if we're talking in three to six months again,

[00:51:20] where will your process have taken you in terms of trying to figure some new things out or, you know, kind of confirm or deny earlier, earlier views? Our view is that these two mega forces are still at play. They're not going away. I think the bias on the policy side is to get some wins on the board. The midterms will be here before you know it. And,

[00:51:49] you know, I think the administration, you know, does have a lot of incentive to improve things against that, that deadline. And that's a very hard deadline. And, you know, I mean, as Charlie Munger famously said, you know, show me the incentives and I'll show you, you know, the, the outcome. So I think you do have to think about the incentives here. Number one, number two, although nobody has really thought, you know, nobody's really thinking about it today or largely it's been pushed onto the back

[00:52:16] burner. I think the force that's going to affect us the most in the next five to 10 years is going to be technology and AI. And I think that it's, I mean, I sit here in San Francisco, maybe I am a little bit closer to, to the noise, but it's an incredibly optimistic perspective here. And I feel like a lot of the investor community can get so locked in the macro and which obviously last few months has been

[00:52:46] the dominant driver, but again, they can kind of lose sight of the forest for the trees. And so all of our work has just shown that, you know, the right tail risk is, is big. Timing is hard. You know, is it, is it six months, 18 months from now? I don't know, but I think it's coming and we're just trying to be vigilant of, of that, you know, that as well and not, not losing sight of, of these really big picture forces. We are really at the precipice of, I think some of the most historic times that any

[00:53:15] of us, you know, have experienced or will experience. It's been a pleasure to, to reconnect and thank you so much for, for your time and for being a guest. Thank you, Dean. Appreciate it. It's been great. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback as we aim to utilize these conversations to contribute to the investment community's understanding of risk.

[00:53:43] Your input is valuable and provides direction on where we should focus. Please email us at feedback at alpha exchange podcast.com. Thanks again and catch you next time.