Sayings on Vol and Risk...A Fresh Five

[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. Hello listeners and welcome to what was originally a series called 25 Sayings on Vol and Risk.

[00:00:26] In this five-episode podcast, 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.

[00:00:52] 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.

[00:01:20] What follows are five new sayings on vol and risk. And I'll follow up with five 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.

[00:01:47] 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 five, shall we?

[00:02:15] 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, quote, financial objects at rest tend to stay at rest. Perhaps this is Dean Ker-Newton's 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.

[00:02:42] Many, myself included, have illustrated the correlation between low market and low economic volatility. Take, for example, 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%.

[00:03:04] There were, of course, periodic risk-offs like the China FX repricing in August of 2015 or the VIX event of Feb 18. 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.

[00:03:26] 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 T.O.P. 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.

[00:03:53] 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's been happening with such consistency. The trend is your friend, they say.

[00:04:19] 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, it's a nod to getting fat and happy by betting on stability. What matters in the process is that vol is sold and it can reinforce the stability already in place.

[00:04:48] I've covered this quite a bit, but in simpler terms, a straddle on the S&P 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.

[00:05:05] A, quote, gamma well, as it's sometimes called, in which the index just gets stuck in a narrow range due to 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, the lack of them.

[00:05:26] I can say that around August of 2017, with the 30-year anniversary of the 87 stock market crash soon approaching and with the S&P realizing 5 vol or so, I asked 25 clients what their forecast was of realized volatility over the next one and three months. Suffice it to say, these were very low expectations. But most telling was the expectation of realized vol over the next week.

[00:05:53] The average response was 5.8%. And guess what? The realized vol over those ensuing five trading days wasn't much different from that. Financial markets at rest did indeed stay at rest. Okay, let's keep this list moving. Related to this observation is number 27, which is that, quote, realized vol rules the world.

[00:06:19] Everything in markets and many things in life are a response to realized volatility. Our thinking, our behavior, and the choices we make are always informed by the actual or perceived uncertainty of outcomes. And past uncertainty of outcomes maps directly to what we expect about the future. Drive into New York City and experience nightmarish traffic? You'll think twice next time.

[00:06:46] Find your car ticketed after just a quick run into Starbucks? You're set back not just $25 for the violation, but for $8 for that salted caramel frappe you bought. You, again, will think 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 then refresh levels without a heavy helping of math.

[00:07:16] And at the heart of the price-setting algo is realized volatility. Run a scatterplot of the 500 stocks in the S&P connecting realized and implied vol for each. You'll 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 matters the most.

[00:07:46] 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 the behavior of credit spreads and options on credit in 2024 and into early 2025.

[00:08:16] The CDX IG averaged 52 from the start of 2024 into Feb 19th of 2025 when the S&P 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 SIBO's VIX IG index averaged just 26 over this time frame?

[00:08:40] Saying number 27 moves 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, quote, my portfolio is more liquid and more diversified than I thought. But then, in an ironic twist ad, said no one ever.

[00:09:04] 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 option owners about the morning of August 5th.

[00:09:28] It turns out buying something from someone for a dollar and then looking to sell it back to them for eight just weeks later sometimes can cause a problem. Liquidity in markets can, in the words of Mohamed El-Irian, be a mirage. I decided to reread one of the books on the GFC recently, 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,

[00:09:57] the downfall of BSAM in July 2007. The fund's chief, Ralph Chiaffi, has most of the capital in subprime CDOs, which, for financing purposes, he's repoed to the likes of Goldman Sachs. The prime brokers have been dutifully marking this very complex and highly illiquid paper pretty close to par for many months. Suddenly, Goldman has the paper marked at 50 to 60. Whoops.

[00:10:25] And that, basically, was the onset of a very fast lights-out for Bear Stearns asset management. Marking to model is one thing if you have the 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 more volatile at the same time.

[00:10:52] 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 previously contemplated.

[00:11:21] One of the quotes coming out of the quant quake that I always loved was from Goldman's David Vineyard, who said, quote, 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 bid on market liquidity without some reference to all of the growth in private credit.

[00:11:46] There's nothing bad about the expansion of this asset class, but 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, quote, hold-to-maturity bucket. I'm reminded of the scene in casino when Joe Pesci's Nicky Santoro tells the banker, I think I want my money back.

[00:12:14] The next item on our list is a function of a new dynamic in markets, and it leaves me believing that, quote, the 10-year note, not the S&P, is the risk asset. Let me explain. In remarks delivered on May 5th, Scott Besson invoked the anti-fragile term in reference to U.S. markets. The equity market can hardly be bulletproof when the U.S. government bond market, one of our most important assets, is anything but anti-fragile.

[00:12:44] 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 anti-fragile assets, the notion that a, quote, X date beyond which the borrower is in some version of default doesn't readily come to mind. Unfortunately, the back end of the U.S. bond market, long an insurance asset that rallied on a flight to safety, has become a threat.

[00:13:12] 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 sizable drawdown in the 60-40 portfolio.

[00:13:42] 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 contemplated. The recent dynamics are about a risk premium emerging in the back end of the U.S. bond market. It's an irresponsibility tax.

[00:14:11] Sadly, it's well-earned. In stating that the 10-year note, not the S&P, is the risk asset, I'm 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's the bond market and higher yields for the wrong reasons that serves to threaten the stock market.

[00:14:35] Hopefully, Scott Besson 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 U.S. bond market badly malfunctions. We are set to close out this new addition to our sayings on vol and risk getting us to 30 in total. We'll finish with the recommendation to, quote, shake hands with the government and sell what they're selling.

[00:15:05] This is a play on a statement Bill Gross said 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 GSC 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

[00:15:33] 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 Scott Besson. As I've said before, the precedent for a north of 50 VIX just 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.

[00:16:04] Anticipating the policy response amounted to recognizing that Besson would need to sell the VIX doing something that amounted to forcing it lower. And that, of course, is just what happened on April 9th when Trump cried no mas and 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.

[00:16:29] 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 idea is to try to understand the policy response, its degree of urgency, and its ultimate impact on asset prices.

[00:16:58] 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.

[00:17:25] It was not until Mexico adopted stringent austerity measures in March of 1995, two months after the loan package that the peso finally 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,

[00:17:51] authorities implement various programs that directly impact the price of market risk. Well, folks, that's all I've got for now. As I speak these words, we are two months past the short-lived but intense risk-off that hit the market after April 2nd'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,

[00:18:19] 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. I hope you found this interesting and useful. I wish you a wonderful week. Until next time. 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.

[00:18:49] As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com. Thanks again and catch you next time.