The DOTS (Discounting of Trump Success)

[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] Good listeners of the Alpha Exchange, I thank you for tuning in.

[00:00:23] We've got some interesting items on the docket of discussion, exploring what Mr. Market is communicating by way of prices.

[00:00:30] There's a great scene from a Seinfeld episode in which, shockingly, Kramer has gained employment.

[00:00:36] An increasingly frustrated Jerry, feeling irrelevant and whose efforts at engaging in conversation are futile, exclaims,

[00:00:43] We hardly even talk! Kramer snaps back, You know this is my crazy time of year!

[00:00:49] For those engaged in studying Price, this is indeed a hectic time.

[00:00:54] Outside, of course, of crisis episodes, I cannot recall a more interesting period.

[00:00:59] The calendar is jammed with catalysts and the market is speaking its mind with regard to how it prices options in the context of when those catalysts occur.

[00:01:08] What follows is a pre-election assessment of risk.

[00:01:11] As always, the goal is to make our time together useful for you.

[00:01:15] We value intellectual honesty over here and, as such, find markets rather humbling.

[00:01:20] What I've found over the years is that the process of uncovering value, of developing conviction, can be, actually must be, iterative.

[00:01:30] Utilize what we've learned from the past, incorporate fresh perspective from the present, and see if we can inch closer to triangulating on good ideas.

[00:01:39] In the spirit of accepting that markets are woefully efficient, conviction will not be arrived that often, but there's no way to get there without doing the work.

[00:01:47] Back to Seinfeld.

[00:01:49] A client once called me the Jerry Seinfeld of derivatives.

[00:01:52] Did you notice this?

[00:01:54] Did you notice that?

[00:01:55] My personal process starts with noticing things.

[00:01:58] I ask myself, when's the last time gold rallied and the dollar rallied at the same time?

[00:02:03] And then I ask myself, does that mean something?

[00:02:06] Or in the case of work on FXI, featured in the recent podcast, The Opera of Option Prices,

[00:02:12] I see a risk dynamic unfolding.

[00:02:15] In the case of FXI, it was stock up, vol up, and then bring in the commonalities in such episodes historically.

[00:02:21] All right, let's get this underway.

[00:02:24] It being late October, I need to start with just a bit of reflection.

[00:02:27] I live and breathe risk anniversaries.

[00:02:30] We learn the most about markets when things go spectacularly wrong.

[00:02:35] And on October 19th, 1987, things did just that.

[00:02:39] The VXO, the old VIX constructed on the OEX index, closed at 36.4 on October 16th, 1987.

[00:02:49] It surged to 150 on the day of the crash.

[00:02:53] Hey now, I posted on the AlphaExchange Twitter account, follow it by the way,

[00:02:58] a table that classifies risk-off events with respect to stock and bond returns and correlation.

[00:03:04] I think there's a lot to consider in this table, if I do say so myself.

[00:03:08] My framework has three types of risk-off, which I call the classic, the taper, and the liquidation.

[00:03:15] In the classic, we get a growth shock or some market accident that causes stocks to fall dramatically.

[00:03:21] Bonds in turn rally in a flight to safety.

[00:03:24] Stocks down, bonds up, and negative correlation.

[00:03:27] In the second, the taper, it is the bond market that sponsors the risk-off.

[00:03:32] Bond yields rise quickly, and the equity market succumbs to the uncertainty that the ultimate destination for higher yields is unknown.

[00:03:40] Here, both stock and bond prices fall, and they are positively correlated.

[00:03:45] This is really the 2022 experience.

[00:03:48] Inflation and Fed policy are usually very much a part of the taper risk-off.

[00:03:53] Lastly is the awful risk-off I call liquidation.

[00:03:56] This typically starts as a classic risk-off when bonds rally and stocks fall.

[00:04:01] However, the market's demand for cash-like liquidity is so substantial that even duration exposure ultimately buckles.

[00:04:10] Think of March 2020 in the days before the Fed stepped in to completely backstop the UST market.

[00:04:16] Both stock and bond prices plunge.

[00:04:19] This is the most dangerous risk-off and requires the intervention of the monetary authority.

[00:04:24] The old adage, the cure for lower prices is lower prices, simply does not hold in a liquidation event.

[00:04:31] There's no way out absent a big blank check in a hurry.

[00:04:35] Back to 1987.

[00:04:37] The crash was a lot of things, but I've suggested it was the original and largest taper tantrum.

[00:04:43] In the days before October 19th, the tenure yielded more than 10% nominally and around 6% real.

[00:04:50] Imagine being able to de-risk into that product with equity implied and realized vol already high and rising.

[00:04:58] So, we get a joint sell-off in stock and bond prices and a positive correlation in the process in the week before the crash.

[00:05:05] And ultimately, the value proposition of the risk-free asset and the rush out of the stock market creates massive demand for government bonds and a huge rally.

[00:05:14] The taper risk-off then transitions to a classic risk-off where bonds rally and stocks fall, and they become anti-correlated in the process.

[00:05:24] Paul Tudor Jones' largest profits during the crash came from realizing that bonds were going to rally massively in positioning as such.

[00:05:33] With that little warm-up behind us, let's consider matters of the present-day variety.

[00:05:38] Incredibly, we've got an FOMC meeting on November 7th.

[00:05:41] I was chatting with Ironside's macro founder, Barry Knapp, about the string of catalysts from the 1st to the 7th of November, including NFP, the election, and FOMC.

[00:05:52] Barry said it's much more than that and proceeded to rattle off the upcoming refunding announcement.

[00:05:58] GDP, ADP, PCE, ECI, and JELTS, all occurring before NFP.

[00:06:05] Heck, let's throw in claims and ISM in there too, all before the election.

[00:06:09] I do hope Powell isn't going clubbing this weekend.

[00:06:13] The last FOMC meeting produced a fresh statement of economic projections, including a new dot plot.

[00:06:19] The next round of dots comes our way in December.

[00:06:22] For markets, another more real-time set of dots matters.

[00:06:27] Dots.

[00:06:28] Discounting of Trump Success.

[00:06:31] You know this already.

[00:06:32] I'm an acronym seeker, and there's not much I can do about it.

[00:06:36] The dots.

[00:06:36] Is Trump in the price?

[00:06:39] Wall Street is asking this question.

[00:06:42] Druckenmiller argues strongly, yes.

[00:06:44] It's so difficult to actually know.

[00:06:47] Certainly, DJT equity has been on fire, and I've highlighted the very large call spread and put spread blocks that have traded.

[00:06:54] Bond yields are up, but the same optically pleasing overlay of higher yields and higher Trump odds also looks decent when explaining the softer bond market through rising economic surprise indices.

[00:07:05] Because investors are fearful of political disarray around the election, there's demand for insurance.

[00:07:12] We see this in equity, interest rate, and FX markets.

[00:07:15] In the SPX, implied vol is just 12.2 for the November 5th expiry, but 15.2 for November 6th.

[00:07:23] The November 7th FOMC uncertainty adds nearly another vol point.

[00:07:28] This is set against an abysmal level of realized vol in the S&P.

[00:07:32] One month is a paltry nine.

[00:07:35] That's not enough to get anyone off the couch to engage in defensive hedging.

[00:07:39] The vol risk premium is quite high.

[00:07:42] Let's summarize this VRP, shall we?

[00:07:44] A few cross-asset observations.

[00:07:47] First, the VIX, circling around 19 or 20 with realized at just 9.

[00:07:52] It's probably the case the VIX ought to be 13 to 14, absent the calendar of consequential events.

[00:07:59] I suppose catalysts are implicitly consequential, but anyway.

[00:08:03] Second, in FX, certain FX pairs have even higher VRPs than does the SPX.

[00:08:09] For example, in the Mexican peso, one month implied is 21.4, set against one month realized of just 9.7.

[00:08:17] Euro vol is 8, set against 4.6 realized.

[00:08:21] In gold, the VRP is in the 96th percentile, 17 versus 12 realized.

[00:08:26] And finally, in treasuries, the VRP is in the 98th percentile.

[00:08:30] The 10-year note implied vol is 8.3 versus 5.8 realized.

[00:08:35] These lofty spreads of realized to implied are, as I've argued, an outcome of supply being incrementally removed from the market.

[00:08:44] Let me explain by way of example.

[00:08:46] An eager derivative salesperson, perhaps freshly minted from a top B school, has his first real pricing inquiry in hand from a gigantic global macro fund.

[00:08:58] Said marketer jumps out of his seat shouting to his trader that a two-way price is needed for a put option on the S&P.

[00:09:05] Never mind the trader is in five-way comp, the salesperson forgot that part.

[00:09:10] What's the strike?

[00:09:12] What's the expiry?

[00:09:13] What's the direction?

[00:09:14] And what's the size?

[00:09:15] Seem like reasonable follow-up questions from the index book runner.

[00:09:19] The now, less eager salesperson then needs to break the news that the size is enormous, the delta tiny, the direction unknown, and lastly, that the expiration date is November 6th.

[00:09:33] The conversation ends there.

[00:09:35] That is what I mean by incremental supply being withdrawn from the market.

[00:09:39] But even as a dearth of supply raises the clearing price for vol, we must acknowledge that Realize Vol is the, quote, earnings engine for long option strategies.

[00:09:50] That engine is sputtering badly.

[00:09:52] The S&P has not experienced a 1% down day in more than a month and a half.

[00:09:57] The mathematical connection between Realize Vol and the P&L for short-dated options via gamma means that 9 Realized is exerting gravitational pull lower on short-dated option prices.

[00:10:09] Is this very low Realize Vol and the downward pressure it's imposing on implied vol a gift for hedgers?

[00:10:16] Man, I'm thinking about this a lot.

[00:10:18] One of the lessons markets try, largely without success, to teach us is the speed with which conditions can change.

[00:10:27] We humans never seem to learn.

[00:10:29] If, as Druck suggests, Trump is very much in the price, should that really be the case?

[00:10:35] One part of me wonders if we are staring too much at the resounding lead in polymarket odds and internalizing that as a real probability.

[00:10:44] No political view here, only entertaining the notion that probabilities via option prices may be overestimating a Trump win and the implications thereof.

[00:10:54] More on this in a bit.

[00:10:55] If the Trump hump is prominent in S&P vol, it's off the page in TLT vol.

[00:11:01] We've got more granularity now on option prices around the election in TLT,

[00:11:06] and we can observe prices associated with both November 4th and November 6th expiries.

[00:11:12] The 11.4 TLT at the money straddle is 14.9 vol and 2.03% of spot.

[00:11:21] The 11.6 straddle is 21.8 vol and 3.2% of spot, a 58% increase in premium for just two days.

[00:11:30] If we use the same 14.9 vol for the 11.6 straddle, the premium would just be 2.2%,

[00:11:38] just an 8.4% increase due to the extra two days.

[00:11:42] So there's a 7 vol spread for the TLT from 11.4 to 11.6.

[00:11:47] For the S&P, it's about half that.

[00:11:50] Still a meaningful bump in its own right.

[00:11:53] Volatile bond markets typically do drive volatility in stock markets.

[00:11:58] Should November 6th TLT vol really trade 5 over the S&P?

[00:12:03] One argument could be that the red wave, now 46% odds on poly market, is good for stocks but bad for bonds,

[00:12:11] which tempers how good it is for stocks.

[00:12:13] Who knows?

[00:12:14] We see the election hump everywhere, across assets and around the world.

[00:12:19] These are all very much how a vol term structure would look as a company is reporting earnings.

[00:12:24] There's a large bump centered around the earnings date.

[00:12:28] The idea is simple.

[00:12:29] The realized vol on an earnings date is empirically three to six times that of a non-earnings date.

[00:12:35] But gold, TLT, and IWM, of course, don't report earnings.

[00:12:40] DJT doesn't either, yet at least, and certainly not in the next two weeks.

[00:12:45] The election is what I call an earnings date for the country.

[00:12:50] Nowhere is this more pronounced than in DJT.

[00:12:53] My goodness.

[00:12:54] Take a peek at the chart I posted on Twitter featuring the November 1st to November 8th vol spread.

[00:13:00] It is, as one might say, huge.

[00:13:04] Since we are in listen-only mode here, I will say the following.

[00:13:07] As of this writing, the November 1st ATM vol is 180.

[00:13:11] The same for November 8th, 330.

[00:13:15] Some really interesting prices emerge when vol differentials are this high.

[00:13:19] For example, with DJT stocks circling 39, you can do the November 1st, November 8th 40-65 call spread for around even money.

[00:13:31] Intellectual honesty being a cornerstone over here, it's clear you don't get something for nothing in markets, and this is no exception.

[00:13:38] Your lower strike is $25 below the upper strike, yes.

[00:13:42] But that comes in exchange for losing one week of time value.

[00:13:46] The market judges that one week of time as of enormous value.

[00:13:50] It appears very much that the results of the U.S. election hold great sway on the returns, for better or worse, in DJT stock.

[00:13:58] It all makes sense.

[00:14:00] Event risk of this magnitude reminds me of how the options market prices vol around a Phase 3 clinical trial in a biotech stock.

[00:14:07] As you may have surmised by now, I'm a bit obsessed with how the market prices this tight window of uncertainty in early November.

[00:14:15] We can think about the Trump hump through the lens of the diminution of supply.

[00:14:20] The U.S. electorate is jaded, skeptical, and increasingly vulnerable to conspiracy theory.

[00:14:25] This election is set to be tight, and Trump almost surely will cry foul if he loses.

[00:14:30] We shouldn't underestimate at all the left's desire not to lose, and potential ways in which it too might seek to disrupt the process.

[00:14:39] Airport blockades seem like table stakes to me.

[00:14:42] This election is so unique.

[00:14:44] Think about what's happened in the last five months alone.

[00:14:47] The June 27th debate disaster for Biden.

[00:14:50] The assassination attempt on Trump just 16 days later.

[00:14:54] Biden's withdrawal from the race just eight days after that.

[00:14:57] The Kamala launch full of joy and the brat summer.

[00:15:01] Elon Musk's control of Twitter and his four-inch vertical leap at Trump's second rally in Butler, Pennsylvania.

[00:15:07] The billion dollars raised by the Harris campaign.

[00:15:10] And the endless string of ads used to exhaust that haul of cash.

[00:15:14] The emergence of the podcast as campaign media.

[00:15:18] Theo Vaughn, Charlemagne, Dagad, Joe Rogan, and of course, Who's Your Daddy?

[00:15:23] The polling is endless, but new and interesting are the betting markets.

[00:15:27] Polly market is something.

[00:15:28] We've all been watching it very closely.

[00:15:30] You can bet on anything on, Polly.

[00:15:32] If there's a market for the number of times that Elon tweets, just take the over, whatever it is.

[00:15:37] Man, he's active.

[00:15:39] But the election odds have been very interesting to watch.

[00:15:42] As mentioned, I've been asking myself if the rally in Trump odds are a false signal,

[00:15:47] suggesting that his odds of winning are higher than they actually are.

[00:15:50] Turns out that a few traders have likely moved these odds up quite a bit just through their own presence in this rather thin market.

[00:15:58] That said, I think it's quite plausible that the odds reflect real information.

[00:16:02] One only turn on MSNBC and see poor Mika Brzezinski literally melting down on live TV to realize that the Democrats are very worried.

[00:16:11] What I found most interesting is the work done by Mark Halperin.

[00:16:16] He hosts The Morning Meeting, and you can find him on Twitter.

[00:16:19] He's a bean counter, deeply sourced and critically apolitical, a really rare thing these days.

[00:16:25] He opened a recent segment of the show with the following very provocative statement.

[00:16:30] Quote, if the early vote numbers stay the way they are, we will almost surely know that Donald Trump is going to be president on or before Election Day.

[00:16:40] Wow.

[00:16:41] He's a numbers guy, and he's humbled by the reality that what he does requires him to nearly always operate with incomplete information.

[00:16:49] So there are a lot of caveats, and he makes that very clear.

[00:16:53] But if the early trends of early voting continue to favor Trump, the ultimate outcome will become more conclusive.

[00:17:00] If this is indeed the case, it throws the relationship between pre- and post-election implied vol into serious doubt.

[00:17:07] I'm not suggesting this will be the case, but if you can envision a scenario in which the information content of early voting is conclusive enough to have a very strong idea that Trump will win,

[00:17:19] then the November 5th, 6th vol spread in the S&P very likely will contract.

[00:17:25] All right, let's finish with some thoughts on a favorite topic, correlation.

[00:17:30] I say this a lot, but implied vol and implied correlation are themselves correlated.

[00:17:35] I posted on X, you know, that platform formerly known as Twitter, a scatter chart that maps the VIX versus S&P one-month implied correlation.

[00:17:44] Higher levels of the VIX are associated with higher levels of implied correlation.

[00:17:49] When the market prices options with the expectation that the co-movement in stocks will be high, that mathematically puts upward pressure on the implied vol and VIX.

[00:17:59] We also know that both implied vol and implied correlation both respond to their realized counterparts.

[00:18:06] And further, we know that the same economic and financial conditions that make stocks more volatile also make them more correlated.

[00:18:14] So, the scatter plot of implied vol and implied correlation will show that low levels of both tend to coincide, as do high levels of both.

[00:18:24] But today, implied vol is very high versus implied correlation.

[00:18:28] The former is in the 52nd percentile, the latter in just the 5th percentile over the last five years.

[00:18:35] Let's try to think about why.

[00:18:37] As discussed throughout this and previous pods, we know the VIX is very high to realize because of the EVRP, the election vol risk premium.

[00:18:46] But I think that underlying the bid to the VIX would be a strong bid to implied correlation.

[00:18:52] Instead, pricing is saying that the VIX is high because single stock vol is high, which it is.

[00:18:57] Of course, we do have earnings season in motion.

[00:18:59] It was also pointed out to me that high vol, low correlation can be the market expecting lots of vol from the election,

[00:19:06] but stocks and sectors reacting in different ways, leading to lots of dispersion.

[00:19:11] That could be.

[00:19:12] But the big picture is that the market continues to price only what it experiences in real time.

[00:19:17] And that is very low realized correlation among stocks.

[00:19:21] Let me rephrase that.

[00:19:23] Not just very low.

[00:19:24] Strangely, unusually, and unsustainably low.

[00:19:28] So, as we talk about the large vol risk premium with the VIX sitting 10 over realized,

[00:19:33] one of the factors driving realized vol lower is an almost insultingly low level of realized correlation among the super caps.

[00:19:42] NVIDIA to the others especially.

[00:19:44] The correlation of NVIDIA to Google, of NVIDIA to Tesla, as Dean Warmer told us, 0.0.

[00:19:52] Its one-month correlation to Microsoft, Meta, Amazon, and Apple all range between 15% and 25%.

[00:19:59] These are really skinny levels.

[00:20:01] The bottom line from my perspective is we shouldn't really trust correlations.

[00:20:06] They are fickle, unreliable.

[00:20:08] But via their influence on realized vol, we do tend to trust them.

[00:20:12] Remember, these outlandishly low levels of realized correlation are exerting real downward pressure on overall realized vol at the index level.

[00:20:22] And we size portfolios based on realized vol, which in turn means we size them based on untrustworthy realized correlations.

[00:20:31] Well, folks, I hope I didn't overstay my welcome.

[00:20:34] I need to mainline a fresh round of the political news shows.

[00:20:37] Wake me up when it's all over, as Avicii said.

[00:20:40] Until next time, please enjoy the week ahead of you.

[00:20:43] You've been listening to The Alpha Exchange.

[00:20:46] If you've enjoyed the show, please do tell a friend.

[00:20:49] And before we leave, I wanted to invite you to drop us some feedback.

[00:20:52] As we aim to utilize these conversations to contribute to the investment community's understanding of risk,

[00:20:58] your input is valuable and provides direction on where we should focus.

[00:21:03] Please email us at feedback at alphaexchangepodcast.com.

[00:21:07] Thanks again and catch you next time.