Price is the Only Fundamental

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. Alpha Exchange Gaston founder of the Daily Dirtnap, Jared Dillion, once told me that the cure for writer's block is just to start writing. And that, my friends, is what I'm doing at this moment, trying to get the process underway of sharing what I hope are insights that you value. For me, writer's block is about having too much, not too little to say. And that's the case now because when volatility picks up, prices don't just dance, they sing as well. And in the markets, musical medley are breadcrumbs, those nuggets of information that we are responsible for making sense of. Shall we try? Let's start by framing it out. Yes, the daily motion in the equity market has increased. We are almost exactly unchanged since October 9th, the day prior to the 2.7% China-related dump in the S&P that kind of kicked off this higher vol profile. Yet one in three days since then sports a daily move in excess of 1% either up or down. That's 10 days and 32 with the move that large. In the 32 days preceding October 10th, there were exactly 0-1% moves. I'm not sure my main man Heraclites ever risk managed a vol book, but I am reminded of his timeless quote that there is nothing permanent except change. I'm betting he was more a payer of premium than a generator of carry, but we can take that up another time. Six-week realized vol was running at 6.6% and has materially increased to 15.8%. That's clearly not nothing. But still, 16 vol isn't the stuff that dreams are made of for the long convexity crowd. In fact, post the big payoff to being long optionality on October 10th, there isn't all that much to write home about. Listeners to this pod will know that I really like the SIBO Gamma Index. It measures the results of a trading strategy that buys and delta hedges weekly straddles on the S&P. From October 10th till now, it's actually down. Mind you, its performance recently looks in no way like the falling off a cliff losses experienced from May to October. But it's not like being long vol recently in the strict sense has yielded great results. The explanation, as with almost everything in markets, lies in the entry price. I've spoken a good deal about the healthy vol risk premium at the S&P level that has been persistent over the past several months. When your insurance policy is pricey, the payout to you, should you make a claim, nets out to be less. Over the last six months, the average of the VIX has been 6 vols and nearly 60% north of realized volatility. That's quite a spread and competes with what we saw in 2021 when the market was still working through the equity derivative losses incurred in 2020. As I've said, it's not entirely clear why the VRP is widened, and it goes against much of the common narrative that vol sellers aren't being duly compensated for bearing risk. The miserable performance of the Gamma Index would suggest otherwise. To summarize, we have the following opening observations. First, both realized and implied vol have picked up, but not to any truly notable degree. This is hardly a vol shock like April. Second, we can assert that the hefty vol risk premium has been a complicating factor in playing defense. This is to say that the market is charging you a lot to buy insurance. It's not property insurance in Florida or California, but options based insurance in the market is no steal. To make this point, let me run through an exercise I've done before. If the VRP, that is the spread of implied to realized, is typically 3, and it's more recently averaging closer to 6, what does that translate into hedging cost? Well, we might observe that 15 realized should produce a VIX of 18, but instead it's 21. I'll use a dirty approximation that the VIX is pretty close to 5% out of the money one month put vol. Using 21 vol, the cost of that put is 1.5 times the cost at 18 vol. If you wanted to spend $1 million of option premium, you'd be able to protect $250 million of assets at 18 vol, but only $167 million at 21 vol. These are consequential differences. If there's been a large spread of implied to realized, there's been an even wider gap between narrative and realized. That is, the breathlessness of bearishness over the last few weeks has been highly out of step, relative to the actual perturbations typically concomitant with such commentary. I worked hard on that sentence by the way, perhaps the writer's block is over. I know at least one lawyer listener who may owe me dinner for using the word concomitant so well. They say that there's always a bull market somewhere, and a chart on doom commentary has surely been up and to the right. Perhaps it's been the joint decline in the equity and crypto markets. Nvidia is down 10% in November, and Bitcoin is down almost twice that. Perhaps it's been that there wasn't a hardened fast enough of a catalyst to point to. No trade war, Powell Presser, CPI Surprise, or earning shortfall. These would have at least left us with plausible drivers, satisfying our need for markets to make sense. Despite these traditional places to look, but having to stare anyway at flagging prices, we were forced to ask hard questions. If there's no obvious fundamental driver, is this the market's way of telling us that things went way too far? If we'd risen assets up much, much higher based on a narrative in which price was the only fundamental, what happens when price falters? We're forced to embrace less appealing narratives that fill in the blanks that fundamentals typically occupy. If there's one idea that best captures my own curiosity in markets, it lies in studying our presence in them. As Alec Baldwin said, it's complicated. And here's where the Soros theory of reflexivity is so relevant, especially to modern day risk taking. By the way, I've always found it quite ironic that Soros, the most effective thinker on the concept of market reflexivity, has a last name that is a palindrome backwards as it is forwards. Market reflexivity is a brilliant concept and price is central to it. The financial news media, a publisher perish outfit, woke up every day for the last few weeks and it chose bearishness. Price forced it to do so. Price is surely an outcome that results from changes in economic and corporate profits and also adjustments in the stance of monetary policy. But that's kind of old school stuff. Today, price is more properly thought of as a driver of wealth, which in turn allows it to drive investment behavior and also narratives. In the process, it can actually shape fundamentals. Price as Soros, or maybe it was Mark Twain once said, is the only fundamental. Confidence has eroded in crypto only because price did as well. It's the same with AI. We question the story because absent anything else we can point to, price forces us to. There are many prices to watch to help us construct these narratives. I've said before we over consume prices and overindulge in trying to figure out what they mean. There are all kinds of business models built around the study of price and in crafting narratives around what they tell us. You are listening to one of them right now. Not every last wiggle in a market derived price is meaningful and some prices can be outrageously difficult to read. Prices, as John Burbank once told us, lie. He ought to have told policymakers sipping fine champagne and staring at a VIX of 11 in 2006 at Davos as much. They tragically saw ultra compressed risk-premia levels as a sign of success, not danger. But we should carefully watch asset prices anyway. And there are a few prices I see that I don't really like. First, we should ask questions of whether the market is speaking through higher CDS levels on Mag7 type names. I created a custom index on the old Bloomy to track the average five-year CDS level of Google, Amazon, Apple, Microsoft, Oracle, and Broadcom. This has widened a substantial amount and is now only a few basis points tighter than the broad CDS IG. It's not as if the economy hit a wall or these stock prices plummeted either. It's a repricing based on supply and demand for credit protection, worth putting on your risk dashboard. And if you request, I will happily send you the CIX over the terminal. Just ask. A second market price I've paid attention to is the pickup and correlation across the Mag7. From June to October 9, the average correlation of the non-NVIDIA Mag6 to NVIDIA was just 22%. Since then, it's 52%. That's informative, especially as the CDX index I mentioned has widened from 28 to 50 over the same time frame. We stare at these market implied prices and our minds entertain the factors that drive them. Realized correlations are rising and CDS levels are higher as well. That makes for a pretty good story about risk. It might even be true. We are swimming. Check that drowning in prices and commentary as to why they moved. Amidst the bearish tone and markets that is far outstripped, the actual price damage, the bubble word came up over and over. The question around a market, and in this case AI bubble, is important but mostly not properly framed. Ask five intelligent folks and you won't even find agreement on the words definition. What can be agreed upon, however, is that implicit in the question is the notion of vulnerability in prices. This matters because unless you are truly insensitive to mark-to-market risk, Bernanke Buffett and Besant might be the only three I know, drawdowns do matter. If you bought Amazon in early 2000, you experienced an 80% drawdown. It's more than reasonable, in fact, advisable to have cut your losses along the way. It would have taken you until 2007 to break even. The rest, as they say, is very profitable history. So the bubble conversation is really more effectively framed as whether prices for AI-related equities, which certainly have pulled forward quite a bit of the expected productivity and profit gains, are vulnerable to a correction that is large enough to force a risk management decision. While today's economy bears little resemblance to that of 20 years ago, there's too much riding on Mag7 market cap today in a way similar to the pre-GFC period when the Lynch fin was rising home prices. In both cases, the economy is at the mercy of the market rather than vice versa. The economy market feedback loop today is similar to that of the pre-GFC period. It's the market that will take the economy down, not vice versa, as is traditionally the case. Today's S&P can be summarized as highly concentrated with highly volatile, highly valued, but remarkably uncorrelated tech stocks. A good argument can be made that the market is not properly identifying the linkages, crossholdings, investments, and the extent to which customer-supplier relationships underpin the correlation and outcomes for AI stocks. We are still in the leveraging period, and stock price changes have been vastly idiosyncratic. A similar argument could be made for home prices in the pre-GFC era. House price appreciation was clearly driven by a common factor, the bottomless extension of mortgage credit. But that did not show up in city-to-city correlations until there was a break in the circularity. Once defaults picked up, the credit machinery failed, and the correlation of housing prices surged. In the aftermath of large drawdowns, investors consistently realized they'd underestimated the degree of sameness in assets. It took us until 2008 to recognize that the huge run-up in housing prices was linked to a common driver, the vast supply of mortgage credit. Today, we have to forcefully ask ourselves whether we are missing the vulnerability to a Mag7 sell-off. The negative wealth effect would be substantial. If market cap is the "currency" to fund CapEx, and that same CapEx is driving economic growth, a sell-off in Mag7 has multiple pathways for spillover. Starting with Gita Gopinath's piece in The Economist in October, there have been a number of pieces that sought to model the economic impact of a protracted sell-off in the Mag7. I think there's a lot of value in this framework in thinking about risk right now. Next I want to shift to Bitcoin, which has had a tremendous drawdown, not just in percentage terms but in dollars lost. The 33% drawdown was the 10th larger than 25% since 2017. But the wealth hit more than $800 billion is the most substantial this time around. You know which asset had an even larger drawdown and more significant loss of market cap this year? Nvidia went from $3.5 trillion in market cap in late February to just $2.5 trillion at the post-liberation day lows. But Nvidia, while certainly rewarded with a healthy PE and expected growth rate, reports profits, lots of them. The speed with which the narrative recently turned on Bitcoin was unsettling if not unexpected. If price is the only fundamental and price is plunge, now what? I captured the violence of the drawdown in a table posted on the Twitter, showing those 10-25% drawdowns since 2017. This most recent one has occurred in 47 short days. It rivals those that took place in 2017, but as mentioned, the market cap then was a pittance relative to what it is now. Let's talk about crowding. The LTCM episode feels relevant. It goes back a ways, but as Mark Hanna said to junior broker Jordan Belfort in Wolf of Wall Street, "Stay with me." 1998 was a great year for the Yankees, but a bad one for carry trades. Risk exposures that LTCM engorged on, like swap spreads and short equity index vol, became especially risky even at prices that provided what looked like a good deal of margin of safety because the market knew that the fund was long, wrong, and huge. LTCM is the poster child for the risk that having exposure that overlaps with a vulnerable, large investor can create headaches for you. You need to know the mark-to-market reaction functions of those alongside you. Some might say that today's John Merriweather is named Michael Saylor. Both seem to have diamond hands, but the latter doesn't have bilateral OTC derivatives on, or at least none that we know of. It does not appear that Saylor has any mark-to-market call for variation margin heading his way as the banks famously demanded of long-term. But Saylor's presence in the Bitcoin market probably matters just as LTCM's giant positions in options and swaps mattered. These things are impossible to disentangle, but one could easily argue that swap spreads would have been wider and vol higher had LTCM not taken on its famous carry trades. Where would Bitcoin be without Saylor's buying is an interesting and open question. He's the single best marketer of our time and his capacity to create the fear of missing out is unparalleled. With both capital and tremendous communication skills on his side, his PR campaigns have influenced price, which have influenced what people believe. That in turn has further impacted price. But what happens when price fails to be the advertisement it once was? With Bitcoin, the question may be best framed, not as whether a forced seller will emerge, but how the drawdown and significant markdown in MNAV impact the buying campaign. Not just for MSTR, but for all the digital asset treasury companies that injected copycat capital into the Bitcoin market. This by the way bears similarity to the manner in which the banks, covering LTCM and enamored with its success, sought to replicate its favorite carry trades leading into 1998. If price is the only fundamental and fresh capital is needed to repair it, we ought to ask where that's going to come from. And I do have one place to look and here's where I'd like to close. And that's on how to think through a couple of dimensions of risk. One shorthand I've developed is to categorize sources of uncertainty as monetary, central banks, economic, meaning growth and profits, financial, which captures leverage, carry and correlation, and lastly geopolitical. We have seen them all. Geopolitical is non-market, market risk. This dynamic conjures referendums like Brexit, countries like Russia, China and Iran, conflicts like trade wars and actual wars. But the war to pay attention to continues to be waged inside the U.S. and the escalation is hard to miss. As recent podcast guest Alex Kazan said, quote, "This is not primarily about Donald Trump. It's structural." As recent Bloomberg headline reads as follows, "White House denies that Trump threatened lawmakers with execution. Left-right or center that this can be an actual headline is not good for that shiny beacon on a hill, USA Inc." These things are mostly unobservable in market prices and don't matter until they do. They may never matter. A U.S. political crisis is a very low probability but very high impact event. Sadly, there's no obvious pathway to de-escalation. And looking ahead to 2026, which sets up to be a win at any cost midterm contest for the House and Senate, we might see some unbelievable stuff. One of my old sayings is that, quote, "U.S. politics, like stock price returns, are not normal." And it might be the case that you ain't seen nothing yet. Fiscal discipline, whatever that might mean in today's lexicon of enormous debt and deficits is unlikely to be a thing next year if it means losing control of Congress. If there's a chance to fatten people's wallets, even if temporarily so, to goose the economy and increase your standing with voters, it's going to be attempted. The stakes are viewed as way too high, not too. Lower rates, higher deficits, and more dollars floating around the world, ultimately gold and Bitcoin are outperformance options versus the greenback. Michael Saylor may not be a disciplined buyer, but there's something to be said about assets with disciplined supply. The U.S. government is hardly disciplined in how it releases dollars into the world. When a slowing economy and an incredibly polarized U.S. political climate run into an election year, strange things can happen. We shall see. Well, folks, I'm coming up on 3,000 words, two of which were perturbation and concomitant. I'd like to wish you a very happy Thanksgiving and also express my own appreciation for you all being a part of letting me do what I love, thinking about markets and risk. On Thursday, please eat and drink as much as you're able to, but do take the time to reflect on the good things, especially health and family. 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. 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 [email protected]. Thanks again and catch you next time.