Odd Lots - The Big Trade Underneath the Strangely Calm Surface of the S&P 500

Episode Date: June 17, 2024

For much of this year, the S&P 500 has marched steadily higher while measures of stock market volatility, like the VIX, have stayed pretty low. But looking at the headline index only tells you part of the story. Beneath the surface of the S&P 500, individual stocks have been moving up and down a lot. And of course, traders have figured out a way to make money on the difference between the quiet overall index and all that volatility happening in individual stocks. This is the dispersion trade that's gotten quite a bit of attention in recent months. But figuring out exactly who's doing it and how pervasive it is isn't that easy. In this episode, we speak with Michael Purves, CEO and founder of Tallbacken Capital Advisors, and Josh Silva, managing partner and CIO at Passaic Partners, about this new volatility trade and what it means for the overall stock market.See omnystudio.com/listener for privacy information.

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Bloomberg Audio Studios. Podcasts, Radio, News. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. Joe, how would you describe current market conditions? Up and to the right, every day, basically. We're recording this June 13, and we're probably at new highs in the future.

Yeah, it's just, everything just goes up all the time, and it's pretty easy. Yeah, but even when you say up into the right, if you're looking at something like, like the S&P 500. Yeah. I mean, it's gone up a lot. Yeah. But on a day like Wednesday when we had the FOMC decision and we had inflation data coming in softer than expected, even then, the S&P 500 was up by like less than a

percent. Yeah, but you add up a bunch of less than a percent. Yeah. You put together a historical year of returns. I mean, it is. Yeah, but no one wants to wait for all those days to pile up. So if you look at the single stocks, I mean, there have been days when Invidio, was up like almost 10%.

So this is the thing, you're right. And this is the thing about the market, which is like I am like a boring S&P 500 every month, like put a few dollars into some ETF. But then I see other people around me getting like really rich because they bought Nvidia and it's really annoying. What if I told you there was a way that you could square those two things? So boring indices and the volatility in single stocks.

I don't want the volatility in single sex. I'm the upside of a single side. But yes, if I can have both getting really rich and being boring, that's fine too. Okay. So today we're going to be talking about something that I wanted to do an episode on for a long time. We are going to be talking about the dispersion trade. Have you heard about that? No. I mean, basically, other than the prep that I did for this episode 15 minutes ago, no. I'm going to try not to be offended because I did write about it a few months ago. Actually, I wrote a story about it and I wrote a newsletter. And all thoughts, newsletter, Joe. Yeah. Go on. All right. It's a good thing we're having this conversation then. Okay, the dispersion trade. So basically, it sort of falls into the bucket of another type of short

vault trade. And the idea. I sort of knew that. I sort of knew that. Okay, good. We're getting somewhere. The idea is basically you have traders that are using equity options to bet on this is the important thing. the relative volatility between single stocks and stock indexes. Okay. So, you know, typically you might see someone go long volatility in a basket of individual stocks using single stock options while simultaneously betting that volatility in an index, like the S&P 500, is going to stay relatively low. So implicitly, I guess there's an opportunity to sell that volatility to the people hedging

a portfolio and then doing the other side on the other side. Yeah, that's exactly it. So you kind of need two things for this to work. You need the market dynamics to basically be volatile single stocks and kind of boring, you know, overall benchmark indices. But you also need the cost to make sense. So when you're buying that volatility, it all has to kind of net out. But recent months for a while now, that has been the case. And there's a lot of anecdotes on Wall Street that this trade is absolutely booming. Yeah, I mean, we talk about these from time to time on the show. Sometimes it's expressed more directly and some sort of implicit short VIX trade. Sometimes it's talked about very explicitly,

like a few years ago, I don't know, 2018 or whatever, like the real short Vicks trade that blew up in every one stage. The Volmageddon. The Volmageddon trade. I don't remember what, you know, that was like 2017 or 2018. 2018 or something like that. But from time to time, one thing that seems to be clear is that there are various flavors. of trades that become very popular and all that needs to happen is for roughly, you don't even need the market to go up or anything like that, you just roughly need the status quo to persist. Yeah, absolutely. I mean, traders are very good at making money off of anything, sometimes even nothing, like basically the continuation of what's been happening. And, you know, the one thing,

and you said it out in your intro and the consistency is that among people who say like own the broad index or just own risk assets, period, there is, you know, is probably a persistent inclination to overpay for downside protection at premium. And that creates an opportunity then for someone to get on the other side and sell that premium. Yeah. And we are going to get into all of this. I am very pleased to say we do in fact have two perfect guests for this particular episode. We're going to be speaking with Michael Purvis, CEO of Tallbackin Capital Advisors, and also Josh Silva, managing partner and CIO at Pasek Partners. So thank you so much for coming on the show. Thank you. Great to be here. Why don't we start with an introduction?

Tell us who you are and how you know each other. Well, I'll start. This is Michael Purvis, Talbock and Capital Advisors. We are a cross-asset research firm, which means we get into the major asset classes and how they kind of define each other. That means equities. That means rates, FX, sometimes commodities, but also volatility. I sat on various option desks over the years, and I like to look at life and the markets a little bit through the lens of volatility. I'll let Josh describe himself and his firm. Sure. My name is Josh Silva. I'm the CIO and founder of Pasek Partners, a derivative-based asset manager who uses derivatives as a tool either to reduce risk, enhance risk, or manage a multi-asset portfolio looking at implied volatility as an indicator of when to take risk and when not to. Josh and I have known each other for, I don't know, what, 10 years, 12 years now.

And in full disclosure, Josh is a client of Talbach and we also share office space. So we're constantly talking about the markets. So Tracy and I don't have to do anything. We could just listen to Gab about Vol and that could be our episode. Yeah, I don't know how exciting everyone else would find that. But at least the two of us would be very excited about it. Tracy described it and I pretended to sort of have some maybe intuitive sense of going on. But how would you, either one of you could start like basically describe the legs or the basic construction of the dispersion trade.

This is Josh. I'll start off. First thing, I think you did a very good job of describing the trade, quite frankly. But I will go into the origins of it, which is more fun. Yes. So you have an old Chicago pit trader. So let's go back in time to the old Chicago pits and talk about. Yeah, already speaking our language. So it really came out of the ability to manage risk. I mean, we're talking about a trade that was originally designed as a risk management trade. You know, post-87 crash. You know, Chicago used to be just a bunch of single traders managing their own money. Post-80s. crash, the people who survived ended up running a lot of big trading groups, which I could have 50 to 100 traders working for them in various pits. You know, what ended up happening was when you survived the 87 crash, you learn, I don't want to experience the 87 crash. And so the dispersion trade came out of the ability to manage, quite frankly, the tail of that risk back in the 90s. That changed as we got into dot com.

And what I mean by that is it's sort of a familiar little taste to it. You have a certain sector which everyone's buying and everyone's making money while the rest of us are lonely owning the S&P. And they're chasing upside. And so what that ends up doing is you would come into the pit. And I remember this with AOL specifically, if you can talk about an old stock and all day. Every day they were buying calls. Every day they were buying call spreads. And so you had to collect inventory to prepare for that coming bid into options. And so you ran that inventory long and to reduce your theta. or your decay bill, you would sell some index.

And voila, you have the start of the dispersion trade. Now, granted, that was at a time when spreads were significantly wider, volumes were significantly smaller, and the size of the notional amount was significantly smaller as well. And so that's how this sort of came about, and I think Tracy put it perfectly. You own a basket of single stocks, and you use the index to help reduce that risk.

And at the end, both sides of that trade made money in the 90s as well. And so it became a very, very profitable trade, which leads us into the 2000s. And again, I've been doing this way probably too long. I like this call it a trade in the 90s. And someone taught me this a long time ago, there's trading and there's investing. It became an investment in the 2000s. In other words, it wasn't traders just moving positions because when you trade, you can be very nimble very quickly.

And that's what market makers are very good at doing, which is we like to call picking up the nickel in front of the steamroller. And that's what the dispersion trade was originally. In the 2000s, and leading into 2008, 2009, it became an investment. In other words, I think I listened to your old podcast, an ex-IV, became an investment. That's what the dispersion trade is becoming. Well, I have a question, which is, it's kind of hard to tell how popular this trade actually is. Everything is sort of anecdotal. I remember when I first heard about it. It was actually from one of Michael's notes, and you laid it out perfectly, Michael, but then I went back and I started doing some research and searching for mentions of

dispersion trade. And one of the things I found was, you know, a mention in the Bear Trap's report where they were talking about multi-strat funds, putting, quote, massive amounts of money in the dispersion trade. But then you can't find actual figures. Like, it's very hard to find estimates for how much of this is going on. So walk us through like what indications you might have or what you're looking at in order to determine how popular this trade actually is. Well, one way to get a sense for that. And it's all kind of indirect, right? There's no big like government report that talks about how much, you know, how many options are in this trade or how much capital is in this trade. But if you look at the SIBO implied correlation index, it actually is just now, the three-month implied

correlation index is actually at the lowest levels it's ever been. And they have a couple of the one month implied correlation is also at not exactly a record lowest, but very, very close to it. So that's a little bit of an indication where you can infer that certainly people are pushing this trade here. Yeah. And it's working, right? Everyone's making lots and lots of money on it, which is typically what happens in short ball trades. People tend to make a lot of money until they don't. And so, you could go back to different vol events. I mean, we could talk about 1997 and we could talk about 98. We could talk about 18. We could talk about 20. There's different vol things that have occurred where you didn't know how big the trade was until you knew how big the trade was. And it's sort of

the nature of short vault. It's so funny is that I've been doing this for a long time. Marketing short wall strategies in 2020 and 2021, you might as well had your hair on fire because nobody had any interested in it. Now everyone's interested in. Why? Because it works. And when it works, it works very, very well. The problem with all these things, as I always like to say, is when it becomes too big for the market and there's too much leverage. And so the question always is, where is the size and where is the leverage and how much leverage does it take? We've learned through all these short ball events. It only takes one bad participant to create an unwind or a liquidation. And that's what we saw in 97. That's what we saw in 98. That's what we saw in 20.

So again, this is not an unheard of thing. Right. I think just to add on to that, I mean, one of the things, you know, and I know Tracy and Joe are always focused on that Balmageddon from February of 2018, which was this ETF, right, where you could see that ETF every day and you could see how that ETF grew. One of the things today with this dispersion trade and whether this will become a Balmageddon 2.0 is that you don't have that clarity. It's a little, the waters are a little bit murkier here.

So you can pick up anecdotes here and there. You can look at implied indices. You get a sense, you know, Josh is in the options market every day. And you pick up things. But it's hard to put a crisp number on it. It's the unknown, right? You're testing the unknown. So the thing about that inverse VIX ETF that blew up, it was a trade that existed in various

forms for a while. And then someone went along and like productized it. And so then suddenly, like, you can see like it's AUM or its daily volume. Just a quick definitional thing. because I just so that listeners can understand, when we talk about the CBO three-month implied correlation index, and it's basically at all-time lows or near-all-time lows or something like that, that is just saying that based on the volatility of all the stocks that exist in the index,

it suggests that there is a wide level of expected dispersion among outcomes. Yeah, it's not every stock in the index. It's the top 50. Okay, okay. It's typically market cap weighted there, which I think is very relevant to today's disbursement. Today's discussion, actually. San Francisco.

On April 4th, 2023, around two in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as

Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. Can one of you explain just sort of like from a fundamentals standpoint, why it is that not in a realized basis, but on a trading basis, essentially implied volatility for the index tends to be higher than if you add up all of the implied voles for all of the individual stuff. So it actually ends up, the index ends up being lower because of the relationship of stocks with each other. So, you know, when you think about it's like, you know.

But people pay more for the protection of the industry. They pay more for the implied versus realized aspect. Okay, that's what I meant. That's sorry. That's right. Yeah. So they, and the reason, you know, they do that is because, as you said, they're hedging downside.

They're not hedging downside as much as they normally do right now, but that's a different conversation for a different day. The way it works is to think about it is that if you have this basket of single names, the create the vol of the index is the combination of all those added up, their variance plus their covariance, which is the matrix of how they're related to each other. So if tech stocks goes up and utilities go down, well, then now, that reduces the volatility index because they're moving in opposite directions. When they all move together is when the correlation trade has a problem.

And that usually occurs in some sort of liquidation event. Right. So think about it this way. So in a good benign market like we have right now, you could be long meta-vall and you could be long Exxon-Val. And Exxon might disappoint for some reason and the stock goes down and the vol explodes. Maybe meta-stock price surges higher for some reason. The ball may go up too there, you know, ignoring the actual weights in the index.

If those two stock events cancel each other out, the S&P is kind of flat, right? You know, on those two things. But the dispersion trader may have made very good money. And Tracy put it perfectly. It's like the Navidia is going up and the index is just kind of quietly moving higher. And that's because of correlation. I mean, if they were all correlated together, the index would be up as much as Navidia. So that's another way to think about it, which it's not, right?

Fund managers can dream. Yes, we can all dream, right? But Joe, just to put this kind of prosaically, right? Yeah. Like, you know, when correlations go up really high and when this trade gets unwound viciously, right? Think of that as the equity asset class being sort of in a zero one condition. Like people are just getting out, right? They're like, okay, I'm exiting equities because something bad is happening and I need to sell everything, whether it's Exxon and Meta or a small cap or whatever, right?

In a more benign condition where people are like, you know, I want to be. inequities, right, but I'm going to really be able to discriminate among the fundamentals or whatever's driving that stock picking exercise, then dispersion works, correlation, both implied in realized drops. Yeah, I mean, another way to think about it, it's another way of being short tails. Okay. The hedge funds love being short tails. That's how they make money.

So I want to go back to something that you touched on earlier, Josh, where you were talking about previous historical instances. And when I hear portfolio insurance that this is a type of portfolio. insurance, I think Black Shoals. And then I start thinking about correlation, which we already touched on. And I guess people, you know, trying to figure out the correlation across a portfolio and maybe not doing it that well as, you know, the experience of 1987 kind of taught us. Talk to us about the maths that go into this. And like, what guarantee, I guess, or what comfort can we take that people are actually calculating correlation correctly? Because

Again, correlation is one of the trickiest concepts in all of finance. And history is absolutely littered, not just with 1987, but, I mean, you could argue 2008 and the Gosian copula was also an instance of a failure to accurately capture correlation risk. But it seems difficult. It's incredibly difficult. And what I remember, again, going back in time is when you look at these old Chicago groups, second most important person in the group was the risk manager. Because we're talking about times when, you know, we're talking about Intel.

425 chips or whatever those things are called. You know, we used to run risk matrices and stuff that you'd have to run overnight. Those computers are actually less powerful than your current phone. So that's the kind of way you'd have to look at it. So you need a really good risk manager. And you need someone who understands what that tail event looks like and what the portfolio is going to do. Do I have faith that, you know, I call some of the smartest people in the room, some of the people that I stood next to in the pit are going to be fine?

Yes. Do I think they're actually going to make money on this event? Yes, because they're the smartest people. in the room. I do think there are funds who probably do not have risk managers to understand that that do not have properly quantified that tail event risk. And the biggest issue, which is the thing that scares me the most, is the liquidity aspect. And you can see what's happening in single stocks. I think B of A called it with the fragility index, I think was what they call it, which I thought was one of the funnier names, but that's a whole other thing. Stocks are moving all over the place. And why?

because there's no liquidity. And so wonderful thing about liquidity is when you're putting on a trade or an investment, as I like to say, this again, I say is an investment. When you're training it, like a market maker to trade, when you're putting it on and setting and forget it, it's an investment. Is that when you try to get out of it, it's really hard. And that was the experience of 2011. 2011 correlation traded over one. Why? Because you couldn't get out. And to get out, you had to pay. that's how these things go. And so what I like to say about these events is that when there is a liquidation, it'll be hard, it'll be fast, and it'll be dramatic like we saw with Valmageddon or in 1997, which was a put seller that blew up. But typically the market after that is pretty

awesome. Just to add on to that, I think what's really important when we're talking about these sort of Valmageddon twos is to really distinguish that this doesn't necessarily mean something's broken economically or earnings-wise or fundamentally in any way, shape, or form. Like we saw with Almageddon, as we saw in December of 2018 when you saw crazy price action, you know, the VIX, you know, was soaring into just before Christmas of that year. There was nothing wrong. There was a lot of questions about whether Powell was going to pivot and whether, you know, the whole far from neutral thing setting that stage then.

But that was a lot about modern market structure and the financialization of the equity asset class. which is very different than the 1990s. Yeah. That's a very important thing. If you look at options growth, like, you know, Josh and I talk about this all the time, but like S&P options growth has been growing dramatically, 8% per year. And then that escalated in the last couple of years to much higher levels. Cash volumes have been completely flat.

I'm talking S&P, right? So when you have that, you're going to get funkier price action at the index level and at the single stock level, too, with people chasing Nvidia calls or NVIDI puts it, you know, whatever. You're going to get a much more financialized and erratic price action, which can also then be one of the added matches to light the fire for, you know, a potential Valmageddon, too. Yeah, it's, again, it's, you only need one bad player. I think the majority of people are not. Well, this is what I wanted to get into because with Valmageddon, like, okay, you could kind of see that coming. And in fact, a lot of people did because you knew that once

the VIX curve inverted, it was just going to be the end for some of these volatility products and two of them in particular. With the dispersion trade, the one thing I struggle with is, like, what would be the proximate cause for the unwind? Or a telltale sign like the inversion, like this is flashing a yellow light. So in 2011, it was a sovereign debt crisis that caused a liquidation in public equities or a fear of public equity. movement. In 1997, it was an Asian financial crisis. Everyone forgets that long-term capital lost more money selling all than they did on fixed income stuff. If you go read when Genius fails, they have the numbers in the back, which is quite interesting. The guy who sold options in

97, he wrote a book, too, about three months before it happened, which was kind of funny as well. I'm going to read that. The event's going to be something macro. Yeah. Like, I always like to say, how do you get a five standard deviation event? You have to get the one standard deviation event, which causes this to happen, which is the second. which is what turns into a five. Let's try to get to Joe's question, I think. But if we get a macro shock, right, you get a big uptick in people wanting to get out of the equity asset class, right?

And they run for the fences because something bad is happening. You know, what's going to happen there is that the VIX index, right, which your index which is going to be rising much faster than your basket fall that you're long, right? And that's where the risk manager taps the dispersion trader on the shoulder and saying, close out and then you get a sort of a self-fulfilling loop there. Well, let me put it a different way, which is that, okay, the thing that blows this up will be some macro event, almost by definition unexpected. I don't think any of us in this room probably can like really know like when some country is going to break, et cetera. So at any given time,

you're putting on this trade, you're collecting premium. There's a risk that it blows up with a macro event. But at some point in between that, there must be some calculation where you are not getting compensated enough in order to justify the risk that the once every five years or the once every 10 years macro blowup occurs. So what are those signs or whether it's in the pricing where it's like, yes, you can still make money on this trade because the math is there. But given the fact that there's going to be a macro blowup of some sort every few years or everyone, like this is no longer worth the risk? The math is still there. You know, implied correlations are still higher than realized correlations. Okay. That's helpful. But the VIX is not at 25 right now, right? It's down in this 13,

14 level, right? So your risk return is not as constructive. Josh, disagree, if you will, but I don't think it's as constructive now as it was coming off this massive vol spike we had during COVID, right, where you've had this sort of general reacclamization to the short-val thesis and various forms of fashions. Now it's just gone too far too long. Yeah, I mean, and it's funny is that you actually pay decay in this trade because of the basket of single names is more expensive than when you're collecting on the index. I look at it as sort of you're at the vixis at 12, like how much more money can you bleed out of this rose? I mean, it's really at that point. And that's what I'm saying about the people who are smarter will have reduced this trade who aren't as an investment.

Like the vol traders reduced short vol in 2018 because they need. knew that 2017 was a multi-decade in low movement. We were moving what we moved 2% that year in the S&P and a 2% bulb because we went up 1% every month. You know, the joke is if we go up 1% every month for 12 months, it's all the S&P zero. So it sort of becomes one of those things. And so you just get to the point where you're a risk manager, you go, what's the upside downside? And the downside becomes greater. So when I look at it as a person who's managing risk, I just reduce because how much more money can you take out of it. Now, again, a lot of this is fundamentally driven by stocks and what's happening with stocks and who's making money.

A friend of mine pointed out, you know, 35% of the S&P is now AI, right? So, you know, how does that look? I think we should just set the table a little bit about what's been, why is this trade so popular right now, right? And there's a lot of fundamental reasons that, you know, if you're a dispersion trader, why you go to your boss and say, hey, we need to do this, here's why, right? And the reality is, is that we're in a strange economic cycle, right? We have a risk on condition, obviously, right? VIX is low. S&P keeps putting on good returns and other risk assets do, right?

But how these different sectors are moving with each other and the different stocks is incredibly low, right? Part of that's because we have an unusual cycle. Like if you remember, you know, during COVID, oil prices went negative. Before that, oh, my God, why would you want to own Exxon at all because of ESG and all that? And then, of course, that reversed. Oil went to 120 and Exxon became, you know, the new Google for a few months, right? So you had a lot of strange things coming out of this COVID shock and all the compounding things there. But, of course, you know, just in the last year, you have AI, right?

And so one of the things I like to look at is sort of how each sector correlates across with other sectors, not unimplied basis, unrealized correlations, it's the historic trading. And what's really interesting there is that if you average all the cross-sector correlations, 10 sectors and, you. You see how each one, you know, you get up grid. Right now, that average is about the lowest it's ever been, right? The cross-sector correlation. But what's I think even more relevant is that the tech sector's correlation is the lowest it's ever been, but for 1998, 1999. Which keeps getting us back to 1988 and 1999. Right.

And the tech sector is particularly important because the dispersion trade, generally speaking, is market cap weighted. And of course, the tech sectors are dominant. dominating the S&P 500 here. So that's one reason why you can say, oh my God, like look at Nvidia, it's so different than so many other stocks. If you look at fundamentally, the Mag 6 earnings this year have exploded 22%.

The SBX equal weight is up 4%. Like there's a lot of fundamental arguments suggesting why this trade makes sense here. I think what Josh and I are collectively saying is that the trade's been pushed too far here. And there's another point I'd really want to make here too, which is that, you know, there's a lot of cross-asset comparisons with the late 90s right now, interest rates and so forth here.

But what's really interesting is that the correlations for tech and the correlations, broadly speaking, on a realized basis are much more similar to 98 and 99 than they were today. But the VIX back then was 20 to 25 to 30. It was not, go back to 2017, super low VIX, right? You know, we even had nine-handled prints at one point there. And the correlation was very low. then, it's very low now here. But 2017 was a period when you had very different central banking environment. One of the sort of broader cross-asset theses I'm arguing is that we are normalizing

a lot of central bank policies are not normalizing to 2017, but to something else, right? And if that happens, we may see the VIX. I think the VIX is getting into a higher range here, a higher floor, if you will. And if that happens, maybe you don't even need a macro shock to derail this dispersion trade if the VIX is going to start sort of grinding higher just because that Fed put is too far out of the money right now. And I think one of the big things you're seeing is the lack of put buying in general compared to 1998. And the big thing in 1998 is that we had never seen a Fed put come in like we have since. And so I think the market is comfortable with the Fed putt coming in. So why own puts?

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On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. I definitely want to get into more of like the outlook for volatility in general. But before we do, I have one more question on the dispersion. trade, which is, can you walk us through who is on the other side of this? So maybe hedge funds or some other type of trade or are putting this trade on who is selling or buying that volatility

from them. There's two legs to the trades. So back when I was more on the sell side, not just more I was on the sell side, so it's 2011. You had a lot of structured retail product trades coming out of Europe and Asia, that put a lot of single stock vol onto investment banks' books. They would then sell index as a way of getting out of some of that because there wasn't enough liquidity in certain things. They do the same thing with dividends. They typically get long dividends, and so you assume certain dividend growth, and so that's the sort of the growth of the dividend swap market as well. So they would then use hedge funds as a way of offlaying that concentrated single stock versus index risk. And the reason being is because it doesn't look great on a VAR perspective because

your short tails. And so when your VAR numbers get a little bit too the wrong way, obviously the risk management banks that you need to offload this. And so what happens is they do tend to offload that risk. You know, where it's coming from now, and again, this is totally me guessing on the fact that what I'm seeing is it seems like the market is short, single names, and long index. In other words, if you look at, you know, like with the brokerage, I'll put out, oh, the, you know, the broker market is long $10 billion of front month gamma, or one-day gamma going into CPI and then the market moves like 3%. And everyone's like, well, how does that happen? I'm like, well, it's because they're probably short single names. And a lot of this data,

and again, Tracy, you put it perfectly. Like, there's no central depository of data. We become so data-centric in this world. Like, I feel like when I started in this business, I was like the data junkie and always obsessed with data and whatever. meant and then I've realized, well, it's like kind of like looking at baseball when everyone's using data. Sometimes you've got to move away from it to a degree. And there isn't a good data set. The only data set we have is what Michael's point out is there's just a massive growth in volumes and open interest and options. Everyone's using them. Everyone's paying attention to them. And so my general feeling is that the market is probably long, a little bit of index,

and short a little bit of single names. So I know you guys are both options, guys, for the most part, But what impact does all that growth in the options market end up having on the cash market? This is something that comes up again and again. And as you say, like the figures, if you look at the overall market, are just stunning. And particularly for things like the short-dated options, so the one or the zero-day options. I don't have them in front of me, but like talking about lines that go up into the right, it's just been stunning growth. Yeah, as I like to say, the tail starts wagging the dog a little bit. And I've seen this when I was in Europe, when options got bigger almost than the ability to trade stocks, they become the market.

You see this at month end, where you see large positions and options determine how we end the end of the month as people play cards to determine where we're going to settle. I like to say the month end is like kind of the old fun way of trading if you've ever seen the movie Rounders, which is one of my favorite movies, which is a bunch of professional poker players from New York, go down. to the Taj and they sit at a table and go, we're not going to sit here and play against each other because what's the point? And then people sit down at the table that don't understand how it works and they just start making money. And that's what's happening at month. And there's large, passive option positions that people are aware of and they trade accordingly. And so in that sense, yeah, the tail is wagging the doll. And again, when you look at this again, it would happen in the 90s where you have, if every day people are buying calls on AOL or calls on NVIDIA,

or calls on Apple like they are in the last few days, it can drive a stock significantly higher or lower. And that's why I think you see these large ranges occurring because the options are wagging the dog. It's almost like it becomes kind of reflexive at that point, right? Like you have all the options that are betting on volatility. And so because of all those options, you start seeing bigger swings. Correct. One of the interesting things is that, you know, we talked about like the VIX floor being 20 back in the late 90s, but even though the equity market was doing generally quite well most of the time. But the peak of the VIX in that same time frame, you had the Russian ruble crisis, you had the Asia crisis. The peaks there were exceeded by Vosmageddon's peak,

or at the same level here, which was, again, not a fundamental driven thing. So it's really a good way to think about just that was sort of a more normal VIX environment because you didn't have the financialization of the stock market, the way you'd have. have it today. Again, this is a short-tail strategy. It's like a converter, short-stale strategy, you know, credits a short-tail strategy. That's what hedge funds live with. I mean, that's what they're really good at doing is selling that tail and managing that risk. And so that's where we are. Also, Joe, I think people forget nowadays, but like the Valmageddon blow up, so that was like two relatively small ETS that ended up going belly up. But that sparked a sell-off, a pretty big

sell off in like the cash market in the S&P 500. Yeah. Yeah, I forget that element of it, that it did break containment, so to speak, outside of the ETNs themselves. Can we go back to, I don't want to just talk about AI because AI is a thing, but the AI risk factor, which is, it seems like a lot of the market now, many things are being shoved into an AI thesis. So it's like, you've Nvidia, obviously.

You have other chip companies, obviously. You have Apple hitting all. all-time highs. You have, that feeds into Berkshire Hathaway, which owns a lot of Apple, et cetera. Can you talk a little bit more about this sort of not necessarily price correlation because we know that I guess, you know, the charts or the charts, but this sort of thematic correlation and then how you see that affecting the risk. Narrative correlation, right? Corporates, AI, utilities are AI.

Yeah, utilities. Yeah, yeah, totally. Industrials. Yeah, exactly. I like to say Wall Street's good at doing one thing really, really well, selling greed. and telling stories. And so they can tell a story about getting people to get greedy about its theme. They're really good at making money off of it. And so everybody wants to sell this theme right now. What do you mean sell this theme? Sell the theme of AI.

I mean, Navidia being the ex of the theme. Buy the stock sell the theme. Yeah, I mean, if you think about it. I mean, Navidia is making incredible amounts of money. I mean, the amount of money they make in a quarter. I mean, I never thought it was imaginable. Yeah. So, of course, it's a great theme to sell.

Now, is everyone else going to be as good at this theme as them? I don't know, but it doesn't mean that Wall Street isn't going to sell it. But to answer your question about, is there like theme correlation going too high? Well, I mean, I guess it's like all these people are training models. And one day, it's like, you know what? They're mostly good for making goals and we can't figure out how to make money on them, canceling the orders. Then what happens to this trade? I think that's a really good question and a very relevant one.

But I'm going to put up back like my market strategy. Okay. Equity market strategy had on, not my options had on. Okay. And the thing you have to recognize about today's, equity market is that it's not necessarily particularly expensive at the S&P 500 level there. Obviously, there's always parts of it that are a little bit high, a little bit low. The S&P is not cheap by most any standard here.

But what's very important is that we're not really driven with a PE expansion type of bull market right now. It's really earnings driven here. Right. And if you look at what sectors are moving higher, it's very correlated with how much earnings growth that they're doing here, right? So let's say, okay, let's say if utilities just don't generate their earnings that some of the AI narratives might suggest they will, well, that's going to be reflected in the quarterly reports, the analyst estimates. And it doesn't necessarily have to mean that there's some big blow-up risk because of this AI thing. I think it's, we're dealing with, in many respects, one of the healthiest equity markets we've seen in a long time because it's not really about PE expansion. It's really about really strong earnings growth. And it hasn't been about ZERP or rate cuts either. No, exactly. Companies are making money.

We're having great returns last year with a hawkish, or at least maybe not hawkish fed, as we saw yesterday, but not like, oh my God, we got to cut rates to get the S&P up another 10%. That's not happening. I mean, companies are really making money. And so when we talk about this dispersion trade from a fundamental standpoint, the companies making money are going up and the ones who aren't are going down. And so fundamentally, it's a risk trade. I think, Joe, you put it once. It's like owning equities is kind of a short ball trade to a certain degree. And that's kind of what this is. It's a short vault degree in owning equities as part of that. And, you know, that's a trade that people are comfortable with. Now, is there a time it goes, yeah. But I truly think that, you know, Vol gets a bad name and options get a bad name in a lot of ways because we have these once in a while bad players in the market.

I mean, 2020, we had a bad player as well. I mean, that's a lot of what happened at the bottom was a vol-related event. But I don't know. Are you talking in treasuries or? No, no, no. I'm talking about why the market was going up and down 10% in one day. We can't mention. Say more.

There was a product out there that created a lot of the wall that occurred at the bottom. If you go look at the bottom, it was right when the VIX expired. So that's just another conversation for another day. But that being said, they have a bad name. And I still think that this market, as long as Michael puts it perfectly, these companies are making money. There's a fundamental reason for this. We have fundamentally a reason why we're going up into the right. And as long as that goes on, as Joe said, this equity market is a short vault trade.

This is a short vault trade. It will work. If we go into an 01, 102 or all of a sudden, what do you call it, Y2K goes away and everyone stops making the investment in Y2K, which is sort of the end. Or dogs.com all of a sudden realize we don't have dogs.com not making money. So it's different. As long as those fundamentals are strong, this will be fine. I don't think options are going to be as big of a problem because everyone's had problems

with them so people are aware of it. Again, it's not saying there isn't one player who isn't out there who's over levered, who's put this on an investment. And again, we started this as dispersion trade, not the dispersion investment. And there's a huge difference between a trade and an investment. Yeah, but I think all of this, Joe, is also one reason why, you know, when I do my trade recommendations for market hedging, I've certainly been of the view this year that I've been very constructive on the equity market. Obviously, anything can happen. But the question, is do you want to hedge equity market risk with S&P puts or with VIX calls? And I think this is one of the arguments for going with VIX calls.

Not that we've seen anything explosive yet this year, but if we do see some of these things unwind, you're going to get a kicker there where you might see the VIX cruise very quickly up to 45 and it probably won't stay there unless there's a real good fundamental reason for that to happen. But if you do get this, VALMALMLE get into a 2.0, that's part of it. And you buy that, yep. VIX to 45 is exciting, given that we haven't really.

seen that since like early 2020. But talk to us, I guess, about the general outlook for volatility, particularly cross-asset, because so far the big story for the past few years has been volatility in fixed income. I'm looking at the move index right now versus volatility in equities vis the vix. There's just been this enormous gap. Like all the interesting stuff has happened in rates. Yeah. The way I look at it is that the Treasury volatility, sort of the foundation of the house on which so much other volatilities, FX volatility, equity volatility, foreign equity volatility are sort of sitting on top of. So if you look at the move index and Tracy, I'm looking at your chart right now, if you look at that, it basically comes-

Tracy, put your privacy screen on. That's why I don't have a screen in front of me. Joe, don't say anything bad about our guests in the internal chat. So far, everything's been very flattering, so we're good. But that chart basically shows the arc of of a hiking cycle, right? And if you look at when that move index started breaking out higher, it was March of 2022 when the hiking cycle started. And officially, I guess, assuming we don't get any more hikes, which we probably won't, you know, that last July,

it kind of just stayed there. And if you look at the long-term history of the Treasury volatility or the move index, when you get to that resting place, the ball comes down a lot. Now, there was a lot of vol late September and October, which was, I would argue, was much more term premium ball there. that's maybe a subject for another discussion. But early this year, we had seven cuts priced, and then we went to one cut priced. And right now, treasury volatility should continue to contract, you know, because we're kind of in the short strokes. There's just not too much. Maybe we get

something that maybe, you know, I think there's an argument as we get into the elections that maybe the term premium should expand and we'll see a little bit more craziness as we get closer and closer to November. But I think, and I think Josh would agree, that we're kind of both bearish Treasury vol in the near term right now for all the obvious reasons that, you know, we're in a tweaking situation, not any large-scale things. And, you know, the CPI comes a little hot, a little cold, but basically you sort of know where the trends are and, you know, there's just not much more room here. The broader thing, though, is that are we going to go see a big decline in treasury volatility, like we used to know, right? You know, back when we had basically ZERP and, and, you know,

like, if you look at the ECB's policy rates, they were like stuck in concrete at negative levels for six years until finally inflation sort of broke up that concrete. So if you look at things like the amount of negative yielding debt in the world, that's gone from 19 trillion a couple of years ago to like zero today. There is a strategic retreat away from these ultra-davish policies. And I think as that happens, and you're starting to see more geopolitical news develop, you know, in Europe, you know, election-wise, de-globalization. There all that stuff, to my mind, should help support higher term premium and also higher rate volatility across the curve over the broader thing. So, again, I want to link that back to this notion of to remember that you

had great equity markets in 98, 99, and you had a VIX much higher than it is right now. Yeah. I mean, also, like, this summer seems like it's lining up to be quiet because we have the most... Don't say that. The most certain, yeah, except for August, right? The election certainty is, We know what we got. Everyone knows where everyone stands. So there's nothing uncertain there, let's say, you know, unless one of the two people isn't running. But that's another question for another day. So that's there. As I said earlier, I look at implied volatility across asset classes across the globe. One of the things I also look at is credit. So credit is as tight as it's ever been. And there is a huge correlation between credit and vol, especially in times of stress. And so I think that the credit picture, I think, would be the one that would make me the most concern if we start seeing. You know, everyone's talking about, you know, we're going to come to the cliff and the cliff keeps moving of the credit or the real estate market or whatever. We'll see what happens, right? Everyone says it's this fall. We're going to find out.

So I think the summer is going to be what it's going to be. And we'll see what happens in the fall. I'm less worried about a credit event. I'm sure there's going to be isolated at credit events, but I think it's been pretty well signal, you know, the real estate issues. It's just real tight. Yeah, it's been real tight. Yeah, it's been real tight, but there's good reasons for it to be real tight. More buyers.

But look, to me, what I think is. interesting and again the elections are really started to come in a close focus and one of the things that I'm thinking you know like typically get the question as like what do you do with the equity market on the election to me I think the real question is what do you do with the bond market on the election because what I hear from either side either side of the aisle there's no real plans not announced yet anyway about how we're going to whip inflation now right it's obviously been Biden's Achilles heel But a lot of Trump's policies have been at the margin, at least as inflationary, maybe more so. If he puts his fingers on the scale of the Fed, that's where I think the bond market and the bond market volatility discussion gets a lot more interesting.

And that's going back to the original conversation. If the bond market volatility goes up, that's when the dispersion question becomes more. You can almost look at dispersion as a way of thinking about bond vol because those are the correlated one events, right? I like that we've come full circle to the beginning of this conversation. So, I mean, we could talk for like hours and hours and hours about all of this. Tracy and I, we could just listen to you. Yeah. Well, listeners, if you are interested in hearing more from Michael and Josh, they have their own podcast called the Macro and Volatility Podcast.

So you can definitely check that out. Yeah, exactly. Josh and Mike, thank you so much for coming on all thoughts. Really appreciate it. Thank you so much for having us. Yeah, this was great. Thanks so much. Joe, I love that conversation.

Yeah, I did too. You know, I really liked this idea, trades becoming investment. Once was a trade, whether it's short volatility, whether it's the dispersion trade, something that traders put on. And in my mind, I sort of think, you know, like, yeah, it kind of makes sense. It's like if you're long stocks, you're short volatility, why not just do the short volatility component alone and strip away all the stuff and just get what you're at? I can see how these things become investments over time.

Absolutely. The other thing that stuck out at me was just the reflexivity of all these changes in markets. And I think, I hope, maybe this is wishful thinking, I hope there is a greater recognition nowadays that you can get the tail wagging the dog scenario that Josh described. And we have seen various instances of it, Volmageddon being the prime example. And it seems like when we're talking about a sort of opaque market activity like the dispersion trade where we don't really have a good sense of how big it is. We can kind of try to triangulate it through looking at implied volatility and things like that, but we don't have a good sense. It feels to me like that is a very worthy question to ask, like how much would a big unwind actually end up impacting the market? Yeah. So we don't have an equivalent of this trade of XIV. There's not some ETN where you can just lazily go and click three letters into your. Robin Hood or Schwab. There is a CBOE dispersion index. So there is. Yeah. And I think there's a product attached to it, but I can't remember the exact name. But for, oh, by the way, I'm definitely

going to become one of those people that like, so I, you know, check the fix everyone once in a while, check the move, et cetera. I'm going to now add the CBO three month implied correlation index to those things that I tweet from time to time and hopes of sound like, oh, new low in the CBO three month implied correlation index. Get a few retweets on that. Well, the other things. thing I was thinking about was that idea of like the re-rating of the AI sector and what that would actually mean. Because again, I think about correlation. And like correlation in many ways is the trickiest concept in all of finance, but it's also at the heart of all of finance. And so I guess my question is if investors were suddenly to become disillusioned with AI or if there was a mass

recognition that actually the profits that were expected aren't coming through to the sector, what would that knock-on effect be? Like Josh mentioned investment and the idea that in the early 2000s, everyone was investing in these new internet companies and then suddenly that stopped. Is it a similar situation with AI now? What would the mass impact be if AI was re-rated? The investment stopped. And then we get these knock-on effects in the market as well. Tracy, I have a really good idea for us. Okay. There's a bunch of bluegrass songs that have breakdown in the headline. Bluegrass breakdown, foggy mountain. Breakdown, Earl's Breakdown, et cetera. Can we write a song together called Correlation Breakdown? Oh, I would love that. All right. But also, I really want you to write that other song that I gave you. This is a non-finance song, but I had a brilliant country song idea and I've sold the rights to Joe. Well, we're going to share them. But yeah, let's write correlation breakdown sometime. Yeah, let's do it. Okay. Okay. Shall we leave it there? Let's leave it there. This has been another episode of the Oddlots

podcast. I'm Tracy Alloway. You can follow me at Tracy Allaway. And I'm Joe Wisenthall. You could and follow me at the stalwart. Follow our guests. You can ping them on the terminal. Michael Purvis, CEO and founder of Talbacan Capital Advisors, Josh Silva, managing partner at CIO, Paseic Partners. Look for that green light and say hi. And follow our producers, Carmen Rodriguez, at Carmen Armin,

dash o' Bennett at dash bot and kale brooks. Thank you to our producer, Moses, Ondom. For more oddlots content, go to bloomwork.com slash oddlots. We have transcripts, a blog, and a newsletter, and chat about these topics 24-7 in the Discord. Discord.g. slash oddlots. And if you enjoy Oddlots,

if you like it when we dive deep into the dispersion trade slash investment, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account with Apple Podcasts. To do that, just find the Bloomberg channel on Apple Podcasts, and follow the instructions there. Thanks for listening.

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