Chris Cole of Artemis Capital Management is the latest stellar guest to grace The End Game as he takes Bill and Grant on an extraordinary journey through the many ways in which volatility affects risk assets.
From Golems & Tulpas to the Ouroboros, Chris paints a remarkable picture of the twin realms of fantasy and reality and how they intertwine to create the world around us.
From the option market tail wagging the equity market dog to the assured disaster awaiting the pension fund industry, Chris explains volatility’s important role in the present and, importantly, the future.
This is yet another profound, unmissable conversation in the search for The End Game…
Grant Williams:
Before we get going, here’s the bit where I remind you that nothing we discuss during The End Game, should be considered as investment advice. This conversation is for informational and hopefully, entertainment purposes only. So, while we hope you find it both informative and entertaining, please do your own research or speak to a financial advisor before putting a dime of your money into these crazy markets. And now, on with the show.
Grant Williams:
Well, welcome everybody to another edition of The End Game. Joining me, as always, the other half of this little double we’ve got going here, the great and good Bill Fleckenstein. Hi mate.
Bill Fleckenstein:
Hello Grant. How are you today?
Grant Williams:
I am full of the joys of Fall, I guess. Right, so ye- yes, I’m- I am looking forward to this conversation, Bill, I have to say.
Bill Fleckenstein:
I am as well and the only question I have is I wonder if I should get a seatbelt for myself.
Grant Williams:
Well, listen, I’ve been incredibly fortunate to have spent several hours talking to Chris over the years, and every time I’ve walked away, just like a deer in headlights, I mean, his intellect is staggering. His gift for communication is of a similar level, and the asset class that he deals in volatility is something that you and I both recognize when we started designing this series. We didn’t know where it was going to go, but we knew that volatility was going to be an extraordinarily important component.
Bill Fleckenstein:
Yeah, now more than ever, actually.
Grant Williams:
Yeah, exactly right. So look, I guess without further ado, we should introduce Chris Cole of Artemis Capital Management. What do you think?
Bill Fleckenstein:
Let’s do it.
Grant Williams:
Done. Well, Chris Cole, welcome to The End Game. It’s so good that you could take this time to join us. Now, the first thing I have to do is make sure that we are talking to the real Chris Cole and not one of your Twitter imposters, because you seem to have a few of them.
Chris Cole:
Yeah, exactly. Apparently, this has been a problem with Twitter. So I’ve been trying to talk about a tail risk, that you don’t see coming.
Grant Williams:
Yes.
Chris Cole:
These imposters that have been popping up on Twitter and they’re so busy with the election that they’re not policing…
Grant Williams:
Well, if you could … Just to make sure it’s you, if you could just give us your, I don’t know, your date of birth, your mother’s maiden name, and the name of your first pet, that would be … I mean, just for Bill and I obviously, that’d be great.
Chris Cole:
I can guarantee that it’s me. I recently adopted a puppy, so I think, and her name is [crosstalk 00:02:37]
Grant Williams:
Sorry.
Chris Cole:
That should be confirmation enough, I hope.
Grant Williams:
Hey, listen, while we do this, we should tell anyone listening to this, if you see an account on Twitter, which is, I think Vol underscore Chrstopher, without the “i”, could you do Chris a favor and report them to Twitter because it’s a fake account? Hopefully, we can get a few more people reporting it, Chris.
Chris Cole:
Please do. Yeah, that’d be a big help. I appreciate that.
Grant Williams:
So look, Bill and I kind have been kicking around where to start because it’s just such a big topic, volatility, particularly where we are now and, we arm wrestled over this and I’m going to ask the first question. I want to take you back, if you can, to the first time you and I sat down for a Real Vision interview in a, in a haunted hotel in Austin, Texas. And you said something to me, this must be four going on five years ago, that really, really stuck with me. And you said at the time, you said, “You know, the reality is there’s only one asset class now and it’s volatility,” and that was four and a half years ago. And boy, were you right. And boy, is it becoming more right by the day. So can you just, just to kick us off, talk about why you said that and how that, how your opinion of that has kind of morphed and grown over those last four years?
Chris Cole:
Yeah, absolutely. The idea that there’s only one asset class and that is a volatility and there’s only two types of traders or investors out there, long vol and short vol investors. And, what I actually mean by that, is that, if you look at the way assets behave, if you decompose them based on their return stream, they have characteristics that are mean-revertive with big fat tails to the negative assets that make money most of the time, but then lose money very quickly in big drawdowns and tend to follow mean reversion characteristics. And those assets tend to be correlated to the growth cycle. They tend to be long GDP types of assets as well. So it’s interesting there almost all equity linked investments kind of follow this pattern, but short vol could be, the way I look at it, could be something like value investing, a value investor is going out there and looking to buy in-expensive assets.
Chris Cole:
They look to see when the market has over-corrected or has gone too too far, too quickly and cheap to seek, to buy below intrinsic value. That is a mean revertive strategy. Warren Buffet is the smartest short volatility trader out there. So, people who are on short volatility tend to bet on mean reversion, the expectation of stability and in, in a various myriad of different forms, whether that’s an expectation of a mean reversion correlations, mean reversion in asset price direction or, or some sort of expectation of tangible value. Of course, there’s literal shorting of volatility where people are shorting options, but I extend the definition to really any bets on overall stability. Then there’s long volatility, style of investing and really a lot of global macro traders, tail risk investing, systematic CTAs seek to profit off a trend. These are strategies that look to, they don’t make money most of the time, but they make a most of their money in small periods of divergence and turbulence and asset prices.
Chris Cole:
And they tend to be non-correlated to the business cycle or anti-correlated to other long GDP assets. And so these types of return streams, profit when correlations break down, they profit when interest rates explode higher, they profit when there’s a lot of turbulence in markets. So the problem with most investors, is that their portfolio, their portfolio is entirely constructed of these long GDP, short volatility style assets. And I always say, you break down the composition of the average pension, which is mostly 70% equity linked investments, maybe 20% bonds. And, at the end of the day, the majority of that is, is short volatility in nature. Many of these risk premium strategies are short volatility in nature, and they tend to collapse all at the same time. Now, of course, for a long time, bonds were this classic hedge.
Chris Cole:
In many ways people say, what was the best tail edge you could possibly buy was a long duration bonds, when bonds were 20%, well now at the zero bound, bonds as a put option, it has really failed. And you and I talked about that years ago, we talked about that years ago and we’re seeing it play out today. So in today’s environment, most people are just layering on additional correlated bets, either through risk premia, through leverage, through credit or through liquidity, in essence, to meet their retirement return targets. And it’s a disaster in the making because they’re only relying on the short vol component and they’re not balancing long and short volatility in a way that people create the best outcome over long periods of time.
Bill Fleckenstein:
I wanted to, I like to explore that a little more depth and combined with another topic, but first, I think it would be really helpful for folks to be able to get their head around all of this, is that you shared a really remarkable Tweet two days ago, where you showed, you compared the notional value of the option market at 20 trillion with the size, it’s about the same size as the government bond market with the equity market at say 38. The question that I have, and I think something that would be useful to understand if you can do it in like a third grade … well … maybe eighth grade level. Explain how we got to the point that the tail is kind of wagging the dog? You know, where the option market is really moving the equity market around and at least it seems to my eye, you can correct me if that’s an inaccurate observation, but could, could you tell us how we got to here?
Chris Cole:
Yeah. Let’s just take a step back and I’ll relate it, how the options market is playing a role in this. I think, we sit down and we talk about, how do you define capitalism? What is the medium of capitalism? And that’s fiat money. And of course, this gets to this idea, does money even exist? And it doesn’t exist if it’s not tied to gold, it’s purely a thought abstruction. So, it’s only worth something because we collectively believe it is. And, that’s kind of interesting. We are dependent on thought abstractions. So, in this sense, when we look at what thought abstraction, a nation state exists, because we believe in it, money exists, because we believe in it, political parties exist, because we believe in it. Reality becomes these thought abstractions become reality. And that’s in many ways, an esoteric concept, in Jewish mysticism, there’s this idea of a Golem where you make something out of clay and it becomes real. In Daoist mysticism, there’s this idea of a Tulpa.
Chris Cole:
So, I think today, in this world where they have flooded liquidity in to the system, and they’ve sought to create the illusion of value by transmuting the medium, of money. And this has created, I think, a trillion dollar question, which is, “Can the medium by itself create value or does value exist independent of the medium?” So the idea, and there’s two schools of thought here. One is the school of thought that as somone who has a CFA designation. I grew up believing in which is that value is independent of the medium and intrinsic to the asset. That’s Warren Buffet, that’s Seth Klarman. That’s this idea that the bid and ask don’t represent value any more than an agreed pipe, represents a real pipe or painting or pipe represents a pipe. Prices might fluctuate, but those prices are independently of the intrinsic worth. Well, now there’s the second realm of thought, which says “Value is generated from the medium”.
Chris Cole:
And in this sense, liquidity is the sole determinant of value, defined by that constant bit and ask price. And as long as constant liquidity is supplied with a narrative, value is created. And that’s true, whether the Tulpa is corporate debt, whether the Tulpa is the success of Elon Musk, whether the Tulpa is a factor premium in the market, it doesn’t matter as long as liquidity is flowing and there was a belief in wherever that liquidity flows, that alone creates value. And what we saw in March 20[20], this year, this is the solvency crisis. It’s a continuation of the solvency crisis that started in ‘08 and, what we saw correlation breakdowns. We saw basis trades blowing out. We saw all of these major problems, but I think what’s really interesting is that they can’t deal with the solvency issue. So what global policy makers did is they printed $20 trillion to try to create value out of the medium, to fool people, into solving a credit insolvency problem with excess liquidity.
Chris Cole:
And the net result of that is something absolutely kind of fantastic and in incredible as it’s transmuted in all this different forms. Now, how does this tie back to the options market? I think this becomes interesting. The options market has exploded to a degree that has never before seen. And for a long time options were derivative of the stock market. Option prices move based on their underlying, but when options become the dominant form, the dealer hedging of those options can in turn impact the underlying stock market. So, this dealer hedging and the money flowing into options, transforms the stock market into the derivative of the options market. And so for the first time in history this year, we’ve consistently seen the volume of the options market. U.S. options exceed the volume of the underlying stock market.
Chris Cole:
And a large part of that is you have 13 million in Robinhood accounts, you have all the speculative trading, but it really comes down to the fact that you have policymakers, print $10 trillion globally, funneling liquidity injections into this market and options have become a method for people to play speculative bets, in the medium for the manipulation of that medium. Well, how is that tying around into into a reflexivity? The options market we have seen for the first time in history are, excuse me, it’s not the first time in history, but we’ve seen tremendous number of people bidding up call options, instead of put options. That’s not new, people talk about it like it’s new, but it’s not new. That dynamic were call options, more popular than put options, existed for long periods between 1996 and 2000. So we are actually replicating the regime of that regime in the options market.
Chris Cole:
But what is new, is how big the options market has become. The options world was at a teeny world, a relatively small back in the late 90s. And it was an arena where, you had dentists and doctors with all the extra money, betting on these tech stocks through options, but it really was not widespread. Now there’s been a democratization and, we have these flows are much bigger than they’ve ever been before. So it’s not the fact that the speculative fury has been new. The fact it’s the reality that the importance of the underlying derivatives market has become much more pronounced. That is the main shift.
Chris Cole:
Well, dealers are forced to hedge these flows. So when a lot of people are buying put options, and I’m going to make this relatively simple … because we can get into the weeds here … but there are different exposures; Delta, Gamma, Vega, Vanna that when you buy an option or sell an option, and there’s a presumably a dealer or bank on the other end of it, that bank is looking to, or that market maker’s looking to, to manage their, they’re not looking to take a directional position. They’re looking to earn the bid-ask spread. So they hedge those flows. And as a result of it, they’re supposed to hedge their Gamma or their Vanna flows their vanna positions.
Chris Cole:
I want you to imagine that Gamma, dealer Gamma is like a rubber band and most of the time when there’s a lot of put buying out there and when there’s a lot of call selling out there, it results in a dynamic where there’s a relatively tight rubber band that increases the mean reversion of the market. But when there are imbalances on either side, it can create situations where the rubber band snaps and it can snap in either direction. And what we saw in March, was the rubber band snapping to the left side. And one of the things we’re seeing in this environment is the rubber band snapping to the right side. As dealers are forced to hedge these option flows that are more dominant than they’ve ever been before.
Bill Fleckenstein:
So in the chicken and egg department about that, is the structured products are, did they come about because of the options and the search for yield in a world with no yield? Or were they a consequence of the fact the option market blew up on its own? Or is it still intertwined? It’s not worth knowing, which is which?
Chris Cole:
No, it’s interesting, because in 2017, I wrote a paper that was called the Alchemy Risk, and it introduced this concept of the Ouroboros, this idea that of a snake eating its own tail. And, I said that there was $3 trillion of short volatility products in the equity market, that had the potential to reinforcing volatility in a mean reversionary and lower and lower pattern. But that in the event that they broke, could reinforce volatility higher. And those three trillion dollars represented both, three plus trillion dollars represented, a variety of financial engineering products, that sought to use financial engineering and bets on stability in a myriad of different forms in order to create excess yield. So, the most obvious of those were at the time, the VIX ETPs and the very popular short volatility trade in those VIX exchange traded products that, that actually Mike Green and I quite famously got into an argument, at the EQ derivatives conference with the CIO of velocity shares product. And we told him his product was going to blow up. And that got into a pretty heated argument and sure enough, we were correct just one year later, but that was the smallest portion of that short vol trade.
Chris Cole:
The much larger portion of the short vol trade were things like risk parity funds, which bet on the AQR wrote a paper that called out my characterization of risk parity as being a short volatility. Well, in my definition, short volatility means short correlation and risk parity or short correlation. We saw risk parity products blow out in March when both stocks and bonds, people forget this, were declining at the same time for a portion of time in March. So you have risk parody products that we’re using. There were short Gamma in short correlation, there were short trend and they were short correlation between stocks and bonds.
Chris Cole:
You had strategies like leveraged share buybacks by corporations, which were actually literally short volatility through the mechanism that they use to execute that. So all of these strategies created, they all created a feedback loop that led low volatility to be lower and lower and lower, but when it broke, it would cause an expansion of volatility higher. Now we saw that occur. We saw the washout and the breakage of that, or balls of risk occur just as kind of predicted in that paper, this last March. And it was not just the short volatility, risk premium products, but it was everything from risk parity to all these leveraged basis trades. And you know, some people talk about the federal reserve coming in and spending all this money to support the credit markets and to inject liquidity into the system.
Chris Cole:
It was not meant for middle-class America. It was not. This was bailing out many of these multi-billion dollar hedge funds that had leveraged basis trades on, that had leveraged risk parity trades on, and we’re stuck in a liquidity feedback loop. And it had nothing to do, or had very little, I don’t want to say nothing to do, but had very little to do with the corner bakery or the store down the street. This was a violent unwind of that Ouroboros of risk, which many people had, Mike Green and myself had explained that was a major risk and it was a violent unwinding of that massive multi-trillion dollar short volatility trade. And as a result of that, they had to supply liquidity because the gears of the market had completely broken. But what they’ve done, is they sought to inject so much liquidity that the solvency problem, the debt solvency problem, is still alive and well. And there are people, there are practitioners out there, derivative practitioners out there, smart ones who will say that volatility, all it is, is liquidity.
Chris Cole:
That all vol is, is liquidity. When there is a disruption in the medium and there’s not liquidity, that’s the sole determinant of what volatility is. I actually think that’s shortsighted. I think liquidity is a big part of the, the issue. Liquidity is the disruption of medium, but volatility is a combination of liquidity and credit insolvency. So the classic problem of a volatility spike, is a situation where there is a solvency crisis, which leads into a liquidity crisis because of leverage. And so what the federal reserve has done in attempt to grease the gears, they have thrown so much money, to solve the liquidity problem, that they’ve made the solvency problem, the worst it’s ever been in history. And people sit back and they say, that’s it. There’s no more vol. We’re fine. We’re out of the woods. No, the Ouroboros of risk has come unglued, but the solvency issue is more massive than it has ever been. And that’s not hyperbole. Corporate debt to GDP all time highs. The idea that our government debt to GDP, at the highest levels that it’s been outside of war time.
Chris Cole:
And so we’ve never had corporate debt to GDP this high, and we’ve never had, we can go down the list of what’s occurring. You just go down the list of what’s occurring because we’ve, we’ve temporarily pushed everything off, but you look at bankruptcies for companies with over $50 million in liabilities, that’s all time highs, corporate debt to GDP, all-time highs, banks reporting CNI tightening, all time highs. These are things that typically happen before the big vol spike, not after the big vol spike. And this makes me think that … you guys had Lacy Hunt on this show a while back, I had a wonderful time talking to Lacey in our offices when we did Real Vision Reviews together, it was fantastic to bring him in and I got a chance to speak with him for an hour. But he talks about this idea that once you reach this threshold of debt, adding more debt, doesn’t solve the problem and exacerbates it…
Chris Cole:
… So, I don’t think we’re out of the volatility woods yet, but what they have done is that they have injected so much liquidity. It’s created a Frankenstein monster out of the options market that is causing distortions.
that I don’t think we’ve ever seen before in the inter-play of the way the options market and the stock market are working together.
Grant Williams:
Chris, I want to try and very carefully construct a question here because I have so much going around in my head right now, and I’m probably going to make a complete hash of this, but I’m trying to put a lot of the pieces together here. When Bill and I set out in this search for the end game and Mike Green came on and he quite rightly said, “Of course there is no end game because it just keeps going.” And of course, he’s absolutely right. I think what Bill and I were trying to understand is the transition from the now to the then and what that looks like. But when I listen to you and I’ve read everything you’ve written. And as a writer myself, I throw up in my mouth a little bit every time I read anything you write because it’s just so brilliantly constructed.
Grant Williams:
And the frameworks you use to describe these extraordinarily complex problems seem to not always, but very often come down to a metaphor that you use, which is fantastical in nature, whether it is alchemy, for example, which is one of those papers. And I should quickly tell people if they haven’t read your work, they need to go to artemiscm.com. That’s right. I think I’m right in saying that. Just read everything you can of Chris’ because it will… Don’t read it before you go to bed because you won’t sleep trying to understand it, but read it early in the morning. But you use these fantastical allegories and metaphors to describe these problems and listening to you talking about volatility and liquidity and golems and tulpas, we have liquidity and volatility are illusions. They are ephemeral. They can evaporate at any time and they become nothing.
Grant Williams:
And so I’m wondering, as I listen to you, if the end game isn’t a transition from a world where illusion and fantasy rule and have the upper-hand because of the belief that people have in them, to a world where that belief disappears and what we’re left with when this ephemeral smoke disappears is the reality. And the reality is all-time high debt to GDP. It’s the weakest corporate balance sheets we’ve seen in history. All the things that you point out is the reality. And so, as I listen to you and I read you, and I think about all this stuff, it feels to me as though, and I’m trying to get this question right because in my head, it’s just spinning, is an end game of sorts is a transition from a fantastical world that is really belief-driven, belief in liquidity, belief in all this stuff, to something which is more based in reality.
Grant Williams:
And when you talked about fiat, money being capitalism, it’s so true. And I just hadn’t thought of it that way before. And for that to happen, for that transition to have to take place, the only door we can go through that bridges the two is the volatility door because the volatility door is the only thing that will make people realize, okay, that was fantasy. Go through the vol door. This is what reality looks like. And it’s a smoking ruin of a hellscape on the other side of it. I hope I’m making sense here. In my head, I’m making this much sense, but I’d love to get your thoughts on that. And you can say something like you’re a moron. I’m perfectly fine with that because I get that all the time.
Chris Cole:
You’re very far from a moron. Actually, I’ve always thought your questions are some of the most intelligent of anyone who’s ever…
Grant Williams:
Well, thank you because I’m grasping all the time.
Chris Cole:
So I’ve always enjoyed working with you on these, but I think there is an end game in the destruction of the belief. Volatility is a collapse in the belief system and that results in a collapse in the medium. And so what are two routes that can occur? And in my recent paper, I talk about this idea of an eagle that comes down and attacks the Ouroboros and kills the serpent. So the serpent is that cycle of short volatility that is broken up by the serpent and the serpent has two wings. And there’s this left-wing, which is that’s when people stop believing in the ability of companies to service their debt in these bad business models. And that’s what we saw in the ‘90s, where all of a sudden there is a collapse and a classic debt default collapse. The other framework is one where central banks have a debt jubilee. We go ahead and we make the Fed’s balance sheet legal tender, and people lose belief in the medium of money, which has happened many times historically, as you are a scholar of much deeper scholar than I am of that history.
Chris Cole:
So in either of these wings, you have to be in long volatility-style strategies to survive. You have to be by any study of history. Now, the problem is that doesn’t necessarily mean going out and buying put options or just rolling tail. We have to broaden our concept of what volatility is because if you’re talking about the left wing of that secular collapse, which is what occurred during the Great Depression, which is what occurred in 2008, in that scenario, you want your long volatility exposure comes from left tail protection. It comes from cash. It’s hard to get exposure in bonds now with the zero, but in the past you got a lot of ability from bonds, not so much anymore, but you want to be in high quality assets in that sense that can preserve capital or that can pay off non-linearly like tail risk protection on that left tail. The right tail is something much more interesting. Most recently, we saw that in the ‘70s after the Nixon shock where they devalued versus gold and in that scenario, you want to be in the real assets.
Chris Cole:
You want to be in things like gold. You could bet on the right tail of options, but financial assets lose the real purchasing power. So that’s the other form of long vol. Now this is the problem is that people’s belief in the stock market and people’s belief in the bond market reflects massive recency bias. So, in my recent paper, I talk about this idea that the last forty years were remarkable period of financial history, the last four decades. It’s one of the most significant periods of secular stability and asset price growth ever driven by this combination of interest rates dropping from 20% to zero, this large baby boom generation coming on in and spending, huge reduction in taxes over that period of time, huge ability to export our inflation globally, due to globalization. And it’s incredible. I think it’s 94% of the returns of domestic equities over the last 100 years come from those four decades. Yeah. That period between 1984 to 2007. 76% of the profits from bonds.
Chris Cole:
So, this is incredible, and what’s truly scary is that the pension systems out there have bought into this and have now placed their bet on that model of equity-linked products, private equity, and bonds, and are really just leveraged to this tremendous recency bias over the last four decades. But what will get you through the next four decades of secular shift and secular default will be being able to be diversified in left tail and right tail exposures. Now I am not smart enough to know which way it cuts because what’s going to happen is that’s going to be determined by policymakers. And that’s going to be determined by the winds of social change. And I do know one thing, though. If they keep doing what they’re doing, which is just trying to inject liquidity to solve the solvency problem, further exacerbating the income disparity, we run this 10 standard deviation, 20 standard deviation risk of a breakdown in democracy.
Chris Cole:
And I told that to the New York Times back in 2017. I’m not scared of the left tail. I’m not really scared of the right tail. I am scared that they take this experiment and keep going, and they create a tail risk that you cannot hedge, which is complete civil unrest. And we are now beginning to see that. We are now beginning to see that, and that’s your real risk of the political risk. And that’s also how it can end. You can have a war where you can have a social revolution. Those are the other less…
Grant Williams:
…desirable outcomes. Yeah.
Chris Cole:
Less ideal outcomes. Yeah. We talked about this, Grant, in that interview back in 2000, I think it was 2017 at the Driskell, this idea that volatility, you can not destroy volatility, yuo cannopt destory risk. You can only transmute it in form and time. And so what they’ve done is they’ve distributed one standard deviation risks into tail risks. And they’ve brought that out to the world, pretending like they’re destroying risk and they’re doing anything but. They’re just redistributing it in different ways, taking risks that we can’t even fathom right now. And we’re seeing the result of that just as we talked about many years ago.
Grant Williams:
Yeah.
Bill Fleckenstein:
Chris, you said that you didn’t feel strongly that you knew which way it was going to be, but it seems to me that… Or does it seem logical that you could make an educated guess in that given that the central bankers feel themselves to be almost omnipotent and there doesn’t seem to be anyone who sees the dark side of these money-printing strategies? One of the worst one being the one you just talked about, income disparity and wealth disparity, but they’ve tipped. It seems to me, they’ve tipped their hand. And about the only way that you can get the left tail risk collapse would be after they’ve tried to kick the can down the road again, like after the election, next if the Fed’ll bring more juice, the Congress will bring more juice. It seems almost impossible they would not.
Bill Fleckenstein:
And if the market has a temper tantrum between here and there, it seems quite likely that they will. So it seems to me that I know we can’t know, especially when we’re talking about all of this crazy and wild nitroglycerin, but I think we can assume that they’re going to push the hand in that direction until such time as something starts to break. Does that seem like a reasonable game plan or is it just too deterministic in a world you can’t be that sure about?
Chris Cole:
Yeah. That does tie into my thinking. There’s been a lot of talk about right tail risk recently. And I’m actually of the belief system that given that we have obviously the market is now majority passive. You guys have done a lot of great work with Mike and I actually helped to test Mike’s theory back in the day on passive, actually built my own simulation that verified the idea that as the market’s mostly passive and becomes dominated by passive investing, that it becomes more volatile and there’s less alpha for active investors. In that sense, we’ve already tipped the scale in that direction. And someone can listen to your interview with Mike on that, and he can better articulate it than I can. But in this framework, at the end of the day, you’re going to have massive flows coming out of markets from these baby boomers, huge flows that are mandatory. Mandatory redemptions, the 401ks and IRAs. On top of that, we have this major corporate solvency problem where the idea that we have some of the highest corporate debt in all-time. And we have put off a lot of the problems with the consumer.
Chris Cole:
So let me give an example on this. The CDC has the moratorium on evictions that runs through the end of this year. You have the moratorium on student loans, which runs through the end of this year. The FHA loans. Most people don’t know this. Danielle DiMartino Booth has done amazing work on this. The FHA loan delinquency rates are higher than they were in ‘09, but they’re not allowed to offer close on these individuals, but that runs out in March. So, at some point the Piper has to be paid. And for that reason, I believe we have one more big sucker punch on the left tail. One more big deflationary sucker punch coming. And that’s evident in what we saw in the Great Depression as well, where there were these huge rallies after stimulus. But I think at that point, the social unrest will be so much that we just open up the flood gates and we just do full money-printing, and we will see right tail risk at a level that we maybe have never seen in America that Europe, people’s great-grandfathers know about in Europe.
Chris Cole:
In those scenarios, let me give some numbers on this about how do you construct this. Well, I think you need that left tail exposure in that next deflationary sucker punch, but when the Fed opens up and when they go ahead and they make legal tender and they just print, gold vol is at 20%. Gold vol in the 70s reached 80%. That’s the volatility, not only the price direction. So if you’re owning physical gold, you’re betting on the non-linearity of right tail options on gold. And the vol goes from 20 to 80 in volatility, and gold goes up 800% as it did in the ‘70s in that scenario is what happens during the Fiat devaluation. You are making money in triple convexity. You’re making it on the underlying movement, which is linear, but you’re making it on the gamma of that movement. You’re making it on the expansion of the volatility and you’re making it on the expansion of higher interest rates. And we can talk about how interest rate volatility is at all-time lows. That’s the other amazing thing.
Chris Cole:
So in the event that they let the flood gates go, rate vol should pick up dramatically. So I do think we’re going to get one more big sucker punch before they will be forced. If I had to make an educated guess, I can’t predict. I don’t claim to have this ability to predict, but if I had to make an educated guess, I would say that deflation is going to have one more big sucker punch to the left side before they are politically forced to completely deflate, to completely destroy the medium of Fiat in order to have a debt jubilee. And I think that presents tremendous opportunity if you’re playing volatility. And if you’re holding a balanced portfolio in long vol and short vol assets, I think it’s going to decimate the traditional pension and the way the traditional pension fund is situated and it’s going to decimate, unfortunately, the way the traditional retiree has their portfolio structured.
Grant Williams:
Chris, you chose a word there, which is rattling around my head since you said it, and that’s the word experiment. We’re talking about this experiment that’s been going on and for the longest time, that’s exactly what it felt like was an experiment. Does this work? How can we push this? Now we’re seeing MMT being put forward because again, it confirms what’s happened. And it’s descriptive, as someone was writing about this week, rather than prescriptive. But it feels as though it’s no longer an experiment. It is now moved from an experiment to a necessity. We have to keep doing this. We’re not tinkering here. We’re not coming up with new ideas about how to maybe keep this thing together, how we can get out of this. We are now doing what we absolutely have to do and we’re being forced to do by the underlying conditions.
Grant Williams:
And like you, I think you’re absolutely right. I believe exactly the same. There is one more big deflationary sucker punch coming, but I wonder, when thinking on a longer timeframe, we’re trying to think about the end game, which I don’t think that sucker punch is the end game. That is one more step on the road to the end game. I feel like the end game is that right tail that you’re talking about, ultimately, because that’s when everything will change. That’s when everything, 40 years of deflationary pressure will change and we’ll get a complete paradigm shift. And I wonder, that left tail event, that sucker punch, which is such a great way to describe it, I feel like there’s a chance it could be very dramatic, but also incredibly short because when it happens, we are all going to recognize it for what it is.
Grant Williams:
And I think you’re right at that point, they will throw absolutely everything and that they will go full craziness and create legal tender from the Fed’s balance sheet as you said, which was Lacy’s one deal breaker for him. He said, “If they do that, I will jump off the deflation train after four decades and hop adamantly onto the inflation train.” Do you see it similarly that it’s a very short, very sharp shock, almost one that unless you’re positioned for it and you capitalize on it instantly, you’re almost better off looking through it and trying to position yourself with gut-check in place that you’re going to have to go through this, but what waits on the other side of it is a trend that you can ride for a long time and for a long way?
Chris Cole:
Yeah. I think if they do signal that, that’s going to be a long, long train. The one thing that the people, I always talk about this aspect about volatility during Weimar, Germany, and I’m not necessarily saying that we’re going to get Weimar, Germany, but in 1919, volatility was around 20% in Germany. And by 1923, nominal volatility in their stock market would have topped out at over 2,000%. So in that sense, and what occurred during that period, if you read, as both of you are students of the history, every time you would come out and the loan would be at 5% and people are like, “Oh my goodness, rates have jumped so high.” And then it’d be at 10% and people are like, “Oh, my rates have jumped so high.” And then it’d be at 20% and then it’d be at 40%. So I think there are these trends tend to go on for much longer than people imagine.
Chris Cole:
And I think we began to see the signs of that, where we began to see a lot of the signs of the breakdown of many of these relationships that have persisted for many, many years. One was the stock bond correlation breakdown. I think the one thing that hasn’t gotten enough press, it has not gotten enough press is the fact that stocks and bonds were selling off in tandem in March and that was causing massive pain in risk parity. It was also causing massive pain in these pension systems. And that’s when the Fed stepped in with a lot of liquidity. Another thing that doesn’t get a lot of attention, I pay attention to it because I trade a lot of gamma, which is trend. When you own an option, you own volatility, which is vega, but you own gamma, which is trend. And when we talk about how the flows in the option market are distorting the underlying stock market, it’s because dealers are hedging that second derivative.
Chris Cole:
We get back to the basis on this, but we reached in March, all-time lows in negative auto-correlation, but let me put that a different way. All-time highs in mean-reversion. That’s probably the simpler way of putting that. Mean-reversion in the stock market reached all-time highs ever in March, ever after the Fed injected money. And this is after mean-reversion was already at historic highs for the last decade. And so what does that mean? It means that a buy the dip strategy…
Bill Fleckenstein:
Yes, what does it mean?
Chris Cole:
Yeah. It means that a buy the dip strategy in the stock market, a buy the dip strategy in the stock market, which is by nature, a short volatility strategy, one of the ways that you replicate a variance swap, which is a vol bet, if you’re short it, is by buying dips. So this idea that if today was a huge down day in the stock market, so what you do is just say okay, I’m going to buy. I’m going to buy after the down day and I’m going to sell after the up day. So the profitability of that strategy is based on this idea of mean-reversion, or we might call that negative auto-correlation or negative serial correlation. So each day’s return is negatively correlated to the next day. That reached, that negative auto-correlation, or another way of putting that, mean-reversion, mean-reversion was the highest level ever, ever in over 100 years of stock market data, ever.
Chris Cole:
And the reason why mean-reversion as measured by that auto-correlation when we reached the highest level in March, is because of this liquidity Fed interest rate reaction function. One of the things that we see in markets where the medium of fiat breaks down is that a negative auto-correlation becomes positive correlation to daily returns. So that means equity markets start trending. That means if today was a down day, tomorrow’s going to be a down day. The next day is going to be a down day or if today was an up day, tomorrow is going to be an up day. The next day is going to be an up day. That’s what we see. Guess when mean-reversion was at its lowest or another way of putting that is trend was at its highest.
Bill Fleckenstein:
The end of August.
Chris Cole:
Trend made a huge rebound, but actually if we go further back across history, was actually in the ‘70s after Nixon devalued versus gold.
Bill Fleckenstein:
Interesting.
Chris Cole:
That was the secular high in trend. We reached the secular peak right when interest rates peaked.
Grant Williams:
Yeah.
Chris Cole:
Right. And that’s when all of the turtle traders and the trend followers were at their power. And since that secular peak that coincided with the rise in interest rates and peaks in gold, we have been on a secular down draft in trend or a decline in auto-correlations reaching the worst performance of trend and the best performance for mean-reversion ever. So if you go back and look across history, typically what you see is when a period of secular growth reaches its nadir, that’s when mean-reversion is the most profitable. And that’s what occurred during the last Great Depression. Rates go to zero. The central banks have no more money. You have to devalue. And during the devaluation process and the inflation process, that’s when you see trend come back in.
Chris Cole:
So in many ways, the way of looking at this, this is a mathematical way of saying this is the transition between a short volatility and a long volatility environment. And all of a sudden when a trending equity market becomes back in vogue, which generally occurs when there’s interest rate volatility, when there’s uncertainty regarding inflation or just when companies are allowed to fail, when they’re actually allowed to go bankrupt and capitalism is allowed to… When there’s actual creative destruction is when things trend.
Chris Cole:
The actual creative destruction is when things trend. And I think in one way when you see that come back violently, that’s one of the mathematical ways you can actually measure when this occurs. Of course, we will know it through the policy action. And that’s… Now keep in mind that trend can occur in either direction too. So, but…
Grant Williams:
I think if you step back and simplify this, it makes sense that when interest rates have taken a 40-year journey to the zero bound, I think what’s confused, a lot of people is when we hit zero, it didn’t just turn around, and said we can’t go any further, so we need to go in the other direction, but we’ve been bumbling around here for the last several years with this. But to me intuitively it makes sense that once you reach that level, yes, there’s going to be this period of bottoming and a period of volatility where the market’s trying to continue that trend but can’t do it because we come back to that fantasy versus reality struggle. Negative real interest rates let’s face it are a fantasy, they can’t exist in the real world for any period of time. So when he talks about this, it makes sense to me that ultimately the way this breaks out has to be back in that other direction to positive rates, to higher rates, to reality of a fantasy. It just makes so much sense to me that that’s the period, the process we seem to be going through right now.
Chris Cole:
Literally, it will impact the fundamental way that asset prices behave and move in a very fundamental way in this very simplistic idea of trend versus mean reversion, we take for granted this mean reversion in markets, but we don’t recognize that mean reversion as being a function of the interplay between interest rates and risk assets and the Fed reaction function. And that mean reversion that we’ve become so used to and we take for granted. I was just on a panel the other day, and people were talking about oh, you always have to take your profits. You always have to take your profits on a bull position because, well, if you look over a hundred years, like a long bull position carried positively for the greater part, I actually modeled this in one of my papers, you could show that a long volatility position mainly through the trend component, carry positive and by long volatility, I mean that could either be an option on the right or left tail carried positively for most of 70 years. It’s been the last 40 years that have been the anomaly, particularly the last 10. But we suffer from this recency bias.
Chris Cole:
So the very nature of how financial markets work and what we think about price movement will change if that theory is correct. And that actually causes massive problems for a lot of pension systems and quantitative managers that have really only looked at maybe 10 or 20 years of history to base their leveraged strategies on which is exactly why the Fed needs to inject so much liquidity. It goes back to the idea that the Fed gave a select group of massively leveraged hedge funds that I can’t name but I think people can figure out, a defacto bail out in March be a QE Infinity in this repo liquidity and this is all the time while the middle class is waiting for… Middle class businesses are waiting for a lifeline. So too big to fail has moved from banks and it’s been privatized, so.
Bill Fleckenstein:
Does the passive component, or… Sorry, the size of the passive component, doesn’t that further suppress the mean reversion tendencies?
Chris Cole:
No, actually that it amplifies. So the the passive component, and this is part of the work that Mike Green has done. Two years ago, I wrote about this. Mike came to me and he said, “Look, I’m basing the simulation, can you test it for me?” And I have two hypotheses. One hypothesis is that the more the market is passive, the more it should be a volatility amplifier. And I said, “Oh, okay, that makes perfect sense to me intuitively,” I’m like, “Definitely I get it.” And he said, my second thesis in Mike Green’s theory is that… The second thesis was that the greater the market is passive, the more it crowds out active investors. So Mike said, can you… I said, “I didn’t buy that second part.” I actually pushed back on him I’m like, “That doesn’t make intuitive sense to me. Why would it crowd out the ability to generate alpha for active managers?” Well, I built a simulation and came up with nearly the exact same numbers that Mike did, that showed both of these elements to be true.
Chris Cole:
And the way I looked at it, it’s almost like a drunk guy in a bar, right? And so imagine you have a…. he’s a wrestler, he’s huge. He’s a giant guy. And he gets really drunk at a bar and he wanders out to find his way home, of course he’s hammered and the result of that, there’s going to be a lot more volatility in whatever way he walks, right. That’s clear. Now imagine you’re an active manager who gets paid to guide him home, right? So it’s like, “Okay, hey, I’m going to give you some money and can you help my friend who’s really drunk, just make sure he doesn’t wander off on the freeway somewhere.” But the problem is that the drunk guy is keeps growing and it becomes this Shaquille O’Neal 10 foot tall giant and the active guy is this teeny five foot guy with no muscle. So that’s what happens when the balance comes out, because the role of active investors is to act as a volatility buffer. They buy when things get too high and they sell when things get too low.
Chris Cole:
Well, if the active investors have these puny little guys that are trying their best to drag or guide their drunk passive investors home to value, but they can’t, they’re just dragging along on his foot. They’re not going to get paid because they’re too small to influence. So the predominance of passive becomes this massive volatility amplifier. Now throw on leverage and the options market and tons of new entrants into the market via democratized platforms like Robinhood and lots of uninformed investors. But here’s the kicker, options, the delta hedging of options, I won’t get into the mechanics of it, but actually become more volatile to hedge the options market the lower interest rates go. If you push interest rates into negative territory, an option can actually have a higher delta exposure to the underlying than one. It’s incredible. So maybe not for short dated options, but definitely for longer dated options. This is a phenomenon. So they’re just layered on anomaly after anomaly and my God, here we are. Here we are in this brave new world.
Grant Williams:
You can say when, when you, when you talk about this stuff, and I’m thinking about what Mike was talking about here. And when you get to this point where, the mean reversion feed into the passive, but when it starts to go the other way, the passive to your point has just become so big. But by its very definition because it’s passive, once you’ve gone past that turning point, once you’re on the other side of that and the trend is now the other way to your point when you said, “Today’s a down day, so tomorrow is going to be, tomorrow is going to be down day.” Then we get into that tail of it, that Mike was talking about where markets can go to zero because we’ve crossed through that paradigm and were on the other side and to your points, Shaquille O’Neal is now drunk and he’s dragging Spud Webb around, but he doesn’t want to go home. That’s the problem, he doesn’t want to go home, he wants to go across the freeway and there’s no way to stop him.
Chris Cole:
Absolutely. At that component, theoretically, if you move into a market that’s dominated by passive players and there’s not enough active players to buffer, you remove either the bid or the ask.
Grant Williams:
Yeah, exactly right.
Chris Cole:
It can go, it can go in either direction, it can go in either direction. So this is what I talk about. I think flows over fundamentals. Fundamentals are dead. The only thing that matters are flows. That’s the Frankenstein monster that they created. So passive investing becomes a liquidity momentum flow, and all that matters is who’s putting money in and who’s taking it out. And then the options market, which is now bigger than ever before now amplifies the second and third order effects of those flows through dealer gamma hedging in dealer vanna hedging and the only person who is able to backstop that is the federal reserve, but they have to keep spending an exponential amount of money to do so. This is the lie.
Chris Cole:
They talk about how the Fed balance sheet expansion was important in March, it began way before March. It started a year ago in the fourth quarter of last year when there were cracks in the credit market, there were cracks in the euro bank lending market and they began expanding their balance sheet at the highest rate, actually even greater than early 2009. And COVID was just an amplifier. So COVID has been a convenient excuse. We had to take extraordinary action because of this… COVID was an amplifier to a solvency and liquidity crisis that was already coming. But in this flows over fundamental world, the problem is that it requires an increasing amount of flooding of the medium. The medium of money and the framework of liquidity for them to an increasing amount of… It’s extraordinary, the idea of lending money to the treasury department, the treasury to set up an SPV to buy corporate debt. This is incredible and it’s absolutely incredible. And so there’s an exponential amount that needs to occur. And we’re not at that point because the trust in the medium is still there. The trust is still there. People still firmly believe in the medium, but we will be at some breaking point. I don’t know what tail that goes in, but I think it could be both as we discussed about earlier.
Bill Fleckenstein:
I ask you this Chris, to take current events and knowing that we have the election and the Fed and the Congress coming in the not too distant future and that’ll have some impact on what happens next. I remember vividly we were at the Grant’s Conference or maybe I think he made the presentation ‘09, everyone was terrified of the fall of ‘09 after what had happened in ‘08. And you made the point that was that really nothing bad could happen because there had been so much insurance taken out that… I don’t want to put words in your mouth, but the way I remember it is it would have basically taken an act of God to get the market to actually go down because of what had already occurred. Given that we had this event in March and given that I’ve read that the skew is pretty big through November because people are worried about… and premiums are worried about the dragged out election, are we anywhere close to that sort of thing whereby there’s been so much insurance taken out that they really can’t crack big? Or is it orders of magnitude different?
Chris Cole:
Yeah, this is a great question. So to recap, the Grant’s Conference I presented at the Jim Grant conference was 2012. And that was based on my 2012 paper that talked about the idea that we were in a bull market in fear and that everyone was hedging the wrong tail and the fact that there was so much fear in the left tail and that was when tail risks and then just recapping, I think you got it exactly right.
Bill Fleckenstein:
But I was off by three years.
Grant Williams:
What a three years it was.
Chris Cole:
Yeah. But at that point in time, a lot of times when you’re buying volatility, you’re not buying bull, you’re buying what the market’s expectation of vol is insurance premium. And at the left tail event, that tail risk hedging that left tail event was priced like a standard risk. And that left tail exposure was no longer really affordable the way it was precrisis. Elements of that today the Ouroboros of risks that I talked about before that short volatility has unwound. And there’s a much better bid in the left tail than there was pre-crisis. That being said, I don’t think we’re anywhere near the levels that we were in 2012. In fact, what we’ve actually seen is because of these massive liquidity injections, we’ve been seeing a tremendous amount of right tail buying. And what that has done is it’s created… Without jumping into the technical framework on it, we’ve seen a lot of… Very similar to a repeat of the 1990s, where we’ve seen a lot of stocks skewed to the right side, meaning that people are buying call options in Amazon and call options in Tesla at a much greater degree. 90th percentile level of right tail skew buying in those names.
Chris Cole:
We’ve seen a situation where the indices there’s been much more call buying compared to put buying. There’s been elevated equity returns with elevated volatility. And we’ve also seen this phenomena of spot up and vol up, so this is what we experienced in September and October where when there is a lot of right tail call buying, the way the dealers have to hedge that exposure, it creates a framework where stocks and volatility will rise in tandem. And this is based on the way the dealers are forced to hedge what are known as the gamma or the second order exposure or the vanna. I talk about that being like the rubber band, when the rubber band snaps. So what occurred is that temporarily in September and October, the correlation between the vix and the S&P broke down because of the way that the dealers were forced to hedge all of these call options that they were buying.
Chris Cole:
And that becomes very interesting. Now we saw that in the 90s, but the main difference, it’s nothing new, it’s something that we experienced in the 1990s, but what makes it fascinating today is that the options market is much bigger today than it was in the late 90s and much more prevalent. So the way the dealers are forced to hedge that exposure has resulted in a perversion in some of the traditional relationships between volatility and the stock market that we see as evidence. We were down near the 10th decile in terms of S&P VIX correlation based on that. Is that a long term phenomenon? It’s hard to tell. It’s hard to tell right now. And as the market has begun to show weakness during the last roll off of options, we’ve begun to see a more traditional allocation. There’s been a tremendous amount of hedging around the election. That’s something we definitely saw.
Chris Cole:
I talked on Twitter, how that was one of the most richly-priced known unknowns in the history I’ve ever seen. Truly that that known unknown was seen by the market, was priced by the market. I believe that you sell known unknowns that you buy unknown unknowns. So even though the election was very richly priced for timing go longer out on the volatility term structure and find better bargains. So I think to go back to the original question without getting too technical, I would not say we’re in a bull market for fear yet, if anything, we’re in a different type of… We entered briefly into a different type of 1990s frenzy, where there was a focus on leveraged bets. Now that regime is being challenged and now volatility is not dramatically under priced, has come back to a level that’s more fairly valued than it was pre-crisis. But that left tail is I would not say dramatically overvalued the way it was in 2012.
Grant Williams:
Chris, I get the feeling that the options market and perhaps all markets are somehow simultaneously becoming more and less sophisticated. What do you think about that as a premise?
Chris Cole:
Yeah, it’s fascinating, right?
Grant Williams:
When I look at how these markets have evolved, they are constantly becoming smarter. They’re becoming more sophisticated. They’re having a lot more computing power thrown at them, a lot more brain power thrown at them, but we seem to be at a moment in time where, to your earlier point, the money that’s coming in is dumber and deliberately so in many cases, particularly with the passive vehicles, but accidentally so with the latest injection, the Robinhood crowd, the day trading crowd that we’ve seen. And so I’m seeing this battle that you would think ultimately, you’d always place your bets on sophistication, winning that battle and overwhelming it. But given the place we are in history, what seems to be perhaps the way everything is structured at the moment, potentially the most damaging event of all is for unsophistication to gain the upper hand, because if unsophistication does gain the upper hand, that the way things are set up and with the high degree of fragility we have, it could almost accidentally tip things over and create this outcome we’re talking about, despite the brainpower and the firepower amassed against it.
Chris Cole:
It’s this fascinating, is the dumb money, actually the smart money? Because it’s the money that just tips the equation into the… Yeah.
Grant Williams:
That comes back to the Ouroboros idea, right?
Chris Cole:
In that sense, because the dumb money because it’s so impulsive and comes in with so much philosophy that it actually becomes correct and becomes the smart money. And it goes back to this Jim Rogers concept at the end of the day, he said, “At the end of a massive bull market, at the end of one regime, I want the old school guy who’s been through ups and downs. When there’s been this regime change, or at the beginning of a new bull market, I want the young 22 year old who’s fearless.” But I think it comes down to this idea that it’s like smart money has problems with regime change.
Grant Williams:
Yeah, absolutely.
Chris Cole:
To give another quote on it. It’s like Jim Grant talks about this idea that that Wall Street will find a good idea and then turn it into a bad idea.
Chris Cole:
So I was on a panel with two really good colleagues yesterday at the EQ Derivatives conference. It was a virtual panel. But there was this great question from the audience where someone comes in and say, “Well, if everyone tail hedges and you systematize the execution of the tail hedges and the taking of the money, does it result in a framework where you never have a tail realized? Or does it change the underlying market and absolutely what would in that philosophical experiment. So in this sense, if smart money you take all these PhDs, you take all these machine learning technologies and you optimize to the last 10 or 20 years, you become susceptible to the regime change that occurs. You become fragile to that regime change. And then when the regime change actually happens, it’s the kid who walks in with no idea what’s going on, who’s like, oh, let’s just do this because… and then if enough of those people do that, it tips the market in that direction, particularly when it’s dominated by passive actors. Yeah. So I love the question. The dumb money becomes smart money at the point of the regime change. Yeah. And you don’t know who’s dumb or who’s smart…
Bill Fleckenstein:
Well, haven’t we seen that? Aren’t we in that moment now to some degree given what’s just occurred?
Chris Cole:
Yeah. It’s almost funny because you have sophisticated hedge funds spending millions of dollars.
Bill Fleckenstein:
Trying to front-run Robinhood.
Chris Cole:
Trying to front run Robinhood. Yeah. And trying to front run Wall StreetBets. Yeah. That is literally what we’re… I can’t think of a better real life example of that exact topic but certainly and it goes back to the whole Tulpa concept. At these moments where you have all of these actors that are passive and then you have central banks that have incentivize flows over fundamentals, and then you have leveraged being applied that and that re-hedging of the options market reinforces all these trends, whatever narrative, whatever Tulpa someone imagines, and they’re able to convince everyone else of that, becomes the Tulpa or the Golem that becomes a real creation. And it’s enough to truly tip the market in that way. And that’s exciting. And it’s also terrifying.
Grant Williams:
Yeah. No, it truly is. Yeah. Well, there’s one more thing I’d love to ask you about. Change the subject a little bit and that is pension funds that… they’ve come up a number of times in this conversation. And I think anyone that’s looked at them has looked at the level of underfunding in that world knows that they pose a particular problem to this fragile system we’ve talked about. I’m assuming that you’ve had conversations with many pension funds about volatility, about what’s happening. What’s the sense that you get as to their understanding of this problem. Because if their understanding is not what it needs to be, again, that that adds a massive layer of problematic volatility onto the top of all these other stuff we’ve been talking about.
Chris Cole:
It is one of the biggest systemic problems in our industry today. And I would climb the top of the mountain and scream it because now I think there are very smart people in these pension systems, but they’re heavily bureaucratic. And many times they have a board of trustees, they have to abide by, they have to report to… in many cases, those are well-meaning people who aren’t financially educated. It is a disaster that is about to happen. They are the average pension system is 71% tied in equity and equity link products. That amount has risen and they have about 20% in fixed income. The game plan is that they want to use that fixed income to hedge those equity exposures, and they believe that’s the solution to meeting their 7.25% return target is by layering on more private equity and leverage.
Bill Fleckenstein:
Yeah. Yeah.
Chris Cole:
So, in essence, they have a massively short long GDP portfolio that is not hedged by any right or left tail convexity. And so, I did in my paper, the Allegory of the Hawk and Serpent, I looked back over a hundred years. We looked at the returns of the average Pension system based on data from global financial data over a hundred plus years. It’s incredible. Still, right now, based on the seven, based on the rosy assumptions, 80% of about 74% of state Pension systems are under the critical 80% funding threshold and about one in 10 systems are under the 50% threshold. But if you go back and you look at the numbers that they actually will get, they think they can get 7-8%.
Bill Fleckenstein:
Yeah.
Chris Cole:
They’re going to actually get as closer to 4 or 5% and keep in mind, these are pre COVID numbers. So based on that, what I found is that the majority of Pension systems are already effectively insolvent, effectively insolvent right now and that one third of Pension systems have under 30% funding ratios and this is if you adjust their returns by what is a more realistic assumption based on a hundred years of history. Worse yet, what we’re seeing at these systems have no protection against either the right tail fiat Devaluation scenario that we’ve discussed or the left tail default scenario. They don’t have long volatility exposure. They don’t have gold exposure. They don’t have convexity exposure. They’ve got none of this because they don’t want it because it hasn’t performed in the last 10 years. So, if you go ahead then and you adjust these numbers.
Chris Cole:
If you adjust these numbers are, right now, we see that the average pension liability is about $1.4 trillion. But if you expand the numbers to something much more realistic, the actual liability is about $3 trillion for US State Pension systems and that’s otherwise the cost of four bank bailouts during the great financial crisis where the entire tax revenues of the US Government, actually, there are scenarios. These were numbers. These numbers were pre-COVID. So there are scenarios where you could see up to $10 trillion of unfunded liabilities.
Grant Williams:
Yeah.
Bill Fleckenstein:
Jesus.
Chris Cole:
There is no way out of this. These systems, they’re going to default either default in the sense of not being able to meet their obligations or they’re going to default in the sense that they’re going to have to inflate away the real value of those assets.
Chris Cole:
And I think that eventually a scenario where the state’s issue pension obligation bonds that are bought by the Fed to close this funding gap is inevitable. This is the only way out that I see that the Fed will print. Like not only it will the Fed will print money. There’ll be some conduit the way there is with the corporate debt market right now.
Chris Cole:
You will see that with the pension Systems. The pension Systems will issue a debt that will stop get their funding liability and that the treasury will buy that debt with loans from the Fed or the Fed will just print money and flat out. Of course, this is an inevitability. This is the great tragedy that is coming down. It is not a tragedy that, they could prevent this, because I talk about this idea that if you had a portfolio that can sustain for a hundred years, 20% gold, 20% equity, 20% volatility exposure, 20% trending commodity exposure in 20% fixed income, that portfolio applied in a risk adjusted way can meet the return targets and consistently performs through all market cycles.
Chris Cole:
The portfolio of these pension systems have today will collapse if there’s a secular decline and I think it’s a great tragedy and it’s coming
Bill Fleckenstein:
Well. There’s no real way out. As you noted when past the point of no return and the mindset is to monetize, whatever needs to be monetized, you can see it’s all set up. So the question becomes, it’s pretty easy to see us getting to that point of them doing exactly what you said. The question I have is at some point, either the bond market gives in or the currency gives in because it’s the end of the bond market gives in and then the fed got a plug that dyke, trying to keep rates from backing up. You’re talking about monetization. I know you already know this, I’m just sort of summarizing for others who may not see where on a massive scale that makes what we’ve seen so far kind of looked like a rounding error.
Chris Cole:
It’s a social problem too, because.
Bill Fleckenstein:
Exactly, yes.
Chris Cole:
You’ve got a barbell, right? Because you’ve got in effect, you’ve got the largest segment of the population are the Baby Boomers and the other actually the largest now it’s kind of millennials and Gen Z and then you have Baby Boomers and these are your two big segments of the population and I think this is contributing to political polarization. So on one framework, a portion of the population is going to want to defend those asset prices at all costs in order to maintain their quality of life and retirement and the other portion of the population, which is coming in with inflated home prices, no job prospects, massive student debt loads are going to say, screw it, let’s inflate away and this is going to create a generational crisis and a political crisis in the country.
Chris Cole:
And I think some of the political polarization that we’ve seen, there’s a lot of elements going on there, but I think there is an economic argument that comes down to a generational crisis that we have not even begun to see how that one segment of the population benefits from this QE liquidity policies. The other segment is really getting hurt and this is spilling over into a social crisis and that’s why it’s beyond even an ability to know and what happens in markets. You have to look at it from a social angle as well.
Grant Williams:
Yeah, it’s so true and I think the thing that’s kept everybody pacified to a degree has been the lack of understanding of that transmission mechanism. Certainly through the first iterations of QE people didn’t really understand what was happening. The people that benefited didn’t care because they were getting wealthier and the people that weren’t getting wealthier didn’t understand what was happening and kept being told that this is the right thing to do and it’s saving the country and it’s saving the economy and it’s saving everybody and I was just to either uninformed or nice and passive to actually do anything about it.
Grant Williams:
But that, it’s clear that that understanding level is increasing now because people are just not feeling like they are being told they should feel and so they’re starting to try and understand why and unfortunately, I think the federal reserve for governments, the number of dots you have to join once you decide to try and figure this out is way too short, it’s like two or three dots and once you join those three, the whole picture emerges and that potentially leads to the just.
Bill Fleckenstein:
But, on the other hand, I would just, because it’s just on the same topic, it sort of seems surprising to me that, well, if you really spend time looking at it, it’s rather obvious that the sort of the roots of the bifurcation of wealth and income disparity has been fed policies, particularly in the last 20 years. And yet, the people that rail the hardest against that, guys like Paul Krugman to pick an example who ought to be able to see the thing that he champions a more of those of what’s going on is exactly what’s created the problem that he hates the most and I don’t say that to try to be nasty at some in order to address the problem, the elephant in the room of a lot of these things that have allowed these trends to get to where they are, has been Federal Reserve policies, bad ones and a continuation of the same thing. So to get some recognition of this, don’t we have to have some level of people understand that they’re actually the problem, not the solution.
Chris Cole:
Yeah, I think you bring up a great point. I think if you go up to the average person and I think people can articulate they’re angry.
Grant Williams:
Yep.
Bill Fleckenstein:
Yes.
Chris Cole:
They have a sense that things are not right. They understand that their lives are harder and they understand that the income disparity’s at the greatest level in American history, that’s a fact, yet they can’t tie it exactly why, which I think is why conspiracy theories become so are so prevalent in today’s world.
Grant Williams:
Yeah.
Chris Cole:
Right? I think conspiracy theories are just base theorem gone crazy. You just overinflate a prior and then whatever confirmation comes in, you take an overinflated prior and then add to that massively. But in effect, because it’s very difficult to explain the complexity, it’s hard for professionals to sit back and understand the workings of the Euro dollar market, the workings of how the options market affects underlying stock prices, how past investing does, it’s incredibly difficult for professionals.
Chris Cole:
It requires a multi-disciplinary, people look at me on as a hedge fund manager, I’ve one expertise, right and in the world of asset management, there’s multiple expertise. You need multiple expertise to understand the total picture and it’s almost impossible for somebody to be able to do that when they’re working as a fireman or working as a teacher, much less, if they’re a trustee for a pension system, overseeing an asset allocation. And so, but there’s a sense that something is wrong and that the world is not right and that the economics are unfair and that there’s something deeply perverted and so you just, it makes conspiracy so much easier to accept as a way of a way of having some feeling of control over this economic randomness and chaos.
Grant Williams:
Chris, when we started talking, it was daylight, it’s dark now, we’ve taken a lot more of your time than I thought we would. So I apologize for that, hopefully we can continue this conversation because I’ve got notes coming everywhere. My brain is spinning once again, as it always does. When I talk to you, curse you Chris Cole, but I think this conversation perfectly illustrates why both Bill and I was so keen to have you come and be a part of this series because the perspective you bring is just, it’s extraordinary and it’s so broad and yet it all ties into that, that one single asset, right, you said it to me years ago and nothing I’ve seen in the almost four or five years since has given me cause to doubt it, that this one asset class, the volatility is going to be the most important one going forward. So I can’t thank you enough for sharing your views on it and hopefully expanding other people’s views of why it is so important to understand this.
Chris Cole:
Well, thank you and it’s a great honor to come on the podcast. I think you guys have put together an incredible number of amazing thinkers and I can’t think of two better people to moderate those discussions, both of you, very fond of your work and your journalism and Bill your experience as a short seller obviously in your knowledge,
Bill Fleckenstein:
What did I dodge a bullet when I shut my short fund down, I had no idea. I thought, well, this QE is going to be kind of rough. I know the Feds, they’re my number one enemy. I had no idea what we’re about to embark on.
Grant Williams:
Hey Bill, you just proved that point. You proved that point my Bill, you were dumb money to became smart, how about that.
Bill Fleckenstein:
Let me go.
Grant Williams:
Chris? Thank you so much for this. You can see Bill and I’s faces during this. You can see us hanging on for dear life, but it was a pleasure to hang on. So thank you so much. I will make sure that we tell everybody where they can read more of your stuff and when we wrap this up, so I won’t keep you any longer.
Bill Fleckenstein:
I just like to say, Chris, I love being able to read your papers. I must admit I can’t ever, it takes me three times to through it to get the gist of it, but I really hope that maybe not to, somewhere down the road, after some more variables move around and we get some more data, we can come back and revisit this conversation.
Chris Cole:
I’d love to, been a lot of fun. It’s gonna be an exciting next couple of years. Have a great night.
Grant Williams:
Absolutely. Thanks again. Cheers. Bye.
Grant Williams:
Well, we keep doing it my friend, but keep doing it. I mean.
Bill Fleckenstein:
I’m more wrung out on this one. Because even as we were talking earlier, I have a, for the average hedge fund operator, I have a pretty good understanding of the options market, but what’s transpired in the last decade with all these guys really tearing it apart, doing this stuff and the things Chris and Mike and others along that line have been able to do is absolutely mind-boggling and if we hadn’t had a chance to really, one good thing that’s come out of Twitter, quite frankly for me, is to find guys like, I’ve known Chris, but to see this and then be able to talk to these fellas about the things that they’ve discovered and where it leads, but it’s sort of interesting that the future looks so dark. I’m sorry to say it, but it’s true.
Grant Williams:
It’s unfortunately people don’t like to face dark potential outcomes, right, we don’t like the look darkness in the face. We’d rush for all the cling to the other alternative, even if it’s becoming increasingly less likely because we want the hopeful outcome, but you know, Chris is a genius, that brain of his is an extraordinary thing, but he has this unbelievable ability to communicate what is beyond the realms of most of us in a way and again I cannot stress enough for the people listening to this, that haven’t had the joy of reading Chris’s work. Don’t be put off when Bill talks about reading it three times, I have a colored system. I have three different colored highlighter pens for the three times I have to read the thing. I’m not even kidding, but every single one of them is a true work of art. If you take the time to read Chris’s work and think about it and understand it, your mind will expand in ways that are really hard to describe.
Bill Fleckenstein:
I also think that you and I have been at this for quite a long time. And so, relative to the average person, we’re a little more sophisticated, I think for the average person, not that you’re necessarily going to be able to digest all this, but just to be aware, as Mike Green said, make sure the game you think you’re playing is the game you’re playing.
Grant Williams:
Exactly.
Bill Fleckenstein:
Cleverly said it, the average person kind of needs to know that there’s these kind of spooky things out there. There is this Pension Debacle that’s coming there is this weird brokeness, so to speak of corporations. Of course, when the Fed’s buying the bonds, you don’t get to see that, but there’s some really big festering problems and you have to keep that in the back of your mind and they may not matter tomorrow next day, next week, but they’re probably going to matter in the next group of years and I’m not sure I can tell anyone exactly what they’re supposed to do, but I think you would listen to Chris and get some ideas of what he thinks might be a decent way to position it.
Grant Williams:
Absolutely right. Well, again mate, I was supposed to go for dinner now and I’m gonna be great company sitting there with my head in the clouds, trying to think all this through, but, okay. So, again for those of you listening, you can find out a lot more about Chris, about Artemis capital management in the work he does. You’ll find them at artemiscm.com. There’s a research tab on that website and all Chris’s work is there and it’s God bless him, he makes it free to everybody and it’s just a fantastic thing to read and educate yourself. Chris, you’ll find on Twitter at @vol_christopher, make sure you spell Chris with and I and otherwise you’ll get the imposter. I would recommend you follow him who some of the stuff he puts out, again it’s 240 characters or whatever it is, but it’s incredibly thought provoking every single time.
Grant Williams:
All it remains Bill, I guess this is to thank everybody for listening. I’m sure, just like us. They’re going to go away from this and maybe sit down and have to listen to it through again. But yeah, that’s the beauty of these podcasts. Every single one.
Bill Fleckenstein:
You and I start drinking.
Grant Williams:
That’s what I’m going to do, but that’s the beauty of every single one of these conversations we’ve had almost requires a second and sometimes a third lesson to gain the understanding of this. So dense and we’ve been so fortunate with our guests. Every single one of them has added something extraordinary to this conversation. Couldn’t agree more. Well, we will be back again with the next, in the end game series. In the meantime, if you’d like to follow me on Twitter, you’ll you can do that quite easily. Follow me @TTMYGH.
Bill Fleckenstein:
I’m @FleckCap.
Grant Williams:
Yes, he is at FleckCap. If you want to follow him on Twitter, otherwise [crosstalk 01:40:03] you’re like Prince or whatever. You only got to got the one, then you didn’t even need the app. Please do rate or review the podcast in iTunes. If you have a moment and please do recommend it to your friends, that’s the best way we can help people to find this and grow the audience and I think, as I said, the subjects we’re talking about are worthy of a big audience, because they really do affect a lot of people who don’t realize it yet. Well, thanks to everybody. Thanks to James, our engineer, who does a fantastic job editing these and we will see you next time. Thanks for listening,
Grant Williams:
Boy. Oh boy, Boy. That was quite something
Bill Fleckenstein:
It sure was. I mean, I’m not, I’m not, I’m not stressed in a nervous kind of way. I’m stressed in a focus concentration kind of tired sort of way.
Grant Williams:
Yeah, no, I love that. It really, every time I did, Chris does this to me and he just takes me off down so many roads that and he just, something about him in my brain just ties so many different things together and I can’t help but think, that speaks to how important volatility is. Because when I speak to the Vol guy, he’s the one that for me, ties Mike Green’s work in and Lacy Hunt’s work in and all these things, it’s the vol guy guy talking to him that makes me connect all these little dots.
Bill Fleckenstein:
Yeah. I thought that was really quite useful from like today’s market all the way to the Pension problems and essentially Fed balance sheet monetization or helicopter money. It seems clearer, at least talking to Chris that his view is more that, this is going to end in massive monetization until that somehow stopped. I don’t see anything that can get in the way of that outcome, because it’s the politically most expedient thing to do in the short run, which is what they always do.
Grant Williams:
Yeah and the alternative is chaos. This will lead to chaos a little bit further down the track.
Bill Fleckenstein:
They won’t see the chaos that it leads to. It’ll seem like it’s going to, they’re going to make it all okay and they’d just be, it’s going to be, as it’s been, we started out with Greenspan running, irresponsible, monetary policy in the late 90s, they gave us the white liquidity shot, which blew the top off the market and they took it back out and that was that. Then they came in to try to bail out that bubble and created the real estate bubble. Then they tried to bail out that bubble and now we’re here and it’s just gets bigger and bigger and they’re just not going to stop. And so
Grant Williams:
That’s the thing, that’s why I asked about that experiment thing. It’s no longer an experiment. They don’t have the option to turn it off. Steph Pomboy’s has been talking about this Pension thing for years that, right, she’s been all over that for several years and she’s done nothing but present incredible data to back it up and you look at it, you go. Yeah. But, but it hasn’t happened yet. But when you hear someone like Chris talk about it and you hear Chris talk in such kind of starck terms.
Bill Fleckenstein:
Right.
Grant Williams:
And Chris is not that guy. Chris is a guy that just looks at the numbers, right and he takes what the data’s telling him. So when you hear Chris talking about this stuff, I think that we are so much closer to it all happening than people realize.
Bill Fleckenstein:
I think that’s very true and also there are other little potential warning signs. Like for instance, I’m trying not to draw any conclusions right now in front of the election, because there’s so much noise, but I’ve had a handful of people say to me, well, we’ve now gone through what Felix said, the 10 year we’re going through, everybody said 60 or 70, because we’ve gone through both of these targets that people say, does it matter? I don’t know. But you know, on this day that we’re recording this, the market was quite weak, bonds didn’t rally. That was a little bit we saw in March. So is that a precursor of them having it, gets after to help the buy market as well? I don’t know.
Grant Williams:
Yeah. Well, the point is to face the thing. Right? Does it matter today? No. It doesn’t matter today.
Bill Fleckenstein:
No.
Grant Williams:
Does it matter that it’s happened? Well, possibly and Felix has given you the reasons why, so it’s just something that should be on everybody’s radar and that’s one thing that’s a smart guy said is something he’s watching for. Okay. That’s happened.
Bill Fleckenstein:
Yes.
Grant Williams:
That’s something I need to be watching for now and oftentimes these things they lead to these extreme outcomes and it’s only offers that you look back and you can kind of feel that.
Bill Fleckenstein:
Yeah.
Grant Williams:
When Felix said, if this happens, it was right after that and at the time you never really understand. That’s why it’s so good to have these kinds of models in the ground from people.
Bill Fleckenstein:
Excellent. Excellent point. Excellent.
Grant Williams:
Anyway, well, I will let you go. I am going to start drinking, I need a drink,
Bill Fleckenstein:
I know exactly what you mean. I’m going to do the same.
Grant Williams:
All right mate, take care.
Grant Williams:
Nothing we discussed during the end game should be considered as investment advice. This conversation is for informational and hopefully entertainment purposes only. So while we hope you find it both informative and entertaining, please do your own research or speak to a financial advisor before putting a dime of your money into these crazy markets.
