An interesting recent interview with Steve Diggle on The David Lin Report. He is the founder of Vulpes Investment Management, which is currently raising a new fund to bet on increased volatility in the financial markets. He discusses his “Big Short” trade in 2008, the current setup in markets and why he sees a more promising risk/reward to being long volatility again. Some of my notes from the interview are included below the embedded video. These are for personal reference only and not intended as a comprehensive transcript; any mistakes are also my own.
On his background: he co-founded a hedge fund called Artradis in 2002. They were well known in 2007/08 for being one of the biggest proponents of what became famous as “The Big Short.” They were very concerned about the fragility and excesses in the financial system, felt there was a big systemic risk and had a very big bet against it. There were running US$~2bn going into 2007 and by the end of 2008 that had risen to US$~5bn, so they made US$~3bn for their investors over an 18-month period. When the Fed and all the other central banks rose to the rescue of the financial system and started printing an unprecedentedly large amount of money, they felt that it would have a depressing effect on volatility, because liquidity and volatility are essentially two sides of the same coin. When there is a lot of liquidity around, it is very hard to have high levels of market volatility, as there is always someone to buy the dip. When you have a complete absence of liquidity, as you did in September 2008, that is when volatility spikes. We have been in this period for the last 10-15 years where central banks have been continually producing gargantuan amounts of liquidity and eventually that has led to this very serious bout of inflation we have had in the first few years of this decade.
On the setup we have in today’s market: first, the extent to which central banks will feel comfortable continuing their money printing is limited, because we have had this significant ~50-year high inflation in 2022/23. Second, asset prices have now gotten to a point, particularly in certain areas, where they just look untenable and a very high level of risk taking behavior is present amongst some of the most successful participants in the market, who feel invulnerable because they have had a tremendously good run with very few setbacks. Against that backdrop, the cost of hedging has also come down. It got very cheap back in 2005-07, and then famously spiked enormously (e.g. the VIX went from 9 to 90 in 2008). Although the cost of hedging is nowhere near the lows today, it is still abnormally cheap given how strong asset prices have been, so they would say it is a good time to start revisiting the idea of downside hedging because the chances of volatility have gone up, but the cost of hedging has gone down.
Shorting the 2008 crisis: at the time, there was a great deal of income-seeking behavior by both investment banks and some wealthy retail investors. They were keen to accumulate income in almost any way and there were 2-3 particularly successful products which were being sold by the investment banks. One of those was credit default swaps, the prices for which became crazy low. For the biggest banks, which were at the time taking a great deal of risk, you could hedge ~US$1mn of exposure to that bank for ~US$1k a year. The other thing was that people were happy to sell downside insurance, essentially put options, on markets and individual companies, that were historically the lowest they had ever seen. So you combine a great deal of complacency about risk being expressed through very low prices with what they saw as a systemically rising level of risk.
It wasn’t just the US housing market, many of the global banks were involved in really reckless risk management. When his old firm Lehman went down in 2008, it was ~60x levered, which left it with very little margin for error. In 2008, the epicenter of the risk was in the banks. They knew the banks pretty well and they saw a huge amount of hubris centered there. That is why they thought it was a good risk/reward buying these instruments because the amount of leverage you got for the downside was very cheap. When things started to go wrong, the price didn’t just rise a bit, it rose exponentially. That is how they made so much money so quickly, because the system blew up. Taking a CDS on Lehman, for example, other banks would sell you a CDS for 25bps, but when Lehman went bust and they had the auction for those CDS in November 2008, the closing price was US$91.63.
On the likelihood of a repeat 2008-style financial crisis: financial systems are psychological systems and any crisis of confidence can turn into a runaway train, which is what happened in 2008. But he thinks a 2008-style crisis is unlikely for two reasons. One is that the epicenter of risk is no longer in the banks. The banks have essentially come under government control, and they are never going to be as leveraged as they were in 2008. That means the banking system is a lot more robust than it was in 2008. Second, the central banks are closely watching the broad pillars of the financial system and stand ready to add liquidity a lot faster than they did in 2008. So their base case is not for a 2008 financial crisis.
Instead, what is more likely is we will see a 2000 Nasdaq collapse-style crisis. In 1999/00, tech stocks got very expensive, in some cases even more so than they are now, and we had a major selloff (the Nasdaq fell ~40% in 2000). It is more likely that if we are going to get a super spike in volatility, it won’t be a systemic financial crisis, but rather it will be centered in the areas that have had these extraordinary, exponential increases in value. It is not just that a small number of stocks have captured investors’ imagination disproportionately and that valuations have run up to be very vulnerable to profit taking, but we also have a macro background with a new President who seems to be in a hurry, has a fairly radical agenda and is very unpredictable. It is very unlikely that Donald Trump’s presence in the White House is going to reduce market volatility, it is almost certain to increase it. Overall, however, they are not in the prophecy business, they are in the probability business and relative to the cost of where you can put your hedges on now, the probability that is going to make you some money or act very usefully as insurance has gone way up from where it has been in the last few years.
On current market dynamics: the US economy is in robust shape and it has been very resilient. But it has been growing at what might be described as a normal pace (~2.5% in 2023, ~2.8% in 2024). Meanwhile, the stock market broadly went up 20% in each of those years and the Nasdaq went up ~80%. You currently have a combination of three things that have led to these excessive valuations, all of which look unstable to them. 1) retail investors are very active in the US market and in a relatively small number of names. 2) you have a huge number of large tech hedge funds, quant trading funds etc. that are trading on models that are similar, momentum driven etc. So they tend to buy what has been going up and short what has been going down. 3) on top of that, we have had a very high and unprecedented level of passive investing, which means if NVIDIA is the largest stock in the market, every ETF that is matching the market is buying NVIDIA. So the risk of these imbalances has gone up. But the real reason for volatility is usually not technical or based on valuations alone, it is almost always psychological. You have got this absolutely bulletproof, adamantine faith in a relatively small number of assets that have gone up a great deal and that’s led to extreme risk-taking behavior. Again, it doesn’t mean a serious crunch is definitely going to happen, just that the risk/reward has now turned in favor of people who are looking at increased volatility at the very least, and probably significant downside at some point for some of these most popular assets.
Why now in terms of timing: it is a confluence of factors. The most successful companies in the Nasdaq haven’t necessarily been the ones that have been making the most money. Tesla is a particular focus for them in terms of market psychology. It is a gigantic company with a pretty small earnings base, and it is operating in a tough industry. But people love Elon Musk and they have a faith in him that he is going to turn this into a successful company. The stock went up by ~50% since Trump was elected. That added US$~500bn to the value of Tesla, whereas the whole value of GM is US$~55bn. So you combine the significant rally, with the falling cost of hedging and add in the extra factor of the Trump presidency, and you get what seems to him like a market that has very little room to disappoint with a significantly higher chance of unexpected shocks to the system.
On the uncertainty created by Trump’s policies: we just don’t know what will happen if Trump does start a serious tariff war, particularly with China, which is the second largest economy in the world and is very significantly integrated with the global economy. It is also difficult to compare with the first Trump administration. During Trump 1.0, there was a slow ratcheting up of economic measures against China, but a lot of that was just bypassed by re-exports via Mexico, Vietnam etc. Everyone knew that was going on, but the rhetoric was perhaps more important than the actual results. During the first administration, Trump also didn’t really understand how the levers of power in Washington worked. Now he does. Trump 2.0 is a lot more ideological, it is a lot better planned and the supporting team is a lot more professional. That means they can get stuff done in a way that the early days of Trump 1.0 couldn’t. That is not good or bad, but the prospect that it unleashes unexpected consequences on the global economy are increased.
On the risk of betting against the Fed and central bank stimulus: that was a very significant reason they got out of the long volatility business in 2010. There are two points he would make, however. One is this very significant bout of inflation in 2022/23 will act as a constraint on all central bank money printing. Secondly, if you know that is going to happen, that is an event you can play as well. Rather than buying S&P puts, for example, you might be better off buying call options on long-dated Treasury securities, because if there is a bout of market instability and the Fed comes in with 75-100bps of rate cuts, the long-end of the bond market is going to soar. In 2008-10, the 10-year went from yielding 4% to almost 0%, so anyone long that made a great deal of money. So it may be that the way you express volatility in a post-2008 way is not just a bet that asset prices will deflate, but you might want to bet on inflation (i.e., things that would be caused by a slashing of rates). The Fed put is a reality, but it is not there to protect speculators in single stocks or the Magnificent 7. It is there to protect the economy. There is no reason why we couldn’t see several trillion dollars come out of a narrow group of stocks without provoking any Fed response. It is only if it became broader and more risky to the economy, that we would likely see the Fed step in. And with this strong US economy, and reduced, but not dead inflation, the Fed is going to want a very compelling reason and be aggressive.
On how retail investors can approach hedging: there has only been twice in the history of the S&P when the yield on cash was higher than the earnings yield on the market, and the last time was in 2000. The single best way a retail investor can hedge themselves is to raise some cash. If he/she has been broadly invested, it has been a phenomenal run and the best way to hedge is to simply lock in some profits and raise cash levels. That does three things: 1) right now, raising cash is accretive to your portfolio, given the yield on cash it is not the painful place it has been in the past. 2) it relieves you of significant psychological stress that if you’re fully invested and the market is falling, what do you do? When you have some cash buffer, you are able to think much more clearly. 3) if we do get a serious crisis and prices fall a lot, you are in a much better position to buy the dip.