Yesterday on Talking Markets we were joined by Aahan Menon, founder of Prometheus Research. What a day…
UNUSUAL AFTERNOON ACTION
A rough start yesterday gave way to oil coming well off the highs and stocks well off the lows in the afternoon, fueled by President Trump’s comments that the Iran war could be over soon.
Aahan says it’s a continuation of some odd market behavior he’s noticed over the past couple of weeks: “We keep having these massive rallies after a midday lull. Typically, the tone that’s set in the first 30 minutes ‘til 12pm is the tone that carries through the rest of the day. But what we’ve seen over the last 2 weeks is just the complete opposite, where the [afternoon] session is just super strong.”
SYSTEMATICALLY TRADING THE WAR
If you’re a longer term investor, Aahan thinks you don’t need to worry too much about the current market action.
But if you’re a more active investor, Prometheus thinks “the war itself has created opportunities,” Aahan said.
First, in energy futures. He says they currently pricing geopolitical conflict as a “short term shock,” and said that while the front months of the energy strip are rallying, the back months remain “tepid,” creating a state of “extremely, extremely sharp backwardation” that is historically rare. According to Aahan, this allows investors to be “paid to own oil” rather than having to pay for the privilege.
The specific strategy Aahan advocates involves “buying the back of the curve” to capture a positive roll yield. He explains that as these contracts approach expiration, the price “begins to converge towards the spot price,” effectively allowing the trader to earn a yield.
Second, Aahan observes a “very, very similar dynamic” in VIX. He said the market is presenting an “inverted futures curve,” a rare state where “market stress” has significantly bid up the front end of the curve. Aahan explains that for active traders willing to own “two to four month expirations,” this inversion allows them to capture a “positive roll.”
According to Aahan, the combination of inverted VIX and energy curves is “very, very rare” but provides a powerful “positive carry hedge to stocks and bonds.” His systematic testing at Prometheus suggests that adding these positions as an overlay could result in a “1.5 X improvement in your risk adjusted returns” compared to a standard 60-40 portfolio:
You lose money on this trade “in the event that this is resolved immediately, but the really important thing is you have to recognize that this is not something you should do just as a trade by itself,” Aahan said. “Because let’s say that it’s resolved immediately, your equities and bonds are going to be bid solid.”
RECESSION? PICTURE UNCLEAR
Growth isn’t bad, Aahan said. Prometheus’ weekly GDP reading is “basically holding up pretty well”:
And tax data is showing “extreme positivity”:
However… the labor market is telling a different story:
“I think we’re having the most unique circumstance that we’ve had in the last 40 years in terms of a business cycle,” Aahan said. “The labor market seems to be breaking down, but economic activity as measured by real and nominal GDP is still powering ahead. The divergence between those two things is something we’ve never seen before.”
So, what’s driving the divergence?
“A meaningful shift in the labor force driven by immigration outflows," and
Early effects of AI
Overall, Aahan thinks the probabilities of recession have risen, but he doesn’t think we’re heading into one quite yet.
THE NON-US TRADE
Aahan sees the best risk-reward across markets right now as definitely “in a non-US setting.”
“Today, what we definitely see across the board is that the US, both in terms of equities and bonds, offers very meagre expected returns,” Aahan said. “But when we go to other areas, say the EU, or Japanese bond yields, we see a lot more opportunities there.”
“What we think really makes sense globally is to recognize that equity expected returns have compressed a lot,” he added. “So you should probably start thinking about tilting away from a very equity heavy exposure to a more global exposure, [with] fixed income, energy, and perhaps even FX, because that’s really where all the juice is today.”
🪢For more from Prometheus:
Thank you Cherrian Cherian, jan Goossens, Avi, and many others for tuning in! We’ll be back Talking Markets on Wednesday at 4pm ET with the wonderful Michele 'Mish' Schneider.
Important Disclaimer: It is crucial to remember that this article is for informational purposes only and should not be considered investment advice. Consult with a qualified financial advisor to assess your risk tolerance, investment goals, and overall financial plan.
