SI425: Passive Investing Is About to Face a Real Test ft. Cem Karsan

Cem Karsan · Kai Volatility Advisors

Midterm landslide leaves the administration no meaningful way to contest, opening a window for market stress.

Karsan says the size of the Democratic landslide leaves little room to contest the result. Had the Senate been close at 51-49, he thinks the administration would have pulled every lever. With a blowout, Trump's claim that problems will come if midterms go badly, and blaming Democrats, signals a possible earlier move for markets to face stress and for the administration to step away.

“They are losing so badly. There's no way to contest this election in a meaningful way.”at 9:51

Cem Karsan · Kai Volatility Advisors

Populist pressure to tax the rich and give to the poor endangers equities in a too-big-to-fail market.

Karsan argues populism is making it hard to resolve the debt, and that it pushes toward taxing the rich to give to the poor. He says this is a danger to equities in a market that is too big to fail. He later adds that redistributing money shifts the economy from a supply-side to a demand-side model, which squeezes corporate profit margins and so contracts multiples, creating a catch-22.

“It also is a pressure to taxing the rich, to give to the poor broadly, which is a danger to equities in this market that's too big to fail.”at 15:39

Cem Karsan · Kai Volatility Advisors

Supply-side economics enriched the rich, driving debt and financialization, and now fuels populist backlash.

Cem describes a long pendulum swing toward free-market supply-side policy. He argues it has benefited the rich without the costs of rising labour and inflationary pressure. It has also led to increased financialization, China's growth, and national debt. Because the pendulum swings too far, populism is now returning as people become unhappy with the costs.

“that supply side economics, which has benefited, as a free market approach, that's benefited the rich without all the costs of increasing labor and the inflationary pressures that come with the cost of labor that ultimately has led to increased financialization”at 39:29

Cem Karsan · Kai Volatility Advisors

The Trump administration must act aggressively because incentives leave no alternative to acting.

Cem says he disagrees with many social aspects of how Trump has handled things. He argues that Trump and the people around him understand that the incentives leave them no choice but to act, and act aggressively. He presents this as what is already happening, in response to pressures he believes are building.

“what he understands, at least the people around him understand, is that the incentives are such that they must act, and they must act aggressively. And that is what's happening.”at 45:37

Cem Karsan · Kai Volatility Advisors

Dispersion had a great year, but its price got so high that many managers stepped away.

Dispersion trades have worked well this year, but the cost of dispersion has risen so far that many managers, including those who normally run dispersion, have stepped back from it. Karsan links this to multi-strategy stress, which he says has been building for a year and a half to two years. He notes that two days of volatility action can recover six months of weak performance, so vol strategies are either very good or meh.

“For those that have been trading dispersion, it's been a great, wonderful year. But the problem with the dispersion strategies are that the price of dispersion has gotten so high that many managers who even do dispersion have stepped away from it”at 5:34

Cem Karsan · Kai Volatility Advisors

Long-short equity crowding and index volatility are stressing hedge funds and pushing stocks apart.

As long-short equity hedge fund assets have grown to a size where liquidity is strained, especially with index-level volatility pressures, the strategy is pushing individual stocks away from each other. Karsan argues this has been a major headwind for long-short equity strategies and for index-level funds, and that it is tied to the dispersion stress above.

“We've now seen a tremendous amount of stress that's being exacerbated long short equity as it grows to a size where the liquidity, particularly given the pressures of vol at the index level, is pushing everything away from each other.”at 6:16

Niels Kaastrup-Larsen · Top Traders Unplugged

Retail access to triple-leveraged and inverse ETFs has been a mistake, as investors don't grasp the risk.

Niels argues the industry has shot itself in the foot by giving people financial products such as triple-leveraged and short ETFs. He says people have no clue about the risk they are taking on or how easily leverage is available to them. He thinks taking these products back would be difficult once they have been made available.

“I do think we've really shot ourselves in the foot by giving people a lot of the financial toys that they have at their disposal today, such as triple leveraged, you know, short ETFs... where people just have no clue what they're getting into in terms of risk”at 56:29

Cem Karsan · Kai Volatility Advisors

The market has reached the end of the line on administration support and cannot keep going.

Karsan argues the market has become dependent on extraordinary government support, and that without more extreme measures the support has reached its limit. He points to quiet from Treasury Secretary Bessent and to Trump speaking negatively about markets for the first time since February, which he reads as a sign the administration is stepping back and that the next move is starting. He cites the administration's P&L as evidence of its active market management.

“[The market] has gotten, I will say, to the end of the line in terms of without more extreme measures, increased involvement. It is unable to keep going.”at 13:21

Cem Karsan · Kai Volatility Advisors

Financialization has made US markets too big to fail, with the economy now secondary to markets.

Karsan cites roughly $300 trillion of public and private equity and about $50 trillion of liquidity. A 20% move in equities moves about $50 trillion of liquidity. He argues the economy outside markets matters much less than markets themselves. Earnings, growth and valuations have become narrow, fragile and tied to capex in the names receiving equity inflows.

“The economy has become so financialized that markets quite simply are too big to fail... The economy outside of that is no longer nearly as relevant as the markets quite simply they are themselves.”at 14:32

Cem Karsan · Kai Volatility Advisors

Passive, sit-back investing will not work well as policymakers prop up an unsustainable system.

Cem argues that the passive, sit-back approach to investing will fail. He says policymakers are trying to support what he considers an unsustainable system because short-term incentives demand it. He notes that the bond market broke before and asks what breaks next, implying equities. He frames this as a longer-run view, not a one-week or one-month call.

“And so the whole world of passive investing, the whole idea of sit back, it's easy, Guess what? Not gonna work so well... We said that before the bond part broke. Guess what breaks next?”at 46:13

Cem Karsan · Kai Volatility Advisors

US national debt is unsustainable and accelerating as interest rates rise.

Karsan lists four structural pressures on the US, with unsustainable national debt as the first. He says it is accelerating as interest rates rise, and that populism pushes fiscal spending higher. He traces these pressures back to forty years of supply-side economics.

“a dramatically kind of unsustainable national debt that's accelerating with interest rates rising and with populism forcing kind of more fiscal spending.”at 14:19

Cem Karsan · Kai Volatility Advisors

Debt built at zero rates becomes hard to curb as rates rise and populist pressure grows.

Cem argues that when interest rates were zero, the US borrowed as much as it could and kept feeding more money into the system. He asks how spending can be stopped now that interest rates are higher and people are unhappy. He sees the debt problem as part of the same pendulum that is driving the political and economic pressures.

“and a national debt. Because when interest rate was zero, we will borrow as much as we can, keep feeding more money... how are we going to stop spending as interest rates go higher and people now are unhappy?”at 39:54

Cem Karsan · Kai Volatility Advisors

The US will print money and buy stocks directly, as China did with strategic industries.

Karsan expects the US to print dollars to monetize debt, then go beyond QE and direct investment into corporations strategically, as China did in solar, EVs, nuclear and rare earths, driven by competition rather than profit. He notes the US has already supported the long end through buybacks, and that Fed and Treasury actions backstop the yen so Japan doesn't sell. He says buying Intel and MP Materials shows the approach. He argues such a large policy requires a crisis to gain the needed unanimity, as QE has not been seen without one.

“They are then going to drive directly, much like China has done for twenty years, direct investment into corporations strategically.”at 21:30

Cem Karsan · Kai Volatility Advisors

The Fed smooths cycles, but the system depends on crises to refresh itself, making stability fragile.

Cem argues that the Federal Reserve was created to smooth the business cycle, but that the whole system now depends on some level of crisis to clear out excesses and extend the system in a stable way. He says the Fed has been used to avoid short-term crises, while the underlying burning-off of excess is what is actually breaking the system. Short-term smoothing therefore builds up larger problems that eventually arrive as a crisis.

“This is the creation of the Federal Reserve is to smooth the business cycle, but the whole system is dependent on some level of crisis, a burning of the underbrush, to refresh the system and extend it in a way that is stable.”at 46:59

Cem Karsan · Kai Volatility Advisors

The dollar is the administration's greatest lever, and printing dollars is the only way out of its problems.

Karsan argues that, under pressure, the administration will lean on the dollar, its greatest source of strength from incumbency. The only way out of its debt and growth problems is to print dollars, which monetizes the debt. He sees China as trying to undermine dollar dominance, with the Iran conflict as part of the response.

“What is your greatest lever? I'm not even close, answers the US dollar.”at 17:55

Cem Karsan · Kai Volatility Advisors

US Iran operations aim to wall off the dollar by controlling trade flows out of the Middle East.

Karsan says China began trading in yuan with Iran and was trying to make inroads across the Middle East and Venezuela, which threatens dollar dominance. He argues the US involvement in Iran is about drawing a moat around the dollar by controlling trade out of the Middle East. He says the US has been largely successful, citing a deal with the Houthis, who control the Bab al-Mandab strait, under which only American or US-approved ships pass. He acknowledges significant costs and pressures on the world economy.

“It is quite frankly trying to draw a moat around the US dollar by controlling trade out of the Middle East.”at 18:58

Cem Karsan · Kai Volatility Advisors

The US and China are in an economic war with the dollar at its centre, which is World War Three.

Karsan says he has argued for some time that the world has entered World War Three. He sees it as an economic war with the US dollar at the centre, and says the US is going to plow resources into it. He ties this to China's industrial model and its challenge to US dominance.

“I've said for some time here, we have entered World War three. This is World War three. This is a... It just looks different than we're used to. This is an economic war with the US dollar at the center of it”at 21:56

Cem Karsan · Kai Volatility Advisors

A Treasury market crisis is coming and a backstop facility is needed, per Paulson's warning Karsan endorses.

Karsan cites former Treasury Secretary Hank Paulson, who in April said a Treasury crisis was coming and that a facility is needed to backstop the Treasury market. Karsan presents this as Paulson telling listeners what will happen, and says it came before the more recent Treasury problems. The argument rests on the warning itself rather than on new data.

“There's a coming treasury crisis that's before all the treasury mess we've seen more recently. Right? And we need to prepare a facility to backstop the treasury market”at 22:46

Niels Kaastrup-Larsen · Top Traders Unplugged

Europe may not be ready for its defense ramp-up, and buying US weapons makes it weaker.

Kaastrup-Larsen agrees that Europe is pushing toward 5% of GDP on defense, but says there are major risks because he is not sure Europe is ready. If Europe can't buy the weapons it needs from the US, because the US is spending faster than it can produce them, Europe becomes weaker overall. He sees this as a risk that accompanies the spending increase.

“I do think though there are some major risks in that, because I'm not entirely sure that Europe is quite ready for it”at 25:23

Cem Karsan · Kai Volatility Advisors

Japan's 35 years of money printing caused little lasting yen weakness, a template the US could follow.

Karsan notes Japan owns about 8% of the Nikkei and printed money for thirty-five years without a major cost, as the yen did not collapse. He says the net weakness in the yen over that period was almost insignificant relative to the dollars printed. He adds that Japan benefited from buying its own industries and global stocks. Niels Kaastrup-Larsen pushed back that the yen went down rather than up, and that Japan kept its industrial production onshore.

“They printed money for thirty five years without a major cost that the yen kept going up. Why wouldn't they print money? Of course, that's what they're going to do.”at 26:45

Cem Karsan · Kai Volatility Advisors

US reshoring will need far more internal investment than Japan required, as the US is an import economy.

Karsan argues Japan was an export economy, whereas the US is an import economy that must rebuild its whole infrastructure for internal production. That rebuild, under industrial policy, will take a tremendous amount of internal investment, which he thinks is far more than Japan faced. He adds that China has large industrial production and is challenging the US.

“will take a tremendous amount of internal investment. I would argue way more than, you know, what what Japan was facing.”at 29:32

Cem Karsan · Kai Volatility Advisors

Stock-buying money printing will export massive inflation globally and also raise US inflation.

Karsan argues that buying stocks with printed money creates a very hot economy and drives inflation not only in the US but probably worse abroad. The benefits accrue to the US through investment in its corporations and infrastructure, while the inflation is spread around the world.

“by printing money that essentially drives inflation not just in The US, but probably worse abroad, right, globally. You know, we export massive inflation.”at 31:36

Cem Karsan · Kai Volatility Advisors

AI-driven labour displacement may lead to UBI, with the state giving people AI stock ownership.

Karsan argues the plan fits with AI development. If the labour question ends with people owning the AI, through stock or a sovereign wealth fund, the benefit of AI gets passed on. He says the path leads to something like universal basic income, and that the government is planning to give people stock and control the money.

“It also makes sense in the context of the AI development... if we're really ultimately gonna head to something that looks like more like universal basic income”at 33:53

Cem Karsan · Kai Volatility Advisors

A meaningful financial crisis before June 2027 will force a massive policy response.

Cem believes the US is facing building pressures that are unsustainable without intervention. He expects a meaningful crisis to be allowed to happen to some extent before June 2027, and that it will prompt a massive policy response. He ties this to the midterms, which he says marked an inflection point about six months earlier. He presents this as a timeline, with the pressures tightening as things accelerate.

“we believe there'll be a meaningful crisis that will be allowed essentially to happen to some extent to respond with what is needed in terms of a massive response to what's really a building set of pressures that are unsustainable otherwise.”at 1:00:30