Why Trend Following Might Outlast the AI Arms Race | Mark Rzepczynski | Systematic Investor | Ep.423

Episode Overview

• Understanding "Plumbing-Driven" Market Dynamics: This episode explores how global financial markets are shaped not just by top-down macroeconomic indicators, but by the "plumbing" of money—specifically capital flows, bank intermediation capacity, and the micro-level constraints of financial institutions.
• The Transition from FOMO to FEMO: The narrative tracks a structural shift in equity markets from speculative valuation expansion driven by the "Fear Of Missing Out" (FOMO) to a regime anchored in actual "Fabulous Earnings Momentum" (FEMO), which continues to support asset prices despite higher capital costs.
• The Reality of Rising Rates and Sovereign Debt Risks: The discussion reframes the post-pandemic bond sell-off and 5% interest rates as a return to historical normalcy, while highlighting a critical structural vulnerability: systemic leverage has migrated from the private sector to public sovereign balance sheets, eroding the "convenience yield" of safe assets like US Treasuries.
• Market Microstructure and Algorithmic Vulnerabilities: The episode examines how the changing composition of market participants—including the rise of highly price-sensitive hedge funds in bond markets and the convergence of machine learning models—creates localized liquidity shortages, compressed alpha lifecycles, and heightened market volatility.

Key Concepts

• FIMO vs. FOMO: A structural shift in equity markets from "Fear of Missing Out" (FOMO), which inflates price-to-earnings (P/E) multiples through speculative sentiment, to "Fabulous Earnings Momentum" (FIMO/FEMO), where actual earnings-per-share (EPS) growth drives stock prices upward, offsetting the downward pressure of higher interest rates.
• The Role of the Discount Rate: Stock valuations are heavily anchored by the discount rate (cost of capital), which is fundamentally bound by the risk-free Treasury rate. When earnings growth is exceptionally robust, equities can climb even as rising discount rates compress valuation multiples.
• The Micro Foundations of Macroeconomics: A school of economic thought analyzing macro-level trends (like inflation and employment) through individual decision-making, consumption behaviors, and credit availability, rather than relying solely on aggregate, top-down statistics.
• The "Money View": A framework developed by Perry Mehrling that treats money and finance as an integrated global system. It emphasizes looking at the actual "plumbing"—the physical mechanisms of cash flow, liquidity constraints, payment systems, and dealer financing—to understand systemic crises.
• Intermediation Capital and Market Dislocation: Financial intermediaries (such as primary dealers and large banks) maintain market order by "warehousing" risk when investors sell off assets. If regulatory requirements or capital losses constrain these intermediaries' balance sheets, they cannot absorb assets, causing disorderly price declines and creating trends that systematic investors exploit.
• The Safe Asset and Convenience Yield: A "safe asset" (primarily US Treasuries) commands a "convenience yield"—a premium investors pay through lower yields in exchange for safety, extreme liquidity, and regulatory utility. This premium is dynamic; when government debt issuance outpaces global demand, the convenience yield shrinks, forcing yields higher.
• Geoeconomics and Market Decoupling: The transition from a highly integrated, dollar-centric global economy to a fragmented, multipolar world. As nations employ strategic trade policies, tariffs, and capital controls, historically correlated global asset markets decouple, creating higher market dispersion and fresh diversification opportunities.
• The "Stock-Out" Problem in Commodity Markets: A physical constraint where low inventory levels of a raw material trigger panic buying. Because industrial operations are highly costly to shut down, buyers exhibit highly inelastic demand when physical stocks deplete, paying exponential prices to secure delivery.
• The "Red Queen" Problem in Machine Learning: A phenomenon in quantitative finance where the widespread democratization of advanced algorithms (like transformers or boosted decision trees) causes different hedge funds to crowd into identical trades. This crowd behavior rapidly extracts unique anomalies, shortening the "alpha half-life" and forcing funds to continuously invest in more compute and R&D simply to maintain flat performance.

Quotes

• At 0:04:34 - "Fabulous earnings momentum... at the moment, it's like FEMO versus FOMO, and apparently FEMO is winning." - Explaining that actual corporate earnings growth is currently supporting high equity valuations, keeping pace with the rising cost of capital.
• At 0:05:58 - "There's a limit to how much you can play with the discount rate... it can't be lower than Treasuries... yet stocks are still going up because the growth of earnings has exceeded the impact of the discount rate." - Describing how robust corporate profitability has successfully offset the headwind of higher interest rates on stock prices.
• At 0:09:17 - "There was a whole school of thinking that trend followers only make money when bond prices are rallying... they couldn't make money when interest rates were going higher." - Rebuffing the widely held market assumption that systematic trend-following strategies are structurally incapable of navigating rising interest rate environments.
• At 0:12:12 - "From an institutional point of view, the composition of markets—who is trading in a market—will have a big impact on whether you can make money on trend following." - Outlining how structural market participants (hedgers who transfer risk versus speculators who seek profit) dictate the profitability of trend-following strategies.
• At 0:17:35 - "Keynesian macroeconomics was thought of as more top-down... [the micro foundations approach] is saying, what motivates individuals to make spending decisions? What are the channels of monetary policy?" - Describing the transition toward analyzing global economics through individual liquidity constraints and credit transmission channels.
• At 0:20:34 - "Money is an integrated global system, and as such, we need to really look at how the plumbing of money works... capital flows matter and we should, as some people would say in crime dramas, follow the money." - Emphasizing the necessity of tracking physical money flows and funding mechanisms over abstract economic modeling.
• At 0:22:27 - "If there's a shortage of bank intermediation capital, then we're going to be more susceptible to a crisis... there's going to be a greater flight to safety, and if that's the case, then we're going to see that there's more likely some dislocation in markets." - Establishing how constraints on dealer balance sheets limit risk-warehousing capacity, driving systemic volatility and market trends.
• At 0:28:03 - "You need a global hegemon who can be able to place structure in our global financial markets... a lot of [globalization] had to do with the fact that the dollar was the dominant currency." - Explaining the geopolitical underpinnings that historically stabilized global trade and capital flows under the US dollar.
• At 0:38:31 - "The current environment is a return to normalcy, and the oddity of the bond market was the periods where we had rates that were, in some cases in Europe, negative." - Challenging the narrative that current 5% interest rates are an aberration by showing that the preceding decade of zero and negative rates was the true anomaly.
• At 0:42:21 - "Private markets have been controlling their balance sheets... they have less leverage on in their businesses. Unfortunately, in public markets, that's not the case... their credit-to-GDP numbers are continuing to rise." - Drawing attention to the macro shift where financial leverage has migrated from corporate and household balance sheets to sovereign governments.
• At 0:48:19 - "Then the supply of what is perceived as the safe asset increases... and that means the convenience yield is going to be shrunk. If the convenience yield shrinks, then our advantage in financing actually disappears." - Explaining the risk that massive US Treasury supply will erode the premium investors pay to hold US debt, forcing borrowing costs structurally higher.
• At 1:05:28 - "We're going to have to run faster in place just to stay even... which is called the 'Red Queen' problem." - Illustrating how the rapid adoption of identical machine learning tools across quantitative funds forces firms into a costly technology race just to maintain baseline profitability.

Takeaways

• Differentiate Between FOMO and FIMO: When evaluating stock market rallies, analyze whether price appreciation is driven by expanding price-to-earnings multiples (sentiment/FOMO) or actual underlying earnings growth (fundamentals/FIMO) to determine the sustainability of the trend.
• Track Intermediation Capital to Predict Dislocations: Monitor the balance sheet constraints, regulatory capital ratios, and leverage limits of primary dealers and large banks, as a contraction in their risk-warehousing capacity is a primary leading indicator of market liquidity crises.
• Prepare for Sovereign Debt and Term Premium Volatility: Recognize that with public debt-to-GDP ratios rising globally, systemic risk has shifted from private defaults to sovereign credit pressure; manage fixed-income exposure with a focus on potential spikes in long-term term premiums.
• Adapt to Post-QE Bond Market Microstructure: Adjust risk models to account for a bond market where price-sensitive, highly leveraged private players (like hedge funds running basis trades) have replaced central banks as the marginal buyers of debt, increasing the likelihood of sudden liquidations.
• Exploit Geoeconomic Fragmentation: Diversify investment portfolios globally to capitalize on the decoupling of international asset classes, as the shift toward a multipolar world breaks historical correlations and opens up regional trend opportunities.
• Incorporate Physical Inventory Metrics in Commodity Trading: When trading physical commodities, prioritize short-term physical inventory levels and stock-out risks over long-term production forecasts, as near-zero inventories trigger rapid, non-linear price spikes.
• Mitigate the Red Queen Problem with Unique Data and Architectures: To combat the rapid decay of quantitative trading signals (short alpha half-life), avoid relying solely on standardized machine learning libraries and public datasets; instead, invest in proprietary alternative data and bespoke model designs to maintain a distinct edge.