CHG Issue #159: The Mother of Expectation

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The mother of expectation is patience. Henri Nouwen

If patience is the mother of expectation then patience gives birth to our expectations. If this is really the case then most of us have it backwards. We usually think of patience as delayed gratification or waiting for something to happen, in this way we make patience the child of expectation. Our patience is determined by how strong our expectations are; the longer our expectations go unmet the less patience we have.

I wrote this opening paragraph early Saturday afternoon after my monthly men's breakfast Church group and a 45 mile bike ride in the swampy PA July humidity. I don't really have a regular routine for writing these letters, but I usually form an idea by the weekend and do the bulk of the writing on Monday morning prior to publishing. This week's letter was inspired by that men's breakfast and I was planning on linking it our regular theme of market expectations and the patience of this market. I usually don’t cover news and current events because there are better sources for that, but I do try to deliver a sort of meta-view of the markets linking esoteric finance topics to everyday life. However, because of the attempted assassination on Saturday afternoon I felt it was impossible not to address that event because of its historic significance. After reflecting on it I realized that whatever I had to say about it was actually a continuation of what I was already thinking about regarding patience. Maybe my framing caused that or maybe the event really is a manifestation of the interplay between expectations and patience. Regardless, I thought it was impossible to not address the assassination attempt and wanted to point out the change in direction from the original intent behind this letter.

I glanced at the news on Saturday night and of all the stuff I read this post by Naval stuck out to me the most for truly capturing the moment:

I didn't predict this, no one predicted this, but it shouldn't have been a surprise to anyone. If you are surprised by what happened on Saturday and the reaction to it then you either haven't been paying attention or you an ideologue. That may sound like a harsh judgment but an ideologue is someone who espouses a particular ideology, particularly a political one. An ideology is a set of beliefs or opinions held by a community. Since we all seek community we tend to align with the ideology of our chosen community. What this does is it allows us to frame things morally: we are right, they are wrong. We form expectations about how things should be and we despair when things are otherwise. This is why the assassination attempt on former President Trump was so shocking. People on both sides expect their view of the world to prevail and either are blind to or complicit in the fracturing of society.

Our views of how the world should be tend to form our expectations. There have been a whole host of indicators that say we should be in a recession and that the Fed should lower interest rates but reality has persistently disappointed those expectations since the Fed embarked on their rate hiking campaign. Reality and expectations are constantly converging, forming new expectations and realities. A long-standing theme of this letter is that if you are stuck in your expectations for how things should be you run the risk of missing how things really are.

By allowing patience to determine our expectations we gain the ability to see not only what should be but also what is and there is a tremendous amount of information in that difference. The VIX is trading 12-handle and VIX futures out in 2025 are trading 18-handle, both below the long-term average of 20-22. These levels imply historically below-average volatility for the next 12-months at the same time that the frequency of global conflict is rising, US politics have degraded to the point of an assassination attempt on a convicted felon Presidential candidate, and after a historic interest rate hiking campaign by the Fed. If you get stuck on the incongruity of all this you will miss the rich set of information contained within.

Not only is implied volatility low and priced to remain low but option skew is also relatively flat. The combination of low vol and flat upside and downside skew serves to makes the distribution of future outcomes very narrow(see below). The market is always searching for a price where two-way flows are balanced and to achieve that balance it has to price risk to attract two-way flows. Today's narrow distribution creates favorable odds for betting on tail events but that doesn't mean those tail events will happen or that the market reaction to them will reward the long odds. In fact, those betting on tail outcomes have consistently been disappointed over recent history which has contributed to fewer of them taking the odds and today's current pricing.

Patience is often thought of as passively doing nothing which does not feel great for us, especially when we expect something to happen, when the odds look favorable, or when there is chaos all around us. However, patience is a form of action and it does not need to be passive. By actively observing the world around us without bias (easier said than done), having faith, and trusting in the truth (all actions) we allow our expectations to form out of our patience. This positioning is more sustainable for the long-run creating room for empathy because we are not threatened by the divergence of the present reality and our future expectations. By actively collecting information, asking curious questions, and learning we become more robust and receptive to the wisdom that comes from experience. If you are having trouble connecting the dots just invert the process: forming expectations based on your beliefs threatens those beliefs when reality doesn’t align with your expectations and you spend all your time experiencing fear or greed which prevents any real learning and drains you of any capacity for empathy or creative thinking.

Linear thinking observes low implied volatility and flat skew and concludes to get long vol. Second order thinking sees how the process creating the favorable odds is self-reinforcing at the same time it weakens the foundation of the market itself. Jared Dillian says that by trying to kill something you only make it stronger and that is the market reaction we are seeing today in the wake of the assassination attempt. Second order thinking observes that the rising level of chaos in the market and society continues to be balanced by short-term, speculative flows.

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