Full Transcript: The Excess Returns Weekly Wrap - 3/22/2026

Mispriced War Risk, the Fed Conundrum and a Historical Vol Premium

Jack: Welcome to the Excess Returns Weekly Recap. I’m Jack Forehand, joined by my good friend Matt Ziegler. Matt, I think it’s fair to say the market got a little exciting this week.

Matt: The market got exciting. Special shout out — four words of the week, which are two two-word phrases. I feel like my entire week has revolved around “inference inflection” and “dynamic hedging.” I don’t know if that’s happened in your life too. I feel like all the Excess Returns conversations had dynamic hedging in them somewhere or some type of options part. And this “inference inflection” came out of the Jensen Huang Nvidia presentation. I’ve been jokingly fitting it into work meetings just because I feel like it’s my latest buzzword of choice.

Jack: Dynamic hedging is a great theme. First of all, I didn’t even know that was a Taleb book. I had read some of the other ones — I read Fooled by Randomness — but I did not know about that. But it’s fitting because basically we’ve got a lot going on in the market, and we’ve got two different ways to look at it plus some evergreen stuff this week. We’ve got Jared Dillian looking at it from a macro perspective, we’ve got Brent Kochuba looking at it from an options and flows perspective, and then we’re going to add in a little timeless biotech investing on top of it.

Matt: Timeless biotech. I think my favorite part about this — from D.A. Wallach, who I love, he’s an interloper between businesses and he checks those boxes with his music background and everything else — on top of that, for a biotech interview, that was the most like value investor conversation, with options math and everything else layered in. That was one of the most educational investing conversations I have had in a long time. I actually feel like I learned stuff from talking to D.A.

Jack: It was really good, and we’ll highlight some clips here, but I’d also highly recommend people watch it. I know the YouTube algorithm wants the world-is-ending stuff for people to click on. But this was actually a really excellent episode, and it also got me, Matt — as you know, I’m not a man of the arts by any stretch — to go listen to his band. It is quite good. Oh, it was very good.

Matt: I keep telling people there are a few songs you probably know and you just don’t realize what this is. This is high concept pop art in the best way. It’s really cool that he’s transitioned from music to Spotify to venture, now into biotech, and actually gets it. Going to smart places like Harvard probably helps.

Jack: And I don’t often look at our guests when I’m sharing clips on Twitter and say, “Oh, this guy’s got a million followers.” He basically has a million followers on Twitter, which is pretty impressive.

Matt: Perks of being a rock star. Where do you wanna start? Where are you kicking us off with clips today?

Jack: Let’s start off with what everyone’s talking about right now — the war — and you covered it on a bunch of different angles with Jared Dillian. The first was this idea of: do markets, when a war is coming up, price this properly? Here’s Jared talking about that.

Jared: The Ukraine War wasn’t priced in — like it was the weirdest thing in the world. Russia put about a hundred billion dollars worth of military equipment on the border, and everyone was sleepwalking through it. They were like, “Nah, they’re not gonna invade.” And prices didn’t move until they actually invaded, even though there was plenty of warning. Same thing with Iran. Trump had been agitating for this for a long time. We knew it was coming for weeks — this June 2025 was when the stuff started. We’re in March. So it’s weird because the market is a fantastic discounting machine and it seems to discount some things better than others, and sometimes it doesn’t discount the very obvious things. It’s very strange. It’s like a strange psychological phenomenon. It’s almost like willful ignorance: I’m gonna pretend this thing goes away, I’m just gonna pretend this doesn’t exist until I can’t ignore it anymore. And then it gets priced in. So, structurally bad.

I was heavily influenced by Nassim growing up in the markets. A lot of people don’t realize this, but Fooled by Randomness is not his first book. He wrote Dynamic Hedging, and I read Dynamic Hedging when it came out, although I didn’t understand much of it. I read Fooled by Randomness in 2001, and he thoroughly convinced me about the virtues of being net long options. I’m an option buyer professionally in my fund. In my personal account, I generally don’t sell options as a general rule — not even really covered calls. Especially in the stock market where you have so much gap risk in individual stocks, I don’t want to be in a situation where I’m short calls on something and it gets taken out, or I’m short puts on something and there’s an earnings report and it gaps down 20%.

Jack: This is an interesting debate in terms of — on one side you’ve got the efficient market hypothesis that basically the market’s pricing whatever’s happening. But Jared’s point was that a lot of times with these wars, when we’re leading up to them, the market doesn’t price it that efficiently, or doesn’t price that it’s going to happen, and then it does happen and things change really quickly.

Matt: This is what I love about Jared, and part of it is just the overall neurodivergent sense of the world that he has — on some weird cat psychic level, I guess, is probably the best way to put it. But it’s this awareness that: I see something bad happening or potentially happening in the world, and I see that it’s underappreciated, and that creates my first opportunity. And then my second opportunity is when it’s already being appreciated. He’s always looking for those little rate-of-change adjustments, which is so different from the perspective of looking for the one long big move. He’s like, “Oh, there’s a catalyst as these expectations get normalized.” I hadn’t really thought about this with war before. Had you thought about this specifically with political conflicts like this?

Jack: Not exactly, but what I think is interesting too is — I would argue the market does price it properly more than he thinks. The reason that happens is because it’s really hard to price binary events. Like, there’s either gonna be a war or there’s not gonna be a war. So the market is probably pricing in some probability of that. But in the end, it’s not gonna be that probability that’s realized — it’s gonna be yes or no. The market’s not gonna completely price in that the war is going to happen unless the war has already happened. So that’s an opportunity for people like Jared, who might think the war is going to happen, because if you think that, it’s not gonna be completely priced in. So there’s an opportunity to take advantage of it.

Matt: Yeah. Fascinating on both sides of that trade. If it’s gonna happen, then you look for places where you can own something that benefits from the underpriced side of the event actually occurring — to your point, you’re gonna make your own probabilistic assumptions about what could happen and see where you could profit from that. And then on the other side of it too, once it’s known, people are likely to overreact. So then you’re gonna turn around and think about how do I play this on the downside. The Peloton story that he tells midway through this episode is a perfect non-war example of: here’s the assumption on the front end, here’s the assumption on the back end, here’s where the mismatches occur. And especially with binary outcomes or complete changes of state, it makes some weird stuff, and not your typical value investor conversation.

Jack: Yeah. And we’re not done with the binary outcomes, by the way, with this war. There are all kinds of things, and that’s what makes these things so hard for investors — things could change any day. Like we could decide to blow up Kharg Island tomorrow, and that changes everything about — or we could just completely back off tomorrow, although I’d argue that’s gonna be a little harder right now than it was last time. This will come up in the conversation with Brent Kochuba as well — this idea that it’s just very hard to price these things when you’ve got these major events that are either gonna be yes or no, and all of these things floating out there.

Matt: And that concept right there — it’s hard to price them — and that difficulty in pricing them creates opportunities. Take us to the Brent clip, because I love this. This is one of the reasons I love talking to option market makers who actually have to deal with this. I’m so glad you did one of these Brent episodes this month.

Jack: Yeah, and what’s interesting is — people always say price is truth, and that’s definitely true. But what’s also truth is what people are actually doing with their money. You hear all kinds of stories in the media about what’s happening and people are doing this or that. Brent sees options flows. Brent sees what’s actually happening behind the scenes. Although I don’t trade options and we joke in the podcast that I don’t even know what half these options trades even are, for me as a long-term investor it’s interesting to see what’s going on behind the scenes, because it explains a lot of stuff I’m seeing in front of my eyes. So this first one with Brent is this idea of realized volatility versus the VIX, and something interesting is happening right now as people price this war risk. Here’s Brent talking about that.

Brent: I was trying to put into context just how significant this was. So if you look back to the spread between the VIX — you just take the VIX index and then you take realized vol, which just tells us how much the market’s been moving the S&P over the last month — and you compare those two levels directly, the current spread, or at least the spread when I made this chart, was 10. I think it’s widened out a little. 10 is a very large number. We are as high as 12, and you’re talking about the top 15 spreads we’ve seen over the last 10 years. So it’s very significant. But what’s weird about this is that the VIX is only at 22. If you look back at the biggest spreads here, you’re talking about the great financial crisis, or you’re seeing a huge spike right around the COVID situation or in April, where the financial market seemed like it was gonna cease. All of those had VIX of 40 plus or even higher. That’s where you get this really big premium. So it’s very unusual to get this big vol premium when the VIX is just at 25.

So what is that saying? People are hedged, but the underlying market’s just not moving very much. And so what’s unusual here is not the hedging — I would argue not the VIX at 22. What’s more unusual is the fact that we’re not realizing any real market movement. My concern with this is that I think at some point we finally get that 2, 3, 4, 5% equity market drawdown, vol starts to realize, and then suddenly the VIX just goes, “Okay, great,” and then it goes to 40. You’re just gonna get — and this is the jump risk that I think can happen. And as we remove these options positions with expiration, I think it frees up the market to have that realized vol move. And then suddenly we have that VIX spike that shows up on Wikipedia and makes everyone really sit up in their chair and go, “Uh oh, what just happened?”

Do you know when we see these historically — do they typically resolve by realized volatility moving towards the VIX versus the other way? Normally what happens is the VIX goes to 50 or 60, and then you get a policy intervention. If you think about COVID — Powell announced a bunch of cash, vol came off — or Trump with a Liberation Day tweet. Or in this situation, vol goes really crazy, okay, Iran deal solved, and we’re gonna do quantitative easing or whatever it may be. What then happens is the VIX gets slammed because you can sell forward vol, but you can’t sell realized vol — it already happened. So you’ll see the spread go sharply the other way. As you can see right here in COVID, where the spread goes negative because realized vol remains high. But people start to sell implied vol — they sell, they short the VIX, they sell puts, whatever — implied vol crashes, and then realized vol, still high, takes a little time for that realized window to come in.

Jack: This is interesting just in general because — this is what happens when you get these risk events. What happens first is people start buying puts, people start hedging the event, and so what happens then is you start to see implied volatility or the VIX go up. Realized volatility can’t catch up. And so what Brent was showing in that clip is that’s a one-month trailing realized volatility — which is 22 days or whatever there is in a month. So one day of a volatility spike’s not gonna change that that much. So you always see this in these events. You saw it in COVID, you see it in these other events — the VIX starts to spike, implied volatility starts to spike, people start to panic, but you don’t see it yet in realized volatility. And so Brent was talking about that — we’ve gotten to the 90th percentile right now in terms of the difference between the VIX and actual realized volatility.

Matt: Honest question — how delta neutral are you right now? How delta neutral is the Jack Forehand portfolio?

Jack: Oh, Matt, I’m neutral in all parts of life. As you know, I’m a very delta neutral kind of guy.

Matt: Perfect answer. Maybe you can explain this. Maybe this is a sidebar conversation I’m gonna have with Brent behind the scenes, or I’ll call Chris on this one too. The idea here is that they’re hedged, but they haven’t moved the underlying yet. That’s the disconnect between where the VIX is versus the realized.

Jack: Yeah. The idea is if you wanna hedge something really quick, that’s what you’re gonna do — you’re gonna go to options. You’re probably not gonna start liquidating your underlying positions, and also there are tax reasons and stuff like that. So what happens when you get this spike in implied volatility, it tells you people are going to the options market to hedge versus selling their actual position. The VIX is a fear gauge — that’s what people call it. So you see, when you get these events, you see this VIX spike, and it can sometimes indicate hedging in terms of what people are worried about for the future. And it’s just interesting as a long-term investor to know that people are getting really worried. It’s spiking. What does that mean going forward?

Matt: Yeah, I think it’s really interesting to look at this, and I also appreciate — and Brent says this over and over again in the conversations — we’re looking at day-to-day changes here. He’s talking about: if these moves in the underlying happen over a few days, here’s where you get the giant VIX spike. It’s important to be able to look at the short-term reality of this as it compares to some of the longer-term value, because this stuff is just gonna reset every single day no matter what.

Jack: That’s right. Brent always talks in the podcast about how he deals in 30-day increments. And for someone like me, I don’t deal in 30-day increments — I’m holding positions for the long term. So for me, this stuff is really good at explaining what I’m seeing in front of my eyes. I’m not making changes in my portfolio based on what’s going on in the options space, but you see these spikes in the market, you see these weird moves, and CNBC’s trying to come up with some new story to explain what’s going on. And that’s not really what’s going on. It just makes me feel more comfortable that I can explain what’s going on because I know what’s happening behind the scenes and I can see Brent’s work.

Matt: Yeah. I’ll forever go back to the — I think it was the Kevin Muir story about an index rebalance or a futures roll thing. He was like, “What the heck happened in the markets?” And it was like, “Oh, Carl was sick and he had to take his kid to soccer practice, so we pushed the roll to Monday from Friday.” I see those CNBC headlines go by and I just think, where are the other stories? Brent helps remind me, especially in client conversations where it’s like, “Well, what moved today?” If the technical people are all describing a weird technical thing that happened, I want that in my brain too — not just what the headlines are saying moved the market in isolation on a given Thursday.

Jack: So this next clip gets into what I think is one of the most interesting things going on in markets right now. We had a Fed that was probably with a cutting bias, was kind of holding. Now you get an oil shock, and oil shocks are so interesting from a macroeconomic perspective. Now you’ve got a situation where: what is the Fed gonna do? Before I give my opinion on that, let’s see what Jared Dillian had to say.

Jared: The Fed is doing a very “normy” thing here. First of all, we are recording this about an hour after the latest FOMC, and the rates were unchanged. [Fed governor — name unclear in transcript] dissented, which is expected. There was really nothing in the directive to write home about. And then in the presser, Powell says, “If we don’t make progress on inflation, there will be no rate cuts,” and stocks melted down and bonds melted down and the dollar ripped.

I was kind of expecting a hawkish meeting. So I’ll get back to what I said originally about this “normy” view of the markets. Because the ECB does this too — everybody is talking about the ECB hiking. The conventional wisdom is that oil prices going up cause inflation, which is totally understandable because oil prices feed into transportation costs and everything else and increase the cost of everything. But there’s a side to this that I think people don’t fully understand, which is that they’re also deflationary in the sense that they cause demand destruction. The price of gasoline is not perfectly inelastic — if the price of gasoline goes up, people will buy less, not a lot less, but a little bit less. And if the price of food goes up, people will buy less — there is some elasticity there. And when it comes to more discretionary purchases like apparel or electronics or stuff like that, which oil prices also feed into because of transportation costs, there’s much more elasticity. So I’m not entirely convinced that oil going to $150 a barrel is going to unleash this inflationary spiral, which is what I think most central bankers think.

Is Powell right to be hawkish here? I actually kind of don’t think so. Now, it doesn’t really matter what I think he should do — what matters is what he will do. I don’t know if he’s gonna be able to or will want to hike rates with Trump looking over his shoulder. We’re pricing in one rate cut this year and one in 2027, and those are probably gonna get priced out. The yield curve is flattening here — the two-tens have gone from 70 bips to 50 bips. It’s probably gonna continue to flatten.

Do you think part of that is the idea that a rising oil price ultimately reduces consumption and weakens the consumer? Yes. Therefore you don’t wanna run into a credit event by being extremely hawkish. The right response is to kind of wait and see how damaging that price rise is. Because it’s not like it’s rising because there’s increased demand — it’s rising because, oh crap, the price of this basic input is throttling us. And getting back to what you said about the Fed following the path of least embarrassment: the Fed is not going to cut rates with oil at $100 because that would seem insane. That would subject them to a lot of criticism. So they’re not gonna do something like that. They’re gonna do the conservative thing — they’re going to wait and see, or they’re going to agitate about hiking rates. But they are not going to take a risk and say, “We’re gonna cut.”

Matt: I love calling the Fed “normy” — let the record show, I think that is amazing. Back to your self-deprecating comments about being delta neutral all the time, or being the most neutral — the Fed is the ultimate normy institution. And this idea that they follow the path of least embarrassment, that they just don’t want to get egg on their face, so they’re gonna be cautious and conservative — I think that is an insanely useful framing. So that’s out of the way.

Jack: By the way, I almost used “path of least embarrassment” on the thumbnail. I thought about it.

Matt: It’s a fantastic line.

Jack: It’s a fantastic line. It’s probably not charged enough. And also you run into a problem with long words on the thumbnail because they don’t fit. But no one needs to know about that — that is the truth of building thumbnails. But anyway, back to this Fed and oil thing. Oil shocks are like one of the hardest things for the Fed to deal with, because on one hand this is going to reflect in short-term inflation — inflation’s going up because of this, and we’ve already kind of seen that in some of the producer stuff behind the scenes. But on the other hand, high oil is not good for the economy. It’s gonna pull spending from other areas. It’s not good for the economy. So they’ve got this short-term problem and this long-term problem. They were already kind of in no-man’s-land and didn’t know what to do. I’m just happy I’m not part of the Fed because this is a really hard thing to try to figure out what to do with.

Matt: It’s an impossible thing to figure out, because — and this is probably where they do nothing — right now, over this year and next year, we have the expectation of basically two 25-basis-point cuts or whatever’s currently priced in. Those probably go away as the cone of uncertainty widens. It’s just like, “We’re not gonna do anything, because in the face of uncertainty we’re just not gonna budge.” Because if they go hawkish and tighten credit — if you haven’t heard, some people are concerned about credit bubble stuff, and we’ll not stop talking about it, not saying that’s wrong — if you tighten, you might exacerbate that problem. And the reality is, if you cut into this to try to help, you get a higher inflation print. There’s gonna be demand destruction on the other side of this. This is just a whole part of the consumer economy that’s gonna get the crap kicked out of it the higher these prices last. But the Fed doesn’t have a way to control for this.

Jack: They’re gonna have to do nothing. Jared had the great quote: “The Fed can’t cut into $100 oil,” which is true. They can’t. There’s really nothing they can do here. They’re just gonna have to wait this out and see how it plays out. There are too many problems either way. And like you said, the Fed is kinda like me — they don’t wanna ruffle feathers, they want to kind of just go down the middle right now. They’re gonna probably make comments one way or the other at meetings, but they’re probably gonna do nothing until this plays out a little bit more.

Matt: It’s gonna be really interesting to watch, and it’s gonna be interesting to watch what this means for your fixed income side of your portfolio, what it means for all sorts of the details that we’re all wrestling with.

Jack: So back to D.A. Wallach, because this was a great piece on biotech and just how biotech operates. This is really a masterclass in what goes on behind the scenes, and I loved his idea of thinking about this as a bag of options. Here’s him talking about that.

D.A.: The typical biotech company in its early stages is not selling any product commercially. It’s a company that exists to try and get new drugs through a highly regulated development process, and then ultimately launch commercially. So we can distinguish between biotech companies that are in that phase — where they’re not selling a product — from biotech companies that are selling a product. That latter group is gonna be valued in a more traditional way based on future cash flows.

The development-stage biotech companies are really distinguished by the fact that there’s a high degree of uncertainty that any of their products will get to market. So let’s imagine a hypothetical biotech company. They’ve got three drugs that they want to bring to market, and each of those projects started a year after the one before it — so they’ve got these three staggered projects. Each of those projects is going to move through the development life cycle. It’ll probably start in what we would call the preclinical phase, which basically means that scientists are researching that drug — the petri dish, so to speak — and then they’re gonna do animal experiments. Unfortunately, animal experiments are still a major part of how we try to figure out whether drugs are gonna be safe and effective in humans. So that’s all the preclinical phase of drug development.

Any project in that stage of its life has a very, very low probability of making it to the finish line. The finish line here would be an FDA approval and then a commercial launch. To give you a general orientation, a drug at that stage might have somewhere between a 5 and 10% chance of making it to the finish line. And then what will happen is the drug, if it has generated evidence that suggests it’s worth spending money to take it further, will submit an application to the FDA or a different regulator in another country, and it will apply for permission to start doing human clinical trials. The first human clinical trials — Phase 1 trials — are typically going to be focused on determining whether the drug is safe. Then the Phase 2 and Phase 3 trials are going to be focused on trying to figure out if the drug is actually effective. A drug, to get approved at the end of the day, has to satisfy both of those criteria — it has to be proven safe and effective in the eyes of regulators. And if it satisfies those criteria, it will get a regulatory approval and then the company will have permission to start selling it on the market.

As a drug progresses through each of these phases, the probability goes up that it’s gonna cross the finish line. So you can value any one of these companies typically by basically doing a sum-of-the-parts of the net present value of each of its programs. This company that we’re talking about that has three drugs — you’re gonna calculate the net present value of each of those projects. In each case, you’re both going to be discounting the potential future market for that program, and you’re going to adjust it by the probability that those revenues will ever occur in the future. You’re also going to be adjusting for the likelihood that they occur, and the costs associated with developing that drug. So the valuation is gonna be a sum of each program’s net present value. That net present value is gonna include the uncertain future revenues and the uncertain future costs that go along with that program.

Jack: This is such an interesting space, Matt. These companies have no revenue — they’ve got a bunch of drugs they’re working on, and you’ve gotta look at it as each drug is sort of an option. And I can see how this is a place where there’s alpha, because you really have to dig into all of these individual drugs and the things they’re working on and all the stages of the process — and you’ve really got to have an edge. You’ve really gotta know this really, really deeply.

Matt: I see this as next-level sum-of-the-parts analysis — sum-of-the-parts with options. And I can’t help but think about value investing. When was your era of thinking you were gonna deconstruct companies via sum-of-the-parts and be the next Warren Buffett?

Jack: Yeah, that happened really, really early because I became a quant very quickly, when I realized that wasn’t gonna happen for me. I bought some pretty terrible companies in college and realized I cannot do that in any way. So —

Matt: Were you going like net nets?

Jack: I don’t have the great stories of that.

Matt: Were you trying to do net nets or cigar butts, or were you actually looking at some-of-the-parts catalyst type things?

Jack: There was a Canadian garbage company, Matt, I have to admit — it didn’t go well. The thing went bankrupt, and at the end I’m like, “How is the sum of all these garbage trucks relative to — will I get anything because of the garbage trucks, or am I gonna get nothing?” And it turns out I got nothing. So that’s basically the best I’ve done on that front. You can see why I’m a quant.

Matt: I get it. Same. I’ve had my moments of trying to dabble in understanding it. I love when it explains a story, and I love the idea of layering options over it with a biotech lens the way D.A. does it. I kept flashing back as he was explaining this to me to 2012, when the Marissa Mayer/Yahoo stuff went down. Do you remember that? Did you follow that closely? Yeah. So 2012, Marissa Mayer’s coming in, Yahoo’s just muddling along at like $12 or $15, bouncing around in price but not going anywhere. And a bunch of these analysts started to write about it — I think Dan Loeb and some other people got involved for a while — doing the sum-of-the-parts analysis and basically being like, “Here are all the unpriced things per share and how they stack up on the balance sheet.” Part of it was like: nobody seemed to remember that Yahoo had bought 40% of this then-not-really-heard-of company over in China called Alibaba, and they might be a big thing.

They owned 40% of the company in 2012 or 2013. I remember the filing where it was like, “Yahoo’s gonna sell half the position back and get some equity and get some preferreds or something else for all this stuff.” And it’s like, okay, first off, you had to price it as the option that this could happen — that could monetize a piece of this. And then once it came in, it was like, “Well, you have an extra $3 or $4 a share in cash now, and you still have the optionality of when the other 20% they own in the business eventually goes public.” Starting to layer in all these probabilistic frameworks where it’s like: you own a call, you own this part and this value, and then this call on it. Yahoo Japan — there’s a bunch of other stuff — the best part being that the actual Yahoo thing that I knew them for and would make fun of them about was basically worthless. But you had all these other things that could happen over these timescales.

When D.A. breaks this down for a biotech, it’s like all that logic, but now applied over almost a venture capital framework — which gets so interesting, because now every single year you have a different and reset range of probabilities and possibilities inside of this stuff that you have to price out, map forward. And you can really see: if you could have expertise and you can get some of this right — I’m not saying it’s easy, but I am saying I can see the repeatable alpha argument here. I don’t think I understood it that systematically before.

Jack: Yeah, I can too. Because if you think about this — someone like me, if they’re doing a sum-of-the-parts thing, is gonna look at cash flows and earnings and all that stuff, and there’s none of any of that. So you really are — you have an edge if you understand this process in depth: how these things get to market, the chances at each stage. He talked about that a lot. It’s just really interesting to me, and I can totally see why there’s a huge edge.

Matt: Very cool. Again, one of the most educational episodes in recent memory on that one. Take us to Dillian — I want to go to this idea of correlation changes across regimes. Any thoughts on this one before we play it?

Jack: Yeah, I mean, I think this is something we’ve all been talking about since COVID, because we had this extended period of negative correlation between stocks and bonds, and what happens going forward. Obviously that has changed, but whether that continues — it’s just an interesting topic for everyone. Here’s Jared talking about that.

Jared: After 2020, bonds became positively correlated to stocks. Especially right now with the war going on — bonds are very correlated with stocks, and that really limits the use of diversification and eliminates the diversification benefits. So what was different? What happened? What changed? Well, what changed was from 2000 to 2020 we were in an environment of declining inflation. And after 2020 we were in an environment of increasing inflation. If you go back in history over the last 100 years, you can see that the stock-bond correlation worked in periods of declining inflation, and in periods of rising inflation, it did not.

One of the things I like to say about markets is that they are non-stationary — and I don’t know if that’s a made-up word or somebody told me once, but non-stationary basically means that you’re playing a game where the rules are constantly changing. So imagine you’re playing non-stationary chess — I assume you know how to play chess, I’m terrible at chess. But in a chess match, at some point the knight goes up two spaces and over one, and the bishops go diagonally, and the rooks go horizontally and vertically. Well, what if you were playing chess and you were in the middle of a game and all of a sudden all the rules changed? So now the knights go diagonally and the bishops move like knights and the queens move like pawns — in the middle of the game — and you had to adapt to these new rules. That is what investing is like. Because in a regime which might last 20 years, you get very comfortable with the rules, and it’s hard to imagine an environment that could be different. So when the rules change and correlations break down and everything goes upside down, you’re in an environment you have to adapt to very quickly. So I think adaptability is one of the greatest qualities for an investor. What do you think? What’s the tell? How did we know?

Matt: Because 2020 and inflation coming back into the picture and the post-pandemic stimulus period — whatever else — or was there some other tell that the old playbook was over? And I’m asking that because when do we ask those questions again now?

Jared: I don’t think it’s something you can predict. What I think is that you have a portfolio, the correlations are stable, and all of a sudden they become unstable, and you have to ask yourself what is going on and you have to adapt very quickly. But the problem with regime change isn’t the regime change — it’s that most people fail to adapt. They’re still playing by the old rules. This is a lot about being intellectually flexible, which I think is one of the top 10 or 20 qualities of an investor: to say, “Okay, what I used to do worked. It’s not working right now. I have to do something different.” I think that’s very important.

Jack: I love this idea. I wrote it down so I could read it: the problem with regime change isn’t regime change — the problem with regime change is that people fail to adapt to regime change. And I think that’s really interesting, because it’s very hard. The reason it happens is because it’s very hard to adapt to regime change if you’ve seen something for 40 years — like the negative correlation between stocks and bonds — and then for a few years something changes. It’s hard to know: is this gonna last? It just makes regime change periods one of the hardest periods to navigate for an investor.

Matt: And how it must move markets, because you have people stuck in the old way who are now trying to do it. I think about this a lot. I’m thinking about this a lot right now with all the private credit stuff, with all the alt stuff. The 60/40 worked really well, not just from 1981 to 2021 or 2022. I think about post-GFC, that 2010 to 2020 period — I think about how those correlations were weak to negative, but bonds yielded zero. That ZIRP era was the first period where, especially working with pensions or stuff where there was a hurdle rate that we had to figure out how to meet or get over when bonds couldn’t do it anymore post-GFC — it was like, “Okay, well, this is where you use alts in your portfolio. This is where you do other things.” Seeing all those initial private credit pitches, some of the private real estate pitches, some of the other stuff that started to creep into that world in more meaningful ways as bond alternatives — what’s interesting is they were interesting because they could accomplish a specific task, but they didn’t actually help the average portfolio for a long time. But they weeded their way into the system.

And so now here we are in 2026 and it’s like we have this series of years where that NAV change weeded its way into the system — not the actual reasons that those things work. They could help you out in a ZIRP world. But 2022 happened and we saw the stock-bond correlation flip to positive, and a bunch of people going, “Hey, my 60/40 lost” — what did it lose that year? Like 20% or 22% or something?

Jack: Yeah, give or take.

Matt: So it gets hammered that year. And for a lot of people who had an allocation to, say, private credit or somewhere where it doesn’t have to mark to reality — it’s like, “Oh, guess what? Volatility laundering is a beautiful thing when you own it.” Because that was down 22%. But the riskiest portion of my bond portfolio, or my alt sleeve — that didn’t move at all. And that justifies this. And you slowly see these behavior changes into these new things until they turn into a problem in the next regime. That slow-moving reality is so fascinating and so useful to try to sit back and reflect on and go, “What do I need to own in a way that’s not gonna get me trapped in something stupid?” Because it doesn’t work all the time. That’s the lesson of this one.

Jack: This is the hardest thing about this, because people want to go into these things when they’re working. It’s a hard thing for your own money, it’s a hard thing for managing clients’ money. People wanna go into these things when they’re working. I don’t know if it’s still true, but the biggest inflows ever into the permanent portfolio were at the beginning of 2009, which was the exact wrong time to be adding the permanent portfolio. And that doesn’t mean the permanent portfolio is not a great long-term strategy — I think it is. But the idea is the thing had done so well — I think it lost like nothing in 2008 while the market lost 50% — so everybody wants to be in it. And the problem is these things only work when you’re in them all the time. If you’re gonna try to time them, it just doesn’t work. So you’re right — after 2022, everybody wants to be in these things, and I think it’s a great thing to wanna be in these things, but you have to understand: you’ve gotta stay in them or they don’t work.

Matt: You’re gonna end up in all these scenarios, and we’ll talk about the Awesome Portfolio too — Jared’s amended version of the permanent portfolio. But no matter what, you just end up further and further underweight stocks. If you’re in a regime where basically stocks are the things that work more than anything else — or stocks plus whatever it might be, gold or real estate or bonds or cash — there are just periods where different things work. And it’s back to that diversification definition: if you’re diversified, you’re apologizing for something you own. You hate something in your portfolio. That’s the test of diversification. If you own the permanent portfolio or the five-option Awesome Portfolio or some other variation — something sucks. But if you’re way underweight stocks in one of those periods, like 2010 to 2019, you’re gonna underperform, and you better be comfortable with those reasons.

Jack: So this next one — we talked about Brent and why I like to follow him during times like this, because he sees what’s going on behind the scenes. This one gets into the mechanics of how that actually works, what he’s following. Here’s Brent talking about options and their impact on the market.

Brent: People get confused oftentimes as to who the counterparties are. The idea is that if people are buying a whole bunch of AMC calls, market makers are short those calls. And so if the stock goes up, market makers have to buy stock in order to hedge. I think we’re all kind of aware of those types of dynamics. And then there’s a sort of joke about the fact that people will say, “Well, if everyone sells calls, then market makers still have to buy stock.” It’s a joke about how people confuse these topics oftentimes. The underlying theme here is that: when someone is buying calls or selling calls, there’s somebody on the other side that’s doing the opposite.

Why we care about this is because we want to know who the dynamic hedger is — and why does that matter? Because it’s dynamic hedgers that impact the market. What do I mean by that? If you buy one call and I sell you that call and we just both hold it to expiration — there’s no hedging flow involved, there’s no market impact. We square the risk off between ourselves, and the market impact of that would be fairly mitigated. However, if you, Jack, buy a call from me — I’m the market maker and I sell to you — I have to buy and sell shares of stock in order to hedge that. That’s part of what I have to do as a business operation. And so it’s the trading of those underlying shares that can impact the market. So who holds the risk, from both the initiator and the counterparty, is really key to understanding here. And 90% of options are bought and sold by market makers — meaning 90% of the time, if you go trade, you’re trading against a market maker. And they’re really large and there’s not that many of them. There are only about six or seven really large market makers — Citadel, Susquehanna, et cetera. So that is the transmission mechanism: the trading or hedging of the underlying shares that takes the options flows and brings it to be impactful to the underlying stocks that we’re trading.

Jack: And on this next slide, it’s important to understand this is not a static thing. Once this hedging process is started, now prices are changing, time is passing, and these hedges have to be adjusted over time.

Brent: That’s exactly right. So the minute you trade — let’s say I have to buy 50 shares of stock to hedge your trade — if the underlying stock moves, the delta or the hedge ratio changes based on how the stock is moving. So I’d have to adjust my shares because of that. Also, if implied volatility goes up and down — so VIX goes up and down — I have to adjust my share count as well. And also just as time passes. So if I’m hedged today and the stock doesn’t move at all, but a couple days pass, I have to adjust my hedge ratio.

So the hedging is constantly changing across a bunch of different dynamics. And then on this next slide — this is why we do this on OPEX week — we get to a point where a lot of this stuff expires and that changes the dynamics, and it sometimes can be turning points for the market. And it seems like it’s more often a turning point now, which is interesting. We generally watch the third Friday as the biggest expiration cycle. Positions build up on the third Friday of the month and the hedges associated with those positions build up. And then all of a sudden that OPEX — which in this case is on Friday — hits and positions are cleared out. And oftentimes the trend in the market, both in terms of price trend as well as volatility, can change. There’s a whole bunch of statistical evidence for this. VIX expiration is part of this OPEX window — VIX expiration was Wednesday, as we record here on Thursday — and that opens this OPEX window that’s often talked about.

So there’s statistical evidence that markets tend to shift — in terms of price, if trending up, they tend to sell off, or vice versa — but also volatility, which is a critical thing to understand. Generally, vol spikes into OPEX and tends to sell off after. Now that’s interesting here because we have a relatively high volatility market, but it’s tricky to say that vol’s gonna sell off here because of the Iran situation, which we’re gonna dig into.

Jack: This is really interesting, and this is a huge breakthrough for me — when I realized that when people are buying all these options, there’s not necessarily someone on the other side of the trade that wants the other side of that position. You’ve got these dealers that are hedging all this risk. They have to manage the risk, and managing that risk implies buying and selling the underlying. And when they buy and sell the underlying, they can move the market. That whole dynamic is really interesting. And you see this in many situations. You see it in GameStop — option dealers were certainly contributing a lot to that upward move when it was going on. They had to keep buying to hedge themselves. You see it in COVID, with the top and the bottom. Remember we were all sitting here when COVID was out in Italy and the market’s just not going down? Why is the market not going down? And then an options expiration clears, and the market tanks. And then the market bottoms again on another options expiration. It’s not that that happens every time, but it certainly was a contributing factor to when it topped and when it bottomed. And so I just think as an investor, it’s really interesting to think about how this works and how it impacts what we’re seeing in front of us every day.

Matt: Yeah. This whole idea of just understanding the derivative space next to reality — the underlying, whatever you wanna call it — we can’t separate them. They’re too big, there’s too much there. And the reality is: if I buy or sell something directly with you, if we’re bartering for something, if we’re trading something directly, none of this matters. But in finance land, all this stuff matters. Because there is somebody out there with a derivative instrument who has no vested interest in the underlying, who’s just trying to help somebody else go about their business. And that can help stuff really slosh in one direction or the other in the short term as they reset that exposure. The idea that there’s not always just another person with a slightly different methodology on the other end of your trade is a perfect way to tell you how confusing and frustrating the markets can be if you’re trying to do this.

Jack: And I’ll throw this chart in the podcast, but the idea is that since COVID, the use of options has gone up dramatically. So whatever you think the impact of this is, it should be a lot more now than it was back then. Although I’ve never traded an option in my life, I don’t know if you have or not —

Matt: This is why you’re Jack Delta Neutral Forehand.

Jack: That’s correct. Brent and I were joking this time — when I do my first trade, we’re gonna do a live stream on the OPEX effect. He was talking about put flies and stuff this week. I’m like, I don’t even know what that is.

Matt: I wanna see you start with the iron butterfly. That’s all I want.

Jack: The iron condor. Is there an iron butterfly too? I don’t even know.

Matt: I don’t know either.

Jack: But whatever it is, we’re gonna come up with one of these complicated ones and live stream Jack putting it on at some point when I do my first option trade. But back to the clips — you mentioned the Awesome Portfolio. Here’s Jared Dillian explaining what that is.

Jared: The Awesome Portfolio is 20% each: stocks, bonds, cash, gold, and real estate. I came up with this idea in about 2018. I had this subscriber who lived in Idaho — he’s a financial advisor there, a very smart guy, used to work at Lehman — and we were running some numbers on different portfolios. I was like, “Well, try this, try this, try this.” And he put together this portfolio that was 20% each stocks, bonds, cash, gold, and real estate. The Sharpe ratio on this thing was through the roof. And then he started looking at some of the numbers — the biggest drawdown for this portfolio in history is 12%. The second biggest is 9%, and that was during the financial crisis. The next three are 1%, like, so basically you have this thing that returns a little bit less than stocks. Stocks since 1971 have returned 11% a year — this returns about 9% a year, and it cuts your volatility in half. It practically eliminates your drawdowns.

The whole philosophical reason for doing this is: basically we tell people, “Look, the key to investing success is to get an S&P 500 index fund and dollar-cost average it.” And you can just do a future value of an annuity computation, and if you max out your 401k at $23,500 every year and you put it into this S&P 500 index fund that returns 11%, you’re gonna have $16 million when you retire. And everybody believes these numbers. But the problem is, if you have a 40-year investing career, you’re gonna have one 50% drawdown. You’re gonna have a bunch of 20% drawdowns. And unless you just have this bulletproof constitution, you are not going to be able to hold on during these drawdowns. Even if you don’t necessarily liquidate, your behavior will change — you will invest more when it’s going up, you’ll invest less when it’s going down, you won’t dollar-cost average perfectly, and your returns will go down.

So the reality is that this 11% return since 1971 — nobody actually realizes this. Vanguard knows that their own investors don’t realize these returns because they’re constantly trading their mutual funds — in and out, in and out, into different stuff. And what they found was that if they added a person to the equation — an advisor, they call it Advisor Alpha — who just told them to stop trading their mutual funds and just hold, their returns went up by 3% a year. But you don’t even have to do this. You can invest in this Awesome Portfolio, and it returns 9% a year with virtually no drawdowns. And that’s the solution.

Jack: As you know, I’m a huge fan of this, Matt. I’m a huge fan of the permanent portfolio. I’m a huge fan of derivations of the permanent portfolio. I’m a huge fan of this idea of there are different quadrants of what can happen economically. We didn’t see the inflation quadrant or the two inflation quadrants for a long time. We are now. I think it’s good to have something in your portfolio to handle all of those things, and the Awesome Portfolio does a good job of that.

Matt: This idea of — I think it’s a colorful expression — you don’t wanna be like triple long GDP.

Jack: Yeah, you don’t wanna be like long the same thing three times or whatever. I know what you’re saying.

Matt: Somebody’s got the concept of like, you’re just making a giant positive-GDP bet — and maybe that’s the justification for the 60/40. Clearly I’m forgetting and shouldn’t be making this point live, but that’s the way this is gonna go. But this idea of different stuff works at different times — I’m a fan of this too. And I think I pressed Jared a little bit on this, and he’s discussed it too. When I have the advisor hat on and doing the planning work, it’s about reminding people: you have asset allocation, you have asset location, you have different stuff that’s not on your financial balance sheet per se where you’re managing the risk — like the equity in your house, or the equity in your private business, or the loan you gave somebody. There are all these different places these instruments show up.

So when you start to divide your exposure in five ways — which is his variation: stocks, bonds, cash, gold as your commodities buffer, and real estate — it’s like, well, you probably already have a lot of this stuff going on. You might have your stocks in your 401k or brokerage account, some bonds, or just cash in a high-yield savings account. Parsing all these things out and understanding those different buckets, and saying: the real lesson here is to own a wide range so you can press rebalance. And then if you’re dedicated to owning these ranges — when something is sucking, like it’s been a miserable ride to do something like this for the 2010 to 2020 period — but if you had been accumulating gold and topping your gold off through that, you’re feeling pretty smart in the last year or so. This enables that reinforced behavior of everything kind of going up over time. It’s a great framework to just make sure you’re always eating your veggies.

Jack: And to your point about it sucking in the 2010 period — these things are a double-edged sword. I do this for clients, so I’m a big fan of this type of approach, not the Awesome Portfolio specifically but something very similar. The positives of this is what Jared said: your drawdowns are much lower because you’re dealing with all the potential outcomes, and your returns are more consistent. The downside is when the market’s ripping for a decade, you’re gonna trail by a lot, and it’s very, very hard. Jim O’Shaughnessy talks about this as the second point of failure — in a lot of ways, that’s harder. It’s harder to trail your peers than it is to lose money. So you have to be someone who’s not concerned about that to follow this type of portfolio, because it’s gonna look really different.

Matt: Yeah, which is why all I trade are zero DTE options.

Jack: Well, that’s gonna look really different, Matt, if that’s your zero DTE strategy.

Matt: No, I am also very delta neutral — by means of zero exposure to it.

Jack: I can tell you if I did one, it would basically be just losing money constantly until I didn’t have any left. Which is why I don’t have a zero DTE strategy.

Matt: Fans of diversification — that’s a big thing. I know we both agree with this: more things can happen than will happen, so why not just admit that you don’t know and expose yourself to some assets that can appreciate under some of those various environments? You wanna be able to fight another day. Huge fan. I’m really excited — Jared’s new book on this is coming out, I think in September, he said. And I’m really happy that he’s decided to focus an entire work just on this topic, because even as a benchmarking or logical exercise, I think this is just tremendously useful.

Jack: So one of the interesting things about Brent’s work is this idea of — we’ll talk about what gamma is in a second — but if we can look in aggregate at what all these option dealers are doing, it can kind of tell us: if we get volatility, are they gonna make it less, or are they gonna make it worse? Here’s Brent talking about that.

Brent: The gamma index is measured every night, and then it forecasts next-day volatility. What you see here is that the lower we go in this gamma index — which is referred to as kind of negative gamma — then forecasted one-day volatility tends to be higher. There’s some evidence that this also holds on larger timeframes. And so basically what we’re saying here is that the SPX index gamma is negative, and that is going to drive prices lower, because if the market goes lower, market makers have to sell stocks. And if the market rallies, they have to buy stock. And when they’re doing that, they’re pushing the market as it trends in a certain direction. That can really exacerbate volatility in a significant way.

So I know in past times when this has been to the left and we’ve had high predicted volatility, when OPEX cleared it actually went to the right. Is that what you expect here? Or is this a different situation? This is a different situation, because normally what would happen is: if we were crashing into an options expiration, you may sell your puts and then say, “Okay, risk is kind of over. We had a nice sell-off, I’m gonna close these puts.” In this situation, you can’t afford to not be hedged because of the known unknowns. The known unknown is the Iran situation — we all know the Iran situation is not going very well right now. And you can’t hedge that with a short-term option. You need to own a one-month, two-month, three-month put or VIX call or whatever to hedge yourself. Same thing with the credit market — credit’s getting a little weird right now. We don’t know if something could break. It’s a known that something could break — we don’t know what it would be. So we have to hedge that, and you can’t hedge it with a short-term option.

So what does that mean? Yes, we’re gonna lose a bunch of put protection here at OPEX and with VIX expiration — you have to roll that to a new position. You can’t afford to let that protection lapse. And so I think that keeps the pressure on in a unique way in this case. What does that mean? Now we have the market sort of crashing — it’s sort of like what we were talking about before: it feels like it should break, but it’s not. And I think it’s the positioning that’s been holding in there. If that positioning sorts of wears away or moves away, then maybe realized volatility could really start to spike. If you look at the data, we have about 12% realized vol over the last month, which equates to about 75 basis points of movement in the S&P every day. Well, the average in the S&P is like 68 basis points over time. So we’re just moving at a very average amount. If we have a 2 or 3% sell-off, that’s like 30% realized vol — that’s a big spike. And that would mean that the VIX or implied volatility would spike in kind.

Then we start talking about: if we get one or two sell-offs of about 2%, I think you suddenly see the VIX go to like 35 or 40. That’s the jump risk I’m talking about, and that’s the risk in this market at this moment. So we’ve talked in the past about people using zero DTE a lot. With something like this, you’re gonna see people using longer-term options for hedging. And you’ll see that reflected in the VIX going up. I’ve seen anecdotal evidence of zero DTE volume and flow subsiding when these known unknowns come up. Because you can’t hedge an Iran situation or a possible credit event with a zero DTE when you don’t know the timing of that event.

You can make the argument: the market opened today, nothing really accelerated in Iran, so for the rest of the day [unclear] — you could trade some zero DTE. But what I’ve seen, anecdotally — because there’s not a ton of data around this — when you get these unknown events like a bank crisis, a credit crisis, a hot war situation like this, zero DTEs back away. And it becomes more about hedging to one-month, two-month, three-month options, owning some volatility that could cover you on a day-to-day basis as opposed to intraday.

Jack: So I won’t have to define all my options terms here, Matt — hopefully you won’t ask me to. But in aggregate: are dealers long gamma or are they short gamma? Delta is how much your option position moves when the underlying — the stock — moves. And gamma is how much delta changes when the stock moves. It’s like a second-order effect. But the idea is: you can get these charts on the internet — Spot Gamma has one like this — this idea of gamma exposure. What gamma exposure tells us is: if dealers are long gamma, they’re likely to suppress volatility. If the stock market starts to go up, they’re likely to sell into it. When dealers are short gamma, they’re likely to exacerbate volatility. And in that chart Brent showed, we were pretty far to the left, which means we’re more towards that short gamma situation. So we’re in a situation where dealers could exacerbate volatility if we went down.

Matt: This idea of what Brent says he can see — it feels like something should break, but it hasn’t broken yet. I feel like it’s watching those awful internet videos where a bunch of people are getting on a boat or something that shouldn’t float, but they’re treating it like it’s gonna float. You know the tipping point, you know the comedy value is coming before it happens — like I just saw one of a bunch of drunk people getting onto a picnic table floating in a body of water, and you’re like, “Uh oh, I know how this is gonna end, but I have to watch this now.” It kind of feels like that. You’re like, “I know this isn’t gonna work out.” And if it does, it’s like a minor miracle, but the odds are stacked against everybody getting wet. When I hear Brent talk about it, this is kind of what I envision — somebody who’s trained to see these things, anticipates the outcome that’s more likely to happen in the very short term with larger-scale impacts. Is that a fair way to put it?

Jack: Yeah, that’s right. And “likely” is a key word here, because the options guys always think in probabilities. Brent kind of feels like where we are right now — he doesn’t think we’re gonna have a COVID situation, but he sees parallels from that in terms of this idea that the market was kind of staying up and we’re like, “All this stuff’s going wrong around us, and the market’s staying up.” He sees the potential that when this options expiration clears, we could have some negative stuff associated with that. Obviously we don’t have the economic event of COVID — this is oil pricing going up in a war. It’s bad economically, but it’s not like what that was. That was the entire world economy getting shut down. So it’s not that bad, but it’s good for me, just in the back of my mind, to have this kind of context. I always find it interesting when Brent’s seeing something behind the scenes. Going into that recording, I didn’t really know where he was at because I can’t see this stuff he sees. But I come out of it thinking, “All right, when we do clear this options expiration, the probabilities could be higher that we have a downside event.”

Matt: And I always think about this when I’m listening to Brent, because on one hand the way this adjusts might just be two bad days for stocks. And for long-term investors it’s like, “Eh, two bad days — come on, we’ve got our 15% average annual intra-year drawdown. We’re expecting more than two bad days at some point over the course of the year, let alone over the course of the week or month.” But the part — and it’s inside of that COVID comment, which agreed that we’re not in that type of scenario — when Brent puts something like this together, this is one of the earlier dominoes in every bad event, and every good event on the recovery too. These are the things that happen first because something like this happens in response. You get a giant blowup in VIX — well, now everything that’s volatility-based rebalancing or driven by some of this stuff is gonna respond. And it’s that first or second or third domino falling in a larger sequence. He’s not predicting that it’s gonna carry all the way through, but these are almost like earlier leading indicators of greater things. That’s why you wanna keep your finger on this pulse.

Jack: Yeah. The options are not the events, but they affect the timing. That’s the way I look at it — the event obviously is there’s a war going on, but the flows behind the scenes and the way people are positioning themselves can impact how that plays out in the stock market. And so I think it’s just really interesting. I always love doing those OPEX episodes because I learn so much about that.

Matt: Yeah, same. Really appreciate Brent’s work on this stuff. You ready to take it back to D.A.? I think we’re ending on D.A.

Jack: Yeah, we’re wrapping it up here with D.A. And this is really interesting because biotech had a long period where it didn’t work, but it’s doing better now. He was talking about this idea — it struck me when I originally edited your interview — this idea of competition for capital and AI. Here’s him talking about that.

D.A.: Within the public markets, biotech is competing with all the other risky sectors for investor interest. And so I think what we saw was that for a couple of years, most of the hedge funds and a lot of bigger generalist allocators of capital decided that biotech was just not an area they wanted to be in. They wanted to do other stuff during that period. In particular, the big tech and AI narrative created a competitor to biotech for that risk capital. So money flowed out of the biotech sector into other parts of the market, and that just created a massive headwind for all of these companies.

So during that period you had going on what typically drives this sector — you had companies doing clinical trials, sometimes getting acquired by large pharma companies. These are the things that drive returns. But those returns were occurring against a backdrop of money being sucked out of the sector. And so it was like all the prices were going down together. Only if you were extremely careful and specific with your bets would you find these little instances where you could make money. And of course, what we hope for the rest of the time in more normal environments is that there should be a kind of steady-state risk premium of some kind to investing in biotech. In other words, you would hope that it’s a good place to always have some money. And then if you’re good, you would generate returns far in excess of that by doing the kind of specialist investing that we talked about.

On the other hand, this is, as we were describing it, a market that goes through cycles. And so it was just definitively a bad place to be for the past few years. We came out of that starting about halfway through 2025. There was this massive resurgence of risky biotech investing, capital flowing back into the sector, and you saw returns even in the sort of passive biotech indexes of 80, 90, 100%.

Matt: Did you study — and this goes back to the post-COVID era and doing work with pensions and the hurdle rates and stuff like that, thinking beyond the 60/40 — at that time, one of the most useful things I think I learned, like really felt like I understood at that point, was preferred habitat theory. Do you remember this? Does this ring a bell to you? No. It’s basically the idea — it’s usually used in bond land. It’s the match between duration preferences and risk preferences, usually for fixed income. So different people exist at different parts of the duration and risk curve in fixed income. So if you have pension investors who are gonna go around a certain place, they’re gonna look at maturity and credit quality of bonds: “I need to own these bonds for paying out these liabilities in this period of time.” So the asset-liability matching that goes across these curves makes a difference of who’s where.

And it’s the same thing that describes — for example, there are these high-yield fund managers who will be like, “Oh, we only do ultra-short duration, high yield,” basically a short and intermediate duration high-yield fund. When they’re like, “Oh, we’re under two years, we can’t hold this anymore — it’s not part of our mandate,” somebody buys from them, makes a couple pennies, holds to maturity. Nobody else wants to hold it till the bond matures because the math gets wonky. Then it’s like, “Oh, you could pick up an extra couple bucks if you just understand you live here and you don’t live there.”

What he’s describing is a version of that, but with growth investors. And it’s weird to think about, but if you are looking for speculative or high growth or lottery-ticket opportunities, you’re looking at venture, you’re looking at these different areas, and biotech kind of fits in there — that’s kind of why “tech” is in the name. These growth opportunities are hard-to-price, options-far-away things with no revenue to base them on. But when something like AI appears, it’s like, “Well, forget all those crazy lottery tickets — I want these less-crazy-feeling lottery tickets.” It’s a different preferred habitat for growth. That’s contributed to this serial underperformance and serial underfunding of a lot of these projects. I hadn’t really thought about how preferred habitat theory applies in places like the ultra-risky equity markets before.

Jack: Yeah. It happens everywhere, and that was the same thing for me. I didn’t think about the whole venture capital, high-risk area. Obviously if AI comes on the scene and AI is this new huge thing — AI’s gonna benefit biotech in the long run because they’re gonna use it. But in the short run, everybody’s like, “I need to put money in AI.” And capital’s finite — that money’s coming out of something else if it’s going into AI. I thought that was a really interesting way to look at this, and I’ll look at it differently going forward because of that.

Matt: Same. Capital’s gonna go to the ideas that suit it — the risk profiles, the preferences, what people want and why. And it’s really interesting to think about some of these hyper-specialized areas where there’s a general person who’s like “on or off,” and then there’s a specialist who’s always operating there. It adds a different layer to the manager selection question too — when you’re considering where you wanna be active versus where you wanna be passive and why. This was maybe the best articulation of that I’ve heard since some bond fund managers explained: “Let me explain who my neighbors are — before anything else, I’ll tell you exactly who we buy and sell from and why, where we can earn a couple of extra bucks doing this process.” I hadn’t really understood that in the ultra-high-growth space, or even thought about how they’re competing for angel and VC dollars in some of these scenarios.

Jack: So I think this is a great combination of clips to deal with the world we’re in today. We’ve got a lot of uncertainty. We thought about it from the macro perspective, we thought about it from the options perspective, and then we got ourselves away from that a little bit to think about something that’s maybe more of an evergreen thing we can think about. Yeah, it was fun doing this, Matt. I’ll let you bring us out because you’re the pro.

Matt: I love doing these recap shows. I love revisiting these ideas. Make sure you head over to Substack too — we’ve got the Substack up, we’re deriving lessons from all these posts, we’re putting those there. I think we’re doing some really cool stuff with the Substack, honestly. So Excess Returns on Substack — hit us up over there. But in the meantime, let us know what you think. Subscribe if you haven’t already, press that little like button, leave a comment below. Jack, let’s do this again next week.

Jack: We will. We’ll be here, and we’ve got some great guests next week. We won’t say who they are yet, but we’ve got some great guests. So we’ll see you next time, Matt.

Matt: See you next time.