A veteran volatility trader known for nailing the market’s recent twists and turns warns the Fed still needs to suck ‘the wealth effect’ out of stocks

Must read

You probably won’t find Cem Karsan in an office. In order to talk to the veteran volatility trader and derivatives expert you have to go to the “open outcry pit” of the Chicago Board Options Exchange (CBOE), where traders gather like they did in the age before online brokerages to bark buy and sell orders.

Karsan, founder and senior managing partner of Kai Volatility Advisors, has leveraged his decades of experience on the trading floor of the CBOE to develop a loyal Twitter following of over 115,000. It’s a rare feat for someone who works in a corner of the market that’s often underappreciated by retail investors, but Karsan has been dishing out prescient predictions about stocks’ twists and turns on a regular basis. 

In February 2021, for example, he correctly forecast that the economy was at the “the beginning of what could be a Goldilocks slow reopening,” calling it an “increasingly bullish” development for stocks before the S&P 500 soared more than 20% through the end of that year. And in late January, just before the Federal Reserve hiked interest rates by 25 basis points in its ongoing battle with inflation, Karsan said equities would see a short-term jump in response to the Fed’s actions as volatility fell—and, again, he turned out to be right.

Now, the veteran trader has a warning to share with investors: “The Fed will have to take the wealth effect out of the market.” 

The wealth effect is the idea that as asset prices rise, most commonly in the stock and real estate markets, it can spur consumers to spend more, thereby increasing economic growth and boosting inflation. In an interview from the CBOE trading pit Thursday, Karsan told CNBC that with stocks’ recent rise exacerbating this wealth effect, Fed officials will have to “come back and start talking the market back down” if they want to control inflation. 

After dropping roughly 20% in 2022, the S&P 500 has rebounded more than 8% so far this year. That’s great news for investors, but bad news for the Fed as it attempts to clamp down on sky-high consumer prices. A 2019 working paper published by the National Bureau of Economic Research found that rising stock market valuations lead to a wealth effect that increases labor costs. And that’s exactly what the Fed has been hoping to prevent, with Chair Jerome Powell repeatedly warning over the past year that nominal wage growth is too high.

“It’s not that we don’t want wage increases,” Powell explained in a December press conference. “We just want them to be at a level that’s consistent with 2% inflation.”

Karsan said that he expects the Fed to shift to a more hawkish tone by its next meeting in early May as officials continue their inflation fight. That would be bad news for investors, many of whom have been cautiously predicting officials could pivot to rate cuts soon, as consumer price increases have moderated since June.

Karsan warned that this “inflation is healed” narrative has been overdone in a recent episode of the Systematic Investor podcast, and Fed officials still have work to do. The same “Don’t fight the Fed” mantra that drove traders to buy every dip in stocks during the pandemic is now working in the other direction with the central banks hiking rates. “Don’t ignore it. The tide is going out,” he warned, arguing stocks remain in a bear market.

Subscribe to Well Adjusted, our newsletter full of simple strategies to work smarter and live better, from the Fortune Well team. Sign up today.

More articles

Latest article