Unconventional wisdom: The AI parlay bet that could trigger the next bear market
The AI boom has become a giant parlay bet in a market vulnerable to poor investor behaviour.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The AI parlay bet that could trigger the next bear market
Invert, always invert. Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong. Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail.
- Charlie Munger
Charlie Munger left the world a treasure trove of invaluable wisdom. At the forefront of his contributions is the idea of inversion.
According to Munger one way of identifying a solution to a problem is to contemplate the deliberate steps you would take to achieve the opposite result.
This approach is found throughout strategic thinking.
Cognitive psychologist Dr Gary Klein came up with the concept of a pre-mortem. This is a strategic technique before a project or product launch that involves imagining how it could fail. The exercise is used to uncover approaches to guard against those scenarios.
Military strategy is shaped by the concept of ‘red-team vs blue-team’ where strategists imagine how an opponent will respond to an attack. Those insights are used to create a better plan.
I’ve been thinking about how the AI frenzy could lead to a market bust.
This is not a prediction of an imminent bear market or a call to adjust your portfolio. But a bear market will occur at some point and pretending like it isn’t a possibility is counterproductive.
Call this inversion, a pre-mortem or a ‘red-team vs blue-team’ exercise. It is intended to get you thinking about how a bear market might play out which might help you make better decisions in the future.
Potential trigger for a bear market
The inevitable slowdown in AI spending
The AI infrastructure boom is increasingly intertwined with the global economy. In an illuminating interview former Goldman Sachs investment banker and head of the US Securities and Exchange Commission Gary Gensler described the entire global economy as one giant parlay bet.
Parlay bet leg one: The AI companies including Anthropic and OpenAI and hyperscalers like Microsoft, Alphabet and Meta need to generate enough revenue to make their capital expenditures pay-off.
Parlay bet leg two: The necessity of near term productivity gains to make up for the economic disruption caused by AI.
The size of the spending and the interconnectedness of different parts of the economy are upping the stakes.
According to Moody’s, Microsoft, Alphabet, Meta, Amazon and Oracle have $662 billion of lease commitments to future data centres.
The funding is often providing by data centre suppliers.
According to Bloomberg chipmaker Nvidia has invested $100 billion in OpenAI and $300 billion in Oracle to build data centres. In turn OpenAI and Oracle have committed to buy Nvidia chips.
It is not unusual to invest in new capacity or for companies to give credit to their customers.
What is unusual is the concentrated nature and size of the AI ecosystem. Fund manager Apollo estimates direct AI spending to jump from 1.40% of US GDP to 3% in 2027. This is roughly double the telecom / fibere optic spending during the dotcom bubble.
While significant this doesn’t capture the full impact of the AI buildout. There are jobs associated with creating and managing the infrastructure and the wealth effect on consumer spending from surging markets.
The question and potential trigger for the next bear market is what happens when AI spending plateaus or falls. This slowdown is inevitable after an investment boom and doesn’t require AI to fail as technology.
It could happen because of community opposition to data centres or because revenue is slower to materialize.
It could happen because new AI models require less computing power.
The trigger could be overcapacity or competition creating winners and losers between the hyperscalers.
Every boom throughout history has ended due to one or more of these factors – community backlash, overcapacity, evolving business models, technological improvements and competitive disruption.
Whatever the reason a slowdown will cascade throughout the AI ecosystem. This will impact everything from chipmakers, networking equipment manufacturers, power and cooling companies, electricity providers, and real estate companies.
It won’t take Gensler’s parlay bet to go wrong for a market downturn. Even a slowdown will impact a market trading at a high valuation based on optimistic investor expectations
If either part of Gensler’s bet doesn’t eventuate the market reaction may be pronounced.
Historically severe bear markets often have an initial trigger in the real economy which is subsequently compounded by market structure and investor behaviour. My hypothetical bear market scenario is no different.
A market primed to deepen a downturn
Morningstar’s Mind the Gap study is a fascinating window into investor behaviour.
Mind the Gap annually measures the differences between investment returns and the return the investor receives. The difference comes down to timing decisions. If you sell when the market drops and buy back when it recovers your return will be worse than a buy and hold approach.
The annual headline of the study is investors persistently underperform their investments. In the latest study the underperformance was 1.20% per year.
Digging deeper uncovers some indications that the way people invest today may deepen the next bear market.
One area of concern is the increasing popularity of ETFs. One reason for their popularity is how easy it is to trade ETFs. This allows emotions to play a bigger role in decision making.
The gap between what ETFs returned and what investors earned was 1.60% per year. This outpaces the overall gap of 1.20%. If the market enters a bear market ETFs may make things worse.
The other area of concern is the impact of volatility. More volatility creates a bigger performance gap which is evident in both more volatile periods and more volatile types of investments – stocks vs. bonds for example.
By design gearing increases volatility in investor portfolios. And gearing has impacted markets throughout history.
In the 1929 crash extreme margin lending turned a steep drop into a prolonged bear market. Margin calls forced some investors to sell which triggered more margin calls. The market volatility led to more selling.
Rules around lending are different now but the combination of speculation and debt is alive and well.
In a recent incident hedge fund Situational Awareness suffered a $30 billion collapse after lenders called in loans. The 24-year-old manager of the hedge fund took on 400% gearing to buy AI related shares. He hoped to build a large enough personal fortune to buy a galaxy. I’m serious. A galaxy. You can look it up.
While the Situational Awareness story is interesting - and amusing - I’m more worried about the use of gearing in everyday investor portfolios.
In Australia there is steady growth in the assets in geared ETFs but they still make up a small portion of the overall market.
Overseas gearing is even more popular. In the US geared ETFs have $198 billion in assets. Assets have grown 16% in the last six months and over $45 billion is in single stock geared ETFs.
In some ways geared ETFs are better than traditional margin lending. Investors won’t be forced to sell…but there is reason to believe they will do it anyway.
In the latest Mind the Gap study our researchers looked at single stock geared ETFs. Remarkably over the last three years the investor return didn’t just underperform the geared ETF return – investors underperformed the underlying share returns by 1% per year.
The gearing should have amplified the returns in a rising market. But the poor timing decisions related to volatility outweighed any advantage from gearing.
The point is not that ETFs or geared ETFs are inherently bad. They are just a tool for investors. But ETFs are easier to trade and geared ETFs are designed to amplify volatility. Investors historically have behaved poorly under these conditions.
More gearing can cause more volatility. More volatility often causes poor decision making. The growing popularity of easy to trade ETFs may cause emotion driven selling to lead to a bigger market drop.
Final thoughts
In the run up to the global financial crisis I was not blind to the risks. I saw what was happening in the US housing market and saw it for what it was – a giant speculative bubble.
My mistake was not bothering to contemplate how things would play out with the stock market and my portfolio. I was caught flat footed when things fell apart.
I have no idea if the scenario I’ve outlined will occur. I think it is plausible which is a far cry from certain.
Most investors periodically think in a vague manner about things going wrong. Articulating those fears into a coherent scenario is beneficial in several ways.
Long bull markets can cause compliancy and overconfidence. A pre-mortem can challenge your bullish assumptions and uncover risks you’re ignoring.
You may be buying into the prevailing narrative and falling victim to groupthink. Inversion can challenge widely held expectations and encourage independent thinking.
Contemplating potential scenarios for market drops can help steady your nerves and improve your behaviour if / when a future drop occurs.
The final step is to apply the scenario to your own personal circumstances. What influence does AI spending have on your portfolio? How resilient is your portfolio and can you weather a bear market?
Thinking through these questions today can help you avoid poor decision making driven by emotions.
Share your thoughts and email me at [email protected]
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My cover story for going to the Desaru Coast in Malaysia was to relax on the beach - but I was really there for the sambal. I had it with every meal but this sambal shrimp with fried morning glory from Ambara was a highlight. Slightly caramelised the sauce was spicy, sweet and tangy. The shrimp was mostly a delivery mechanism because eating sambal with a spoon is apparently frowned upon.
