A fire can spread and jump around in unpredictable ways in a forest conflagrations. Contagions are equally unpredictable. Extreme sentiment can jump among fundamentally unrelated assets and introduce unexpected relationships.
We are seeing that now with the latest speculative activity in AI, tech, and crypto. Just to be clear, this relationship has developed largely in 2024. The buyers of these assets were much more measured and independent in 2023.
Let’s start with the AI theme. AI leaders include popular semiconductors names (SMCI, AMD, Nvidia) and other companies. I discussed the AI complex here.
AI dropped two Fridays back. And continued to stall from last week to today.
Going forward the move is probably not higher. But it is hard to predict if the prices consolidate or pullback further. What is certain is that sentiment was at an extreme. In my opinion it still is frothy as buyers in March pile into options over shares for short term gains. Remember when betting with options, the option bettor is gambling with time as options have an expiration. Investors only use stocks.
That AI is driving the Nasdaq which has been widely observed. But those speculating on large Nasdaq moves (again driven mainly by AI) may actually be making a bet on crypto.
Since COVID, crypto has had a strong correlation with the QQQs (orange line below is crypto and blue is a highly levered NASDAQ product). Causality in the short term is hard to pinpoint. Meaning it is hard to determine which is pulling the other and in exactly what timeframe. But for many years now they have risen together.
In the beginning of the year crypto and AI flew higher together. Now after the AI stall last week, crypto has been stalling/dropping this weekend.
AI and crypto are driven by the same hot money population who now have a bag of leveraged products to make bets. The same hot money population bought everything on the way up and now a flush down in one area will result in a contagion into the other as degens, gamblers, and speculators sell to raise cash from falling hot assets. The ways to make speculative bets continue to grow. We have the rise of options generally, the rise 0DTE options, crypto futures, and margin trading for both crypto and stocks in traditional accounts.
Everyone’s Casino
This is neither good or bad. The investing game keeps changing and this is just another feature of investing today. This easy access to speculation and these mini short term manias are here to stay. Buffet saw as much when he wrote this his annual letter.
“For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young,” Buffett wrote in the letter. “The casino now resides in many homes and daily tempts the occupants.”
I personally have played a tiny part in the speculative fever in both assets. I have used only a small portion of my portfolio to ride the wave. It is fun and opportunistic but it is not where I would place a large bulk of wealth assets. And unless you very skilled in the art of speculation within a specific asset class, it is a very dangerous casino to risk a future nest egg.
Speculation is its own asset class now and its own hive mind now. Speculation is for everyone now. The flames of speculation jump around in today’s financial forest.
But the other point in all of this is that this staying and probably expanding access. Today it is crypto, AI, and a few other things. Tomorrow it could be another sector, country, or theme that captures speculators fascinations. Speculation is its own asset class and its own hive mind now. Speculation is for everyone now. The flames of speculation jump around in today’s financial forest. Access is easy, vehicles of speculation abound, and the world is hyperconnected. For example, never before could millions of small time speculators from Asia join into manias starting in the US and spread the speculator frenzy to other parts of the world.
To keep things simple this piece has focused on crypto and AI with an emphasis on semiconductors and major crypto currencies. But the speculative domain is much bigger. In the crypto space there are smaller cryptocurrencies called meme coins, digital images on sales for millions, and a dozen or so publicly listed stocks that operate in the crypto space (Coinbase, Microstrategy, Riot, Marathon Digital Holdings). Some of these names were up 100%-400% at different points this year. The AI frenzy includes other names like Palantir, IBM, and Dell.
A Word About Crypto in Portfolios
Although this article discusses crypto and speculation, it is not to say crypto is speculation. Only the run up in crypto over the last few months has had a distinctive speculative flavor. Crypto is now here to stay and expanding into portfolios. On Jan 10th, the SEC approved crypto ETFs and responsible investors are exploring cryptocurrencies and digital assets now. Part of the speculation is driven by the next Bitcoin halving event which reduce supply of crypto. After the SEC approval, investors have jumped into crypto before the supply shrinks further.
AI - Myth vs Reality
A quick aside. Is AI useful?
AI hype is getting a rethink. It is just not as useful for final production ready copy as everyone thinks. Every slight change in style or the world needs a ton of training data. No AI machine will keep with the incessant daily changes and developments in the human experience. AI as an assistant for repetitive work will find a home, AI as a replacement for creativity and usable value is clearly a dying reality.
I am was speaking with a copywriting executive and they highlighted that their clients are now explicitly disallowing the use of AI in copywriting. A popular programmer highlighted that AI is unreliable for coding. It seems more useful to teach coding basics than to make a finished product. But it is more popular to lie and celebrate AI’s magic.
AI as an assistant or guide with a half capable user is a now working model with Khan’s academy Khanmigo. Sal Khan sensed Open AI’s flaw was that it was designed for subservience: “which makes a lot of sense when you have cutting-edge tech, and you don’t want to freak out your users. But in an educational context, second-guessing humans is kind of the point.” Khanmigo was carefully designed to prevent AI hallucinations and biased users breaking the AI. Read the article for the specifics or try it out yourself: https://www.khanmigo.ai/
AI not Inflation Is Moving Market Segments
Now back to our market analysis.
Last week we had these inflation numbers (consumer and producer) and the market barely budged as it awaits the Fed meeting today.
Consumer: CPI came in hotter than expected last week. CPI y/y came in at 3.2% vs 3.1% expected; CPI m/m was 0.4% vs 0.4% expected; core CPI y/y was 3.8% vs 3.7% expected; core CPI m/m was 0.4% vs 0.3% expected.
Producer: PPI also came in much hotter than expected. PPI y/y printing 1.6% vs 1.2% expected; PPI m/m was 0.6% vs 0.3% expected; core PPI y/y was 2.0% vs 1.9% expected; core PPI m/m was 0.3% vs 0.2% expected. A large part of the PPI increase was energy as oil prices jumped.
Fed rate cut probabilities keep dropping and getting pushed further out as a result. As a result, different indices had different responses. The less speculative SP500 and Dow Jones were mostly unchanged for the week. The Russell 2000 was down over 2% as small caps are most sensitive to high interest rates.
But the large cap Nasdaq was down almost 1.5% as the AI rally stumbled along with crypto.
So where do we invest if this area is burning out?
Assets That Won’t Burn
Today's FOMC (The Fed) decision is expected to project rate cuts getting pushed to May or maybe even June. The traders are gradually lowering their expectations of # of rate cuts in 2024 (now they think between two or three). How will the speculative ends of the market handle this? Investments in higher quality/profitable firms could see more demand. With the leading company stocks at high valuations but the rest of the market is fairly priced, we could see a continued rotation into midcap.
Indeed this is what happening over the last 2 weeks
There was a stealth rally in energy last week. Up 3.48%! The pundits and headlines have seemed to miss that energy is crushing the Nasdaq.
As of last Friday, the Nasdaq is up 6% while energy is up 9.21% this year. The headlines have also missed the outperformance of midcap growth with a 11% YTD return. Investors are chasing growth at a lower price as midcaps have lower P/Es versus megacap. The MSCI Quality ETF (QUAL) is up 10.51% as higher quality companies are getting a relative bid – this ETF does include some of the leading MAG 7 stocks.
Let’s see what performs post FOMC. We are shifting to a new regime and whatever outperforms post FOMC may be winners for the rest of 2024.
If you have any questions, leave a comment. Thanks for reading Embrace the Chaos! Sharing perspective that makes sense.
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- Vikas Kalra, CFA
I love reading your letters full of knowledge..