Artificial intelligence represents a transformative technology that is currently reshaping the dynamics of daily life and labour across the globe. Yet AI can also precipitate a market meltdown, a recession – or both. Timing is paramount. Capital is flooding into the AI sector at such a velocity that it is surpassing the capacity to generate returns. This unsustainable mismatch must come into equilibrium, one way or another. The recent collapse of a highly successful AI-focused hedge fund illustrates the inherent risks and rewards associated with the AI boom. Those risks are amplified by the exorbitant costs associated with fostering the AI revolution, as companies rush to acquire state-of-the-art chips and construct data centers that span the dimensions of numerous football fields. “I absolutely believe the technology is transformative. But that doesn’t mean you won’t go through irrational exuberance at some point,” Max Gokhman told. Timing is crucial in determining whether the AI boom will persist or if it will conclude in disappointment akin to previous asset bubbles. Will the substantial investments being allocated to the development of AI yield tangible returns before the patience of Wall Street is exhausted?
Currently, the major players in finance are continuing to invest heavily in AI. Nvidia, the $5 trillion AI infrastructure superstar, has secured $500 billion in financing from Apollo, BlackRock, Goldman Sachs, and other Wall Street firms to support customer orders for its cutting-edge chips. Nvidia CEO Jensen Huang even argued that AI compute – the hardware and software underpinning AI models – is transforming into a “investable class.” It indicates that a significant number of participants in the financial markets continue to have faith in a future propelled by artificial intelligence. Investing in technology has become increasingly complex due to its swift advancements, a burgeoning price war between open and closed AI models, and numerous supply chain constraints. These include challenges related to chip access, local resistance to data centers, and the substantial energy requirements for infrastructure development. Nvidia’s blockbuster deal serves as a reminder of an innovative, and arguably perilous, aspect of the AI boom: circular financing. In circular financing, one entity provides financial resources to another—whether thru a loan, investment, lease, or other forms of financial support—in return for the latter purchasing the former’s products. It is a phenomenon that functions effectively – until it ceases to do so.
During periods of economic expansion, these arrangements can foster a self-reinforcing cycle. However, they can also drive speculative bubbles by generating the perception of swift expansion — and such bubbles ultimately collapse. It evokes negative recollections of the dotcom bubble era, during which certain telecom equipment firms extended credit to clients for the acquisition of their products. “Circular financing will end badly,” Gokhman said. “You are living on not just borrowed time, but levered time.” However, Gokhman expressed his continued faith in the AI boom, asserting that he does not perceive leverage as having reached concerning levels, at least for the time being. Similar to the late 1990s, the current AI boom has enabled certain investors to amass significant wealth, while others face abrupt setbacks. Late last month, Situational Awareness, a relatively obscure hedge fund concentrating on AI investments, collapsed after its highly leveraged positions unravelled. Run by a former OpenAI employe, Situational Awareness was compelled to divest the majority of its portfolio at a significant discount to Citadel. The AI hedge fund continues to show significant gains over the past two years, albeit at a reduced rate compared to earlier performance. Tellingly, Situational Awareness didn’t encounter difficulties due to an incorrect directional stance regarding its conviction that AI is indeed a legitimate force.
The issue arose when the thesis was disrupted by a transient decline in AI stocks – a disruption that was exacerbated by leverage, which amplifies both profits and setbacks. Torsten Slok, chief economist at Apollo Global Management, cautions that the calculations in the AI sector are not yet coherent. The substantial profits at the pinnacle of the AI hierarchy are propelled by investors rather than consumers, he stated. “Capital can bridge the gap for a while, but not indefinitely,” Slok wrote in a report last week. “And therein lies the risk: Will the ROI show up for AI’s end customers fast enough to sustain the spending that is generating those upstream margins?” After analysing profit margins in the S&P 500, Slok found no evidence that AI is enhancing the profitability of sectors such as healthcare, consumer staples, energy, or real estate. However, Jeetu Patel, president and chief product officer at Cisco, stated that it is challenging to compare the AI revolution with the dotcom bubble, as supply was established prior to demand in the late 1990s. Patel, whose company is developing infrastructure to support the burgeoning AI sector, anticipates that AI agents will become mainstream, thereby sustaining the remarkable growth in demand. “The demand is there (today), and supply is massively short on power, data center capacity, compute, memory and network,” Patel told. “We’re in the very, very early infancy.” The stakes are substantial – and not solely for obscure hedge funds speculating on AI equities. The US economy has increasingly depended on AI and its substantial expenditures.
The remarkable increases in the valuations of Nvidia, Micron, Alphabet, and various other AI-related stocks have significantly enhanced the net worth of millions of Americans, bolstering the value of their retirement savings, college funds, and investment accounts. “Without the AI boom, we probably would be in a recession,” economist David Rosenberg said. Timing is crucial in periods of economic expansion and contraction. As economist John Maynard Keynes famously stated: “The market can remain irrational longer than you can remain insolvent.” Consider the events surrounding Julian Robertson, the renowned hedge fund investor. In the late 1990s, Robertson accurately recognised the significant dotcom bubble. However, his positions against overvalued technology stocks proved detrimental as the Nasdaq continued its upward trajectory. Robertson ultimately closed his Tiger Management hedge fund in March 2000, coinciding with the onset of what would evolve into a significant decline in the Nasdaq. “Just because you think things are frothy doesn’t mean it’s time to get out,” Franklin Templeton’s Gokhman said. “The best returns occur when the party is about to end.”
