The AI/Crypto/Everything Bubble
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Each crypto bull cycle has brought exponential growth, both in terms of value creation and the growing number of people who believe they are part of a financial/technological revolution.
Crypto found itself in direct competition with AI to achieve these same bull market hallmarks this cycle and has simply failed to keep pace, depressing industry sentiment despite seemingly high dollar-denominated crypto prices.
Unfortunately, while AI has almost single-handedly catapulted stock indexes to new all-time highs, troubling warnings continue to suggest that markets are ensnared in an unprecedented bubble, with recent indications supporting the notion that it has begun to burst.
Crypto sentiment may already be extremely pessimistic, but that doesn’t mean the outlook won’t get worse from here 👇
Crypto's Narrative Slowdown
Crypto assets are desirable to hold in large part because of their past performance.
To promote its IBIT spot BTC ETF to potential buyers this January, BlackRock publicized that BTC had been the undisputed best-performing asset of the past decade, providing annualized returns 10x higher than those of stock market indexes and rewarding those who had held since 2013 with mind-shattering 315,678% gains!
Blackrock is putting out charts showing Bitcoin is the best performing asset in the last decade pic.twitter.com/z7pORcY0j1
— gaut (@0xgaut) January 11, 2024
Ethereum surged over 5,000% in the first 6 months of 2017 alone, compounding that to a 17,500% return by January of 2018 before the bottom fell out of the ICO market and the crypto industry vanished from mainstream relevance for the next 2 years.
During 2020, a non-trivial portion of monetary stimulus intended to combat COVID contraction was funneled into crypto assets, causing valuations to balloon. Simultaneously, the inflation that unsurprisingly followed in 2021 as economies reopened increased the attractiveness of decentralized cryptocurrencies as instruments to opt out of fiat debasement.
Although crypto assets are yet again managing to outperform many alternative investment categories on a percentage basis this cycle, the industry has found itself playing second fiddle to a new investment category that claims it can revolutionize humanity: AI.
While the broad market S&P 500 (SPX) and tech-heavy Nasdaq 100 (NDQ) are pushing practically unabated to new all-time highs, Bitcoin topped out over four months ago on March 13. Since then, crypto markets have failed to provide superior returns over stocks; even smallscap stocks (RTY) and the equal-weighted S&P 500 (RSP), considered to be major index laggers in 2024, have consistently outperformed BTC!
Mainstream investors flocked to crypto assets as a bastion of superior return in cycles past, but in 2024, the industry has failed to deliver on these promises despite continuing to exhibit wild price fluctuations, or high levels of volatility.
Herein lies the problem: increased volatility conveys a higher degree of underlying investment risk, and investors expect to receive boosted returns as compensation for this marginal risk. While BTC and Nvidia experience similar amounts of volatility, the former has underperformed by 100% this year.
Although crypto’s nascency in cycles past allowed it to achieve incredible gains despite failing to accomplish meaningful adoption, the industry appears to have achieved critical mass and must catalyze real-world usage to explode higher.
Bitcoin supporters have long extolled its primary use case as a store of value, yet amid fears of escalating Middle Eastern conflict this April, BTC tanked 15% as onchain investors repudiated internet money in favor of “tangible” tokenized gold at up to a 40% premium!
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Instead of a store of value with the potential to replace gold, BTC behaves as a “Veblen good,” or an item for which demand increases as price increases.
Plotting the relative valuation of BTC/SPX against BTC reveals an extremely strong positive correlation (i.e., they’re basically the same chart) that has persisted since BTC’s inception, indicating that buyers only want BTC during periods of relative strength when they believe they can sell to someone else at a higher price.
With BTC now underperforming AI stocks that provide comparable levels of risk, the likelihood that holders can profit has come increasingly into question.
A Tough Road Ahead
Actually usable blockchains like Ethereum and Solana aim to foster an ecosystem of next-generation finance onchain.
But, in my opinion, smart contract platforms haven't seen the same leaps this cycle, and what consumer-facing high-visibility innovations there have been have centered on ponzinomic points system mechanisms and tools for inciting memecoin mania via extractive celebrity scams. It all just doesn't feel the same.
Blockchains offer undeniable advantages over traditional financial systems, such as increased transaction speed and innovative composability, but usage of crypto for tokenization and payments has failed to gain adoption beyond black market contexts, namely for stablecoin payments in jurisdictions like Argentina, where many forms of U.S. dollar transactions are banned.
Even though reputable asset managers like BlackRock and Franklin Templeton offer tokenized US Treasury products, the real-world asset sector remains a rounding error in comparison to the hundreds of trillions of dollars in global wealth standing ready to be tokenized. Just last week, leading multinational investment bank Goldman Sachs unveiled its intentions to delve deeper into tokenization during 2024; this announcement came with the crucial caveat that GS will only operate on private blockchains.
Crypto should be applauded for striving to preserve anonymity and privacy, but such a model is unworkable for the broad majority of financial system participants and comes in clear conflict with nation state desires to have insight into these systems to prevent crime.
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The merits of blockchain may be obvious, but that does not ordain permissionless blockchains as victors over a “traditional” financial system keen to emulate their benefits.
Although impossible to ignore that hostile regulation has encumbered crypto and noticeable that global leaders are beginning to take more pro-digital asset stances, particularly in the United States where the only thing rising faster than AI stocks has been an ostensibly pro-crypto Donald Trump’s polling numbers, it is alarming that the majority of crypto use cases have failed to receive free market adoption.
With crypto assets now an empirically poor investment on a risk-adjusted basis and the industry having failed to gain meaningful traction for existing use cases that could actually incite adoption, it is unsurprising to see the industry’s long-term value proposition increasingly called into question.
🛩️ Economic Turbulence Ahead
If crypto is unable to satiate our innate human desire to get rich quick, at least we can always fall back on AI stocks! 🚀 Right?
Artificial intelligence has supplanted crypto as the one asset class investors must have in their portfolios, and whether you know it or not, your exposure to the sector is likely enormous thanks to the prominence of market cap weighted stock indexes that programmatically allocate increased exposure to their best performing components.
While explosive growth in demand for compute fueled a capital expenditure cycle that greased the wheels of production and launched AI stocks into the stratosphere, recent moves in stocks are indicating that this bubble just burst.
Revealing the immense distortions currently present in markets, on July 5, the percentage of S&P 500 stocks underperforming the index over a rolling 21-day period hit the highest level in history following weeks of outperformance from its tech-heavy AI leaders.
Fates reversed last Thursday, July 11, when the paradigm seemingly shifted and investors identified a new leader, rotating out of mega cap tech with vigor into previously underperforming small caps.
Small caps outperformed Large caps by 4.5% today, a 6 standard deviation event and the 2nd biggest outperformance on record (trailing only the 10 sigma differential on October 10, 2008). $IWM $SPY
— Charlie Bilello (@charliebilello) July 12, 2024
Chart of the Day: https://t.co/7ELaBkErm6 pic.twitter.com/HLmVmqQusj
Although AI stocks have generated tremendous revenue and demonstrate high growth potential, the Cambrian explosion of AI utilization will need to continue at an unprecedented rate indefinitely to justify these valuations going forward, and eventually, the companies purchasing hundreds of billions of dollars in hardware driving this bubble will actually need to turn a profit.
While there are no doubts that AI is valuable and can revolutionize productivity over time, looming concerns remain that investors have priced in unsustainable levels of growth for related stocks that will not be achieved at steady state until multiple decades in the future, just as they did during the dotcom bubble.
To highlight the absurdity of the current stock market bubble, the Buffet Indicator – the favored value metric of legendary investor Warren Buffet that compares America’s stock market capitalization to GDP – recently reached a modern-era high of 195%.
Assuming moderate 15% market capitalization gains for the three largest stocks (Apple, Microsoft, and Nvidia) and above-trend GDP growth of 3%, the value of these stocks alone will equate to 107% of US GDP in 10 years, leaving little room for investment into any other assets.
John Neff’s Q2:2024 letter from Akre 🔥🔥🔥
— John Rotonti Jr (@JRogrow) July 11, 2024
“Satisfying these conditions would require the respective market capitalizations of Apple, Microsoft, and Nvidia to grow from nearly 12% of GDP today to nearly 36% by 2034. Combined…would then equate to 107% of US GDP.” pic.twitter.com/35YaB66ByK
It remains an unanswered question as to how far exalted tech valuations will plunge once the AI supply shock dissipates and customers come to understand they have overestimated the demand for AI services, but considering last week’s historic rotation out of AI-associated plays, the sector’s glory days could finally be over.
Inflated asset valuations have helped to increase perceived wealth, allowing individuals to spend more freely, but stock market retracement risks collapsing a global economy already on the fritz.
U.S. consumer inflation as measured by CPI slipped into “deflation” territory in June on a month-to-month basis, the index’s first negative print since peak COVID in May 2020, meanwhile, PPI accelerated during the same period, a trend indicating producers are slashing prices to appeal to struggling consumers that is likely to weigh on profitability.
Although the greatest perceived risk for many market participants has been whether the Federal Reserve will shift benchmark policy rates a meaningless fraction of a percentage, it is not difficult to anticipate fundamental downside for a stock market priced to perfection as earnings begin to trend increasingly negative.
What if rising odds of a Fed rate cut aren't actually bullish because they could happen within the context of both a slowdown in the economy and disinflation, both of which could erode revenue and earnings? Something to consider. Certainly the bond market appears to be seeing it. pic.twitter.com/CYEO2AoKAu
— Markets & Mayhem 🤖 (@Mayhem4Markets) July 12, 2024
Full-time employment is free falling on a year-over-year basis, and increasing unemployment has triggered the “Sahm Rule,” a lagging indicator that has accurately predicted every recession since 1950 with only one false positive.
While there would certainly be power in the ability to control the price of money itself, it is unclear how much power central banks can exert on the economy through artificially manipulating interest rates, which are largely priced at a combination of future growth and inflation expectations due to their “risk-free” return status.
To combat economic decline in China, central bankers have perversely restored to shorting government bonds to push capital into the real economy, a course of action that will increase interest rates in the short term and runs contrary to Western thought that lower interest rates provide stimulus.
Rate cuts may be imminent, but this proclaimed silver bullet appears unlikely to be potent enough to kickstart sustained resurgence for global economies and markets trending towards contraction, just as they’ve failed in cycles past.
i get tired of hearing about how the Fed is waiting too long to cut. Look at this chart. If this is restrictive, the die is already cast. The markets and economy have stage IV liver cancer. Put your affairs in order. pic.twitter.com/nS5suoJhrs
— Dave Collum (@DavidBCollum) July 11, 2024