The Emergence of Convergence
The Emergence of Convergence
If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck – The Duck Test
For the past six months, the stock market has traded in a tight range where sell-offs mysteriously lead to short-squeezes before they can pick up momentum. I’ve been observing this sequence since the end of 2009 leading me to opine that it represents present-day industrial policy.
People seem shocked that their short positions have been reversed even as consumers weaken, private credit festers, war in the Middle East, and AI data centers become worthless. The rally since 2009 has been built on a combination of short-squeeze, belief the market can’t drop, stock buybacks, and now, wishful thinking about AI. It's not going to last forever.
But it can continue because long ago, it ceased to be a discounting mechanism of forward cashflow. There is far too much passive money in the market combined with information asymmetry that favors efforts to maintain upward momentum in the equity markets. Like it or not, it’s today’s reality and it’s why efforts to profit from a market decline have been failing for 17 years.
The government is one step ahead of the market. Risk-free rates go to 0%, insurance companies need to invest premiums, so they get forced into the riskiest part of their universe – private credit. Banks got slapped in 2008 so the risky credits left their books and went into asset managers such as Blue Owl, KKR, Blackstone, and others. Now, 17% of bank lending is to these asset managers. The same crap is being funded by banks only with a middle-man to make it appear proper.
Home Loan Banks
Never before in modern times has so much of the world been simultaneously hit by a confluence of economic and financial turmoil such as we are now living through – Timoth Geithner
In 1999, a change was made to what Federal Home Loan Banks could own in their portfolios. Historically, they were set up to buy residential mortgages like the name implies but in 1999, they started funding small business loans and small farm loans. Private credit represents loans to smaller businesses.
We can see from the chart how this segment of the market has been inflated, guaranteeing strong demand from insurance companies and asset managers that fund this market.
The difference between private credit and public credit is that private credit doesn’t have readily available market prices. As such, prices are imputed for valuation purposes which allows for a ton of latitude and makes it poor collateral. By the time these credits get marked down, the damage is already done – like what’s happening today in funds that buy this paper.
Think of the Home Loan Banks as a repo market with asymmetric knowledge of valuations – it’s perfect for graft. Still more, the Home Loan Banks are perfect suppliers of capital in repo market during crises because credits only get denied if government administrators pull the plug. In my opinion, this is the reason why the market for private credit hasn’t collapsed and won’t collapse until creditors stop paying on these loans – when it’s too late.
Yes, asset managers are gating those funds that contain this garbage to prevent withdrawal but that buys them time to get out of position without wholesale liquidation. Contagions start when liquidity dries up completely so as Home Loan Banks continue to accept private credit as collateral, this cancer is unlikely to spread beyond retail funds.
What’s the second derivative of a collapse in the value of these risky loans? Without a massive government bailout, the Home Loan Banks won’t be able to fund residential real estate and supply a secondary market for credit unions and savings banks. Without a massive government bailout, housing prices will tank because they won’t be able to get funded.
The elite isn’t leading anymore. It’s trapped – David Frum
Why is Meta slashing 20% of its workforce to fund its data center strategy? Is it because the strategy is a winner? Or is it because their valuations will collapse, along with the rest of the AI universe, if they don’t keep funding it?
It should be clear by now that the data center model is broken for the simple reason that it’s impossible to supply the extraordinary electrical needs of these electricity hogs. The Stargate Abilene mega-data center needs 10 gigawatts, equivalent to the power output of 10 nuclear power plants. And they need this power in the next two years…
The data center model represents science fiction fantasy and it’s not happening. It also requires a market for its output that hasn’t materialized. The only way the data center model succeeds is if the US government funds this extraordinary build-out with the express intent of instituting an Orwellian control mechanism over the US population. These systems excel at tracking people but little else.
Without embracing the absurdity of science fiction fantasy, it’s clear that the AI bubble is going to burst later this year because there are no revenues to service the debt. For now, I believe we’re going to watch the major tech companies like Meta, Microsoft, Google, Amazon, and Tesla supply the credit from their operating cash flow to keep the bubble inflated.
The second derivative of getting squeezed for cash flow is that competitors are going to de-throne these insanely powerful entities. We can already see it with Microsoft where people hate Windows 11 and where laptop companies are increasingly offering Linux as standard operating software. Google is losing share of the search market and with it, pricing power on advertising. Meta is cutting software developers and will fall behind on product improvements. Everyone will cut into Amazon’s Wholesale market and Tesla just cut two premium models from their line-up.
A secondary consideration is if these data centers are not going live, how many Nvidia chips and how much memory is sitting in inventory waiting to be deployed? Will we ultimately experience a deluge of chips and memory once the liquidation phase begins in earnest? Something to ponder…
The Prisoner’s Dilemma
The hazards of the generalized prisoner’s dilemma are removed by the match between the right and the good – John Rawls
Somebody is going to jump ship in the consortium of companies keeping the AI bubble alive. The Mag 7 are all extremely overvalued and now, they need to borrow in the debt markets to buyback shares – if at all. The pressure to jump ship is growing and the CEO’s of these companies are NOT virtuous creatures.
Jensen Huang is perhaps the worst amongst them because he’s the CEO who benefited most from this insanity. Nvidia is like a commercial airplane cruising at 20,000 feet that needs to maintain a minimum amount of speed to keep from falling out of the sky like the mythical Icarus, son of Daedalus. Daedelus was the Greek mythological figure who crafted wings of feathers and wax to escape the labyrinth in Crete. He warned Icarus against flying too close to the sun to prevent the wax from melting. Icarus ignored him and crashed into the sea. Since antiquity, Icarus has been the warning against flying too high.
We’re at August 2025 levels and with a $4.5 trillion market cap, Nvidia’s ultimate crash will not only destroy the company, they’ll destroy the value of the S&P500 and Nasdaq indexes. The second derivative of an AI bubble crash is a stock market crash because the top tech companies are ALL-IN. When they run out of cash flow and/or employees to cut, it’s game over for these over-valued companies and the wealth-effect they have created in the US economy.
The problem is in trying to front-run this crash because it’s extremely profitable for the parasitic elements of the equity markets. Not only can options-writers benefit from wide premiums on puts, there is the aforementioned coordinated buyers that have proven remarkably consistent over the past 17 years.
Corporate management is highly dependent on the value of their stock. As long as their stocks remain elevated, the Prisoner’s Dilemma can be held at bay but rats jump from sinking ships. These people are neither patriots nor statesmen.
Oil – Double Trouble
Better never trouble trouble until trouble troubles you; for you only make your trouble double when you do – Robert D. Keppel
The Fed should be slashing interest rates aggressively but the rise in the price of oil allows them a reason to drag their collective feet. It’s an interesting question – kind of like what comes first the chicken or the egg? Does higher oil prices create inflation? Or do higher oil prices act like an interest rate increase?
My position is in the latter camp where I see people forced to pare back on consumption to accommodate higher gas prices. Companies that are forced to raise prices to accommodate higher gas prices usually experience a decline in demand for their products/services unless the government is putting money in their pockets like in 2022.
On a net basis, this government is taking money out of people’s pockets as compared to 2022 through January 2024 because immigrants had been showered with all kinds of benefits until those policies were reversed. That extra money moved through our economy and as such, it led to higher demand for goods and services, all things considered.
Higher oil prices are hurting the US consumer economy just as higher interest rates are hurting the US consumer economy. People are fixated on inflation but they should be focused on deflation because at the margin, it’s going to be more difficult to pay for food, insurance, mortgages, and property taxes. The pressure is building; Jay Powell is fiddling while our economy burns.
Just like private credit and AI, things are largely under control today even as the underlying stress on the system continues to build. This is why I acknowledge the stress but I don’t expect it to create the type of contagion that typified Y2K and 2008 just yet. The pressure is merely building for now. The biggest risk is when these pressures converge later this year along with all of the global pressures that are building.
Conclusion
I am a firm believer in the people. If given the truth, they can be depended upon to meet any national crisis. The great point is to bring them the real facts – Abraham Lincoln
The US has oil and therefore, it is in comparably good shape. Europe and Asia aren’t as lucky. This is where I expect the global problems to start in Europe and Asia later this year.
I have only touched on a fraction of the problems facing the US in the above piece. There are many more but unlike Europe and China, there is an emerging growth story that is still in its embryonic state where re-industrialization reverses some of the damage.
Western Europe, particularly the UK, France, and Germany, is going to be destroyed economically, financially, and probably socially. I’ll touch upon this in the next piece.
As things pertain to the US, the problems are largely under control or at least enough where they are not overwhelming the markets. As stated above, this is temporary but while it lasts, investors can make money. It’s probably best to avoid stocks that are significant parts of major indexes apart from short term trades. The indexes are heavily levered to AI and will be like roach motels when the AI bubble bursts.
The wealth management industry has been putting client money into models and indexes for a few decades. We believe that money is trapped and will prove impossible to access when things get difficult. When everyone owns Nvidia and Microsoft directly or indirectly and short-sellers have been hunted to extinction, there is nobody to sell to when a contagion starts.
Another downside to hunting short-sellers to extinction is that there is nobody to apply the brakes to fanciful ideas that break the laws of physics and economics. If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA