Cracks in the AI and Private Credit Bubbles?
For good reason, it feels that the only major discussion in markets is whether AI is in a bubble or whether it’s actually the early innings of a revolutionary phrase.
So here’s another one, decidedly from the pessimistic camp. It’s a take from independent research firm the MacroStrategy Partnership, which advises 220 institutional clients, in a note written by analysts including Julien Garran, who previously led UBS’s commodities strategy team.
Let’s start with the boldest claim first — it’s that AI is not just in a bubble, but one 17 times the size of the dot-com bubble, and even four times bigger than the 2008 global real-estate bubble.
And to get that number, you have to go back to 19th-century Swedish economist Knut Wicksell. Wicksell’s insight was that capital was efficiently allocated when the cost of debt to the average corporate borrower was 2 percentage points above nominal GDP. Only now is that positive, after a decade of Fed quantitative easing pushed corporate bond spreads low.Garran then calculates the Wicksellian deficit, which to be clear includes not only artificial-intelligence spending but also housing and office real estate, NFTs and venture capital. That’s how you get this chart on misallocation — a lot of variables, but think of it as the misallocated portion of gross domestic product fueled by artificially low interest rates.
But Garran also took aim at large language models themselves. For instance, he highlights one study showing that the task-completion rate at a software company ranged from 1.5% to 34%, and even for the tasks that were completed 34%, that level of completion could not be consistently reached. Another chart, previously circulated by Apollo economist Torsten Slok based on Commerce Department data, showed the AI adoption rate at big companies now on the decline. He also showed some of his real-world tests, like asking an image maker to create a chessboard one move before white wins, which it didn’t come close to achieving.
LLMs, he argues, already are at the scaling limits. “We don’t know exactly when LLMs might hit diminishing returns hard, because we don’t have a measure of the statistical complexity of language. To find out whether we have hit a wall we have to watch the LLM developers. If they release a model that cost 10x more, likely using 20x more compute than the previous one, and it’s not much better than what’s out there, then we’ve hit a wall,” he says.
And that’s what has happened: ChatGPT-3 cost $50 million, ChatGPT-4 cost $500 million and ChatGPT-5, costing $5 billion, was delayed and when released wasn’t noticeably better than the last version. It’s also easy for competitors to catch up.
“So, in summary; you can’t create an app with commercial value as it is either generic (games etc), which won’t sell, or it is regurgitated public domain (homework), or it is subject to copyright. It’s hard to advertise effectively, LLMs cost an exponentially larger amount to train each generation, with a rapidly diminishing gain in accuracy. There’s no moat on a model, so there’s little pricing power. And the people who use LLMs the most are using them to access compute that costs the developer more to provide than their monthly subscriptions,” he says.
His conclusion is very stark: not just that an economy already at stall speed will fall into recession as both the data-center and wealth effects plateau, but that they’ll reverse, just as they did in the dot-com bubble in 2001.
“The danger is not only that this pushes us into a zone 4 deflationary bust on our investment clock, but that it also makes it hard for the Fed and the Trump administration to stimulate the economy out of it. This means a much longer effort at reflation, a bit like what we saw in the early 1990s, after the S&L crisis, and likely special measures as well, as the Trump administration seeks to devalue the US$ in an effort to onshore jobs,” he says.
The firm’s investment recommendations are to be overweight resources and emerging markets — India and Vietnam in particular — and underweight the AI and platform companies. They also recommend being long gold equities (GDX), long short-dated U.S. Treasurys, long volatility (VIX) and long the yen vs. most currencies outside of the U.S. dollar.
Robert Smith and Harriet Agnew of the Financial Times also report Jim Chanos slams ‘magical machine’ of private credit after First Brands collapse:
Jim Chanos, one of Wall Street’s best-known short sellers, has sounded the alarm on the private debt boom, telling the Financial Times that First Brands Group’s chaotic bankruptcy could augur a wave of corporate collapses.
Some of the biggest names on Wall Street are facing the prospect of multibillion-dollar losses from the bankruptcy of First Brands, a heavily indebted maker of spark plugs and windscreen wipers based in Ohio.
First Brands has now disclosed almost $12bn in debt and off-balance sheet financing built up in the years before its Sunday bankruptcy filing, which also ensnared less well-known private lenders such as a Utah-based leasing specialist.
“I suspect we’re going to see more of these things, like First Brands and others, when the cycle ultimately reverses,” Chanos told the Financial Times, “particularly as private credit has put another layer between the actual lenders and the borrowers.”
Chanos, 67, cemented his reputation shorting energy trader Enron, which like First Brands made substantial use of off-balance sheet financing and whose $70bn collapse heralded the onset of the 2001 stock market crash.
He announced in 2023 that he was closing his main hedge funds after more than three decades, while continuing to offer bespoke advice on fundamental short ideas as well as some macro insights.
In a 2020 Lunch with the FT interview, Chanos said financial markets were in “the golden age of fraud”. On Thursday he said this phenomenon had “done nothing but gallop even higher” since he made the remark.
First Brands has not been accused of fraud. However, a bankruptcy probe into its byzantine off-balance sheet financing is examining whether the company pledged the same invoices multiple times. This investigation has also uncovered that debt collateral may have been “commingled”.
The FT has previously reported that the group’s founder and owner, low-profile businessman Patrick James, was previously sued by two lenders that alleged that fraudulent conduct had exacerbated their losses.
James strongly denied the allegations of fraud in the two cases, which were both dismissed after settlements were reached.
First Brands and James did not respond to a request for comment.
Chanos likened the near $2tn private credit apparatus fuelling Wall Street’s lending boom to the packaging up of subprime mortgages that preceded the 2008 financial crisis, due to the “layers of people in between the source of the money and the use of the money”.
Privately owned First Brands’ eschewed the more public bond market in favour of borrowing money through so-called leveraged loans. It also raised billions of dollars through even more opaque financing backed by its invoices and inventory, which was often provided through private credit funds.
“With the advent of private credit . . . institutions [are] putting money into this magical machine that gives you equity rates of return for senior debt exposure,” he said, adding that these high yields for seemingly safe investments “should be the first red flag”.
The FT has previously reported that some private credit fund managers had estimated returns in excess of 50 per cent on First Brands’ supposedly secured inventory debt.
Even many of the most sophisticated credit specialists on Wall Street were until recently unaware of the existence of the US auto parts maker’s special purpose entities (SPEs) backing its inventory financing.
Traders at Goldman Sachs told clients hours before these financing vehicles separately filed for bankruptcy last week that they just had discovered indications of high-cost borrowing from these entities that were “hard to reconcile”.
Chanos said: “We rarely get to see how the sausage is made.”
First Brands’ bankruptcy has revealed that James controlled both the auto parts conglomerate and some of its off-balance sheet SPEs through the same chain of limited liability corporations. Chanos described this common ownership as a “huge red flag”.
His short thesis against Enron was fuelled in part by the realisation that executives at the group were managing SPEs that engaged in complex transactions outside the purview of its corporate balance sheet. In contrast to Enron, First Brands’ financial statements were not publicly available. While hundreds of managers of so-called collateralised loan obligations had access to its financial disclosure, they had to consent to non-disclosure agreements to receive the documents.
“The opaqueness is part of the process,” Chanos said. “That’s a feature not a bug.”
Sean Conlon and Pia Singh of CNBC also report it was another another solid week for the S&P 500 even if Friday's rally fizzled:
The S&P 500 retreated from a record on Friday but held on to solid weekly gains despite a U.S. government shutdown dragging on for a third day.
The broad market index closed little changed, ticking up just 0.01% at 6,715.79, while the Nasdaq Composite declined 0.28% to settle at 22,780.51. The Dow Jones Industrial Average outperformed, trading higher by 238.56 points, or 0.51%, to finish at 46,758.28. The Russell 2000 also popped 0.72% to close at 2,476.18. All four benchmarks had hit all-time highs earlier in the session.
Stocks were knocked down a bit in afternoon trading by declines in key technology names like Palantir Technologies, Tesla and Nvidia. Palantir led the S&P 500′s pullback, falling 7.5%, while Tesla and Nvidia dropped more than 1% and almost 1%, respectively. The CBOE Volatility Index spiked, signaling some investors were scrambling to buy some protection against a future S&P 500 decline in the form of put contracts.
Still, the three leading indexes saw a positive weekly finish. The broad market S&P 500 rose around 1.1% on the week, along with the 30-stock Dow, while the tech-heavy Nasdaq increased 1.3%. The small-cap Russell has jumped nearly 2% in the period.
Investors have been overlooking anxieties surrounding the government shutdown, which entered its third day Friday. While the stoppage has exacerbated underlying concerns this year about macroeconomic and policy headwinds, inflation risks and a slowing labor market, investors expect it to be short-lived, thereby limiting potential hits to the U.S. economy. Those on Wall Street also believe that the shutdown won’t stop the momentum in the artificial intelligence trade. Shutdowns have not been market-moving events in the past.
The shutdown has led to an economic data blackout, and the Labor Department’s pause on virtually all activity has blocked the Friday release of the September nonfarm payrolls report. Although that removes a factor that could lend pressure to stocks, it lessens the amount of economic data the Federal Reserve can take into account for its interest rate decision at its October meeting. Markets largely expect the central bank will lower its key interest rate by a quarter percentage point then, per the CME FedWatch tool.
Adding to ongoing concerns regarding the jobs market, President Donald Trump has threatened massive layoffs and said Thursday that the Democrats have given him an “unprecedented opportunity” to cut federal agencies. Treasury Secretary Scott Bessent also told CNBC Thursday that the current lapse in federal funding could lead to “a hit to the GDP, a hit to growth and a hit to working America.” The Congressional Budget Office estimates 750,000 federal workers will be furloughed each day.
Their remarks come a day after private payrolls posted their biggest decline since March 2023 in September, according to ADP. Wednesday’s report serves as yet another sign that the labor market is weakening, and some believe that the state of the labor market combined with the shutdown bolster the case for the Fed to cut.
“We view September’s mixed, private-sourced substitutes for the Labor Department’s delayed jobs report as soft enough to justify another interest-rate cut by the Federal Reserve at the October 29 FOMC meeting,” said Jennifer Timmerman, senior investment strategy analyst at Wells Fargo Investment Institute. “Prospects for further rate cutting by the Fed, reinforced by the yellow flag for the economy raised by the latest jobs data, has cemented a rally in stocks and left the yield on the benchmark 10-year Treasury note low enough, at 4.11%, to lift the S&P 500 to a fresh all-time high.”
Alright, it was a big week on Wall Street but you have to dig below the surface to appreciate the speculative frenzy.
For example, shares of Rigetti Computing, D-Wave Quantum and Quantum Computing have surged more than 20%. Rigetti and D-Wave Quantum have more than doubled and tripled, respectively, since the start of the year. Arqit Quantum skyrocketed more than 32% this week.
The jump in shares followed a wave of positive news in the quantum space.
Keep in mind, most of these stocks are up over 3,000% during the last year and they keep being bid up.
And it's not just quantum computing, everything speculative is rallying hard in these markets, look at the most active stocks on Friday, all these stocks had a monster week:
In my opinion, this market only wants to go up, the shutdown is positive for Trump and markets and his administration will use it to its advantage.
But that's just the tip of the iceberg.
Importantly, FOMO is kicking into high gear as we head into year-end and most portfolio managers are drastically trailing their benchmark and looking to chase winners to make up for lost performance.
Having lived through many bubbles, I can tell you they typically go on for a lot longer than anyone can imagine.
And there's always more money chasing new bubbles so this one will likely last longer than the previous one, especially since the US dominates tech trading and that's where bubbles find a home.
But it's also fair to say this rally is broader and not just AI led.
US banks are on fire this year, healthcare stocks led by Humana (HUM) and Pfizer (PFE) had a terrific week, as did gene editing stocks like Taysha Gene Editing (TSHA) and Crisper (CRSP). Nike (NKE) had a great week.
Hell, First Solar (FSLR) is on fire after dipping hard earlier this year:
I can show you a lot of great stocks that look the same and it's not just AI related, which makes you wonder why are so many portfolio managers underperforming the S&P 500??
In closing, we all know the AI bubble is alive and kicking, that OpenAI isn't really worth half a trillion dollars but Wall Street wants us all to believe this is it, this is the next Big Thing.
Enjoy the ride while it lasts, nobody ever rings the bell at the top (or bottom), usually something breaks sending markets tumbling down hard.
All I can tell you is to watch stocks closely here, speculative manias feed on themselves, it can last a lot longer than you think, never mind what smart strategists think or write, it's irrelevant.
Below, CNBC’s “The Exchange” team discusses whether there is a brewing market bubble in artificial intelligence stocks and how they’re thinking about the AI trade.
Also, Lo Toney, Plexo Capital founder and managing partner, joins 'Closing Bell' to discuss Jeff Bezos' recent comments on AI, how to distinguish between the good and bad ideas and much more.
Lastly, Marc Lasry, Avenue Capital Group chairman, CEO and co-founder, joins 'Closing Bell' to discuss if auto company bankruptcies are the tip of the spear, potential effects of the explosive growth around private credit and much more.
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