Views #227 : The Dark Knight Rises II

I am doing something here I have never done before. 

I am repeating a Views.

I warned in these views that people ended to stop talking about the fundamentals or valuations and recognise that the plumbing of the massive rally in certain stocks in the world is what worries me. People like to have endless debates on bubbles, valuation or the wealth creation of the SpaceX IPO. Of course,  I have views on them, but they are not that original and most of you can predict them anyway.

What I think people continue to underestimate that the speed and violence of this rally in certain sectors have been driven by a leveraged ETF extravaganza that is an amazing accelerator of trends.

If for whatever reason this goes in reverse, the consequences are not something the market is ready for. These ETFs and the levered ones particularly, do not care about valuation numbers or announcements. They only care about flows and rebalancing. It is spectacular on the way up but I can assure you that it is the same way down. 

We live in incredible times with amazing companies emerging and growing and a technology revolution that we have might not fully understand.( I certainly cannot enough)

But human greed never changes and leverage never lies. Whatever statistic I mentioned on leverage ETFs a few weeks ago has been massively increased in the last month. The problem has not gone away and has only gotten much bigger.

Koreas was down last night 10% last night on very limited news. Is it the beginning - I don't know but ignore the forces from the Dark Knight at your risk. 

Remember you can be a believer in AI, bullish on the long-term potential for the market and the companies and think that the current rally is not healthy or sustainable. It is possible.

Be careful out there

Now that I think about it, I have never repeated one before!

Wow, I must be worried.

Thoughts as always welcome

Edward

My family knows that I am obsessed with The Dark Knight trilogy, Christopher Nolan’s masterpiece on Batman. The second and third movies introduce the idea of the “Dark Knight.” First, he emerges, and eventually he rises. I can watch those films over and over again and still get pulled into them.

The last few weeks have seen some of the most extraordinary moves in parts of the equity market. Indices overall have done well as investors combine relief over the Iran war consequences with renewed excitement around AI. But beneath the surface, certain sectors have completely separated themselves from the rest of the market. I have never seen the word parabolic being used so frequently out side a math class.

At the centre of these moves stands the entire semiconductors and the broader AI infrastructure complex: compute, memory, networking, power, cooling and every adjacent component linked to the race for more computing capacity. Across much of this ecosystem, stock prices have moved almost vertically higher as expectations for future spending continue to rise. The recurring themes has been. We are short compute... (not exactly sure what that means but you sound smart if you say it)

This piece is not about the fundamentals. Everyone is already overwhelmed daily with commentary about revenue growth, demand projections, token usage, inference costs and capital expenditure cycles.

The fundamentals are undeniably strong, and we might not be able to imagine how much better they will get. Let us leave it at that.

What interests me more for this piece is the mechanism underneath the move in the equity markets.

In every major financial mania, fundamentals start the story. But the truly violent moves — both up and down — are usually driven by something else: positioning, reflexivity and eventually leverage.

And I think leverage is now becoming the Dark Knight of this cycle.

In previous decades, we mostly looked at leverage through traditional margin debt measure. Currently, US margin debt today sits around $1.2 trillion, close to 4% of GDP — historically elevated, although perhaps less alarming than it appears given the amount of cash still sitting in the system.

But this cycle has evolved far beyond traditional margin accounts.

We now live in a world of leveraged ETFs, single-stock leveraged ETFs, zero-day options and ultra-short-dated derivatives structures. The market has effectively industrialised leverage and packaged it into products that can be accessed instantly by anyone.

This matters enormously because these structures are fundamentally mechanical.

When money flows into a leveraged ETF focused on semiconductors, the manager is not asking whether valuations make sense, whether positioning is crowded, or whether the stock has already doubled. The mandate is simply to buy exposure — and because leverage must be maintained dynamically, those purchases can become increasingly aggressive as flows accelerate.

Today investors can buy securities such as simple and leveraged semiconductor ETFs, memory ETFs, and AI infrastructure baskets and even leveraged single-stock products tied to individual names. And with no difficulties.

These instruments now hold tens of billions of dollars directly, but their effective exposure is far larger once leverage and hedging dynamics are considered. And they are all short term liquidity instruments which means the money can leave as fast as it comes in.

At the same time, the explosion in short-dated options activity has created another layer of reflexivity underneath the market. Dealers hedge flows. Momentum attracts more momentum. Rising prices create incremental demand, which pushes prices higher again. These ETFs have active option flow around them.

On the way up, this becomes an almost perfect market machine: strong fundamentals, earnings momentum, passive inflows, systematic buying, and embedded leverage amplifying everything.

It is a spectacular combination.

And to be clear, this can continue much longer than people expect. Certainly, more than I did.

That is what makes these environments so difficult. The fundamentals may continue validating the move for quite some time. AI may genuinely reshape large parts of the economy. Revenue growth may continue to surprise positively. Many of these companies are extraordinary businesses.

But financial dislocations are rarely created by fundamentals alone. Fundamentals may trigger the process, but leverage is almost always the accelerant.

And right now, leverage is everywhere.

What concerns me is not whether AI changes the world. It almost certainly will. What concerns me is whether the market structure surrounding that narrative has become unstable. Because once flows reverse, these same mechanisms can operate violently in the opposite direction. Leveraged ETFs rebalance. Dealers unwind hedges. Momentum disappears an reverses. Liquidity shrinks when everyone wants liquidity most.

And because these sectors have become such a large part of overall market capitalisation, there is almost no realistic scenario where the damage remains fully isolated. Of course, semiconductors and the AI complex would likely suffer disproportionately, but broader markets would inevitably feel the effects as well.

People often underestimate how much of modern market behaviour is now driven not by discretionary conviction, but by systematic positioning and automatic flows as a result of these flows.

That is the Dark Knight here.

Not AI itself. Not the companies .Not even the valuations necessarily.

The hidden force underneath the move.

Of course, I may be completely wrong. The profitability of these businesses may ultimately exceed even today’s aggressive expectations, and what currently looks extreme may eventually appear obvious in hindsight. A brief period of consolidation could correct the move recently and the leverage might stabilise

But I do not think the path will be nearly as smooth as many people now assume.

And if this leverage-driven unwind eventually arrives, it will likely also create extraordinary opportunities — as these episodes always do. The key is simply making sure you still have capital left when that moment comes. Thes moves in reverse are very sharp in speed and everybody suddenly finds good reasons to think they are logical when that happens.

The Dark Knight trilogy was outstanding. If this particular Dark Knight rises in markets, I suspect it will be far less enjoyable for many portfolios.