The Big Reset#

I worry about rare events. Events that happen less than one percent of the time. Why? Because I live in a world cursed by these events. That’s the age we live in. The continual series of once-in-a-lifetime financial catastrophes. Most people start with the dot-com bust, but that’s because history is poorly taught. I’m going to choose an arbitrary starting point but here is a list.

1. The Arabia oil embargo (early 1970s)
2. The 1970s inflation (1974-1980).
3. The savings and loan crisis (1980s).
4. The dot-com bust (2001).
5. The mortgage backed security crisis (2008).
6. Pandemic supply chain and chip crisis (2022).

I’m leaving out smaller, but still very rare events. For example, there was the Latin American debt crisis, where many S banks had bad loans to Latin American countries. There were major, almost economy shaping frauds like Enron and Worldcom. There was a trading firm that almost tanked several major banks (Long Term Capital Management). There was also the 1987 flash crash. And let’s not forget Silicon Valley Bank, for which the Fed had to inject liquidity.

We’re coming upon a weird time. The AI economy seems pathologically circular. With the stock prices or valuations hyped up as companies engage in an incestuous orgy. NVIDIA is pumped up through its chip demand. NVIDIA invests in other companies that will by their chips, raising the value of those startups. Which in turn by more chips and ink deals with cloud providers for insane amounts of month. Which in turn buy more chips. And those service providers invest in startups, which buy cloud services from those same providers.

But the rest of the economy is fine, right? We have a stock market that is grossly overvalued. Even companies not part of the ouroboros AI economy have nose-bleed level valuations. Any company with decent prospects is probably trading at twice their ’normal’ multiple. Meaning if they are normally are worth 15 times earnings, they’re trading at 30 or more. What justifies a multiple is complex. It is a carefully crafted formula based on the expected future cash flows…

Who am I kidding? It’s based on a lot of paper assumptions. The 58 times earnings multiple for NVIDIA is based on the assumption their good fortune continues. It answers the question of how many years of current earnings you would forgo to own the company. Who knows what life will be like in 58 years? Beyond one or two years out, it’s all guesswork. These high multiples result from excessive optimism.

Then there’s a growing culture of betting. We’re betting on everything, everywhere, all the time. For reasons I don’t want to go into here, I’ve always maintained that every “investor” in the stock market is actually a speculator. But now “fin-tech innovators” will allow you to just place a bet on the market. No need to own stocks. No need to even buy 0 days until expiration options (which are basically just bets). Just place a bet like you would on golf.

Don’t have money for a bet? That’s okay, borrow it. Brokers and trading apps are happily extending margin to their inveterate gamblers … I mean investors. Don’t worry about the interest rate - there’s money to be made. The SP500 will definitely close up at least 0.25% today, so why fret a 9% interest rate for a few hours? Gaming apps will also allow you to fund the account with a credit card. Borrow whatever you need at 25%. The Bucs will almost certainly have 3 passing touchdowns. Margin balances are at an all time high and 30% above last year.

Add to that the volatility of the securities, if I can even call some things like crypto a security. There are large day-to-day swings in Bitcoin or Ethereum, the “gold standard” cryptos. The 0 DTE options swing like crazy during the day. Cryptos are coming to a 401k near you. More retail investors are piling into the options market. More retail investors are finding ways to take short term bets on cryptos. And there is a lot of evidence cryptos are high cyclical. When the market tanks, they can tank harder. Which makes them less a store of value than a vehicle for gambling.

And then there’s the dark money. That sounds notorious but it’s basically private money that transacts outside open markets like the NYSE or NASDAQ. This can be anything from the dreaded private equity, to hedge funds, to just large transactions between private parties. More stuff is happening in that world. And these companies are getting into higher risk loans. The nascent cockroach problem is that loans made by dark money went bad because the borrowers were frauds. But dark money also borrows to lend, meaning their creditors (banks or other dark money) are at risk.

But everyone is fat and happy because everyone’s making money. You’re sixty or fifty five and your 401k is up 75% over the last year or two. You feel rich. That means you are willing to spend. Moreover, you are rewarded for not questioning the system. Keep sticking your money in Broadcom, NVIDIA, Meta, and Apple. And keep spending.

For the other folks there’s buy now and pay in four easy installments. Including your groceries. More and more money is being lent out to lower income folks. There is an insane level of individual consumer debt. And we’ve made it harder to discharge debts in bankruptcy (for those who can afford the process). And federal student loans are being sold off, making them unforgivable in the future. It’s important to have as heavy a boot-heel as possible on the neck of the bottom 50%.

It feels like there’s a perfect storm. High debt levels. Less transparency. Lots of pro-cyclical investing. Volatile investments. And a likely bubble. More wealth driven spending, which collapses when assets prices fall. Have I left anything out? There’s a lot of dry fuel out there to burn.

What’s the unlikely scenario? I don’t know. Nobody knows. It’s a large, chaotic, interconnected system full of non-linear responses. Let’s take the bursting of the AI bubble off the table as the ignition. Everyone has their eye on it, just waiting for the spark. Let’s go to the old problem of too much debt and too much fraud. That’s easily accommodated by the dark money and cockroach problem. If people lose confidence in PE firms, those firms can’t raise money. If the value of their investments are written down, the money they do owe is at risk. That risk is held by other PE firms and hedge funds but also by banks.

If banks can’t trust each others’ balance sheets, liquidity dries up in the inter-bank markets, like 2008. The overnight market dries up. The government steps in and tries to inject liquidity. Paulson and Bernanke were good at what they did and they still kind of fucked it up. Surely this administration is also staffed with highly competent people. Really? Those goons? Nutlick is going to manage this? Bessent is barely qualified.

We suddenly have an unknown level of risk around an unknown amount of money. Could been 10s of billions, 100s of billions, or trillions. We just don’t know. As credit dries up across the board, economic activity grinds to a halt. You can no longer get a 7 year car loan or pay for groceries in 4 easy installments. The crash in 2008 was caused because of a loss of confidence in counter-parties. Lehman was killed by a lack of confidence in Lehman as much as their bad positions.

Let’s go back to that thing about multiples. Remember how it’s based on assumptions about the future? What if those assumptions suddenly turn negative? Now Apple doesn’t look so hot at 36x multiple if people can’t finance new iPhones. Nor does Ford, GM, or Stelantis look great. Don’t worry, Tesla fan bois will find some reason to keep pumping that meme. Suddenly, that wealth based spending dries up as 401ks and brokerage accounts shrink.

People sell off crypto and begin to question the AI “boom.” Suddenly, we’re looking at a full stock market rout. It won’t happen in one day. The 1929 “crash” took two years to fully play out. Most of the market is supported by 7 to 10 stocks, depending on how you do the math. When those go down, broad market funds and ETFs will also go down. Add to that drop in price the selling pressure from margin loans being called in.

Okay, you don’t believe there are enough “cockroaches” out there. Or you believe all those johnny come lately hedge funds and private equity funds know what they’re doing. Let’s say the Chinese decide to fuck with the crypto markets. I’m sure the people that let rampant fraud go on for years have great security. But aren’t the node decentralized? You’d have to hack a lot of bitcoin farms. That’s impractical. Or you could automate it with … I dunno … AI?

Or companies just keep laying off in the US due to increasingly poor conditions, while inflation remains sticky? Why would that happen? Because of tariffs keeping the Fed from moving quickly on the labor market. Or inflation is just sticky because AI data centers are pushing up energy costs? Gas, liquid or natural, is being fed into generators to power data centers. It’s raising the cost to local consumers who will not benefit from a data center that hires at most 30 people in their community. Rising energy costs can stoke other inflation.

Or the long term rates are stubbornly high even though the short term rates keep dropping? Why would that happen? Because of a loss of confidence in the US, given its upcoming insane debt load. You could wind up with a persistently slowing economy. Long term rates stay high because lenders to the US Government don’t see a way to sustainable debt. Eventually you wind up with no fiscal or functional monetary policy and the economy just spirals.

I don’t know what the igniter will look like. I do see a lot of dry kindling lying around. The sparks could get put out with decisive action, but at a cost. We’d essentially have to paper over the problems by printing money. Injecting liquidity as they call it. Which will exacerbate both the income inequality problem and inflation problem. Any which way you slice it, it’s scary.

The scariest part for me is that large portions are poorly regulated or dark. Like the fire in LA smoldered underground, hidden, before suddenly roaring forward. We could have a line of cockroach infested PE firms. We could have little insight about counter-party risks between hedge funds and PE firms. And these are being pushed, more and more, toward retail investors. The “hot” funds could just be hot because they’re sitting on grossly over-valued assets.