The everything AI economy and stock market, being built on high levels of debt could create a 1929 style stock market crash and recession.
How much does the gung-ho everything AI, stock market remind you of the roaring 2020s, which led to the infamous stock market crash of 1929 and the subsequent great depression that followed?
To find out, I attended Andrew Ross Sorkin’s (author of “1929 - Inside the Greatest Crash in Wall Street History” ), talk on Thursday night, and it was illuminating to see some early parallels of high debt and leverage between the current AI boom, the 1929 crash and the 2007-2009 Great Financial crisis. Sorkin is a tremendous historian and an excellent researcher, having spent close to eight years working on this book, examining previously unavailable journals, memoirs, and handwritten notes to complete his magnum-opus.
Sorkin was in fine form that night and spoke about a lot of similarities between the 1929 stock market crash that led to a decade old recession. These are important lessons from history, which we should keep in mind.
The start of consumer lending: America was not an indebted nation, there was no consumer lending till about 1920. General Motors started this credit and consumer lending journey, by allowing you to buy a car in installments - the first auto loan starting the lending boom, which led to consumers borrowing beyond their limits.
Margin debt: In the twenties there were brokerage trading desks in hotel lobbies, where the broker would give you 10:1 margin leverage, for $10 you could trade up to $100!Everybody bought stocks, many in bucket shops. Leverage eventually became ridiculous across the board - companies, banks, industrials, traders and consumers. If you were not leveraged in 1929, it wasn’t a problem, but if you were they came after your house.
Current parallels - Pajama traders, meme stocks, Zero day options, crypto traders all supposedly enjoying commission free trading (FYI, the brokerages - Robinhood, Fidelity, Schwab and so on make money routing your trades for a cut - you just don’t see the commission).
Relaxing rules: Previously you were allowed to day trade if you ponied up $25,000, now FINRA endorsed the proposal to transition to a risk-based, intraday to $2,500, pending SEC approval. The rule change is expected to be implemented toward the end of 2025 or early 2026.
Private lenders: Sorkin, too, brought attention to the fact that private equity getting into AI financing is scary, though in his opinion it would take 2-3 years for the cracks to widen. I felt that we had 18 months, but regardless of how far out this may be we will be on our toes for leveraged companies.
Increasing participation of non institutionalized public lenders is riskier for the economy and the market - The biggest fear is lack of disclosure and accountability, which private equity does not have and that’s what drives debt contagion. In the twenties, compliance was a joke - it didn’t exist and it really seems ridiculous that we’re relaxing compliance after the great financial crisis that swallowed Lehman Brothers and Bear Stearns, and led to ownership changes in Merrill Lynch and Morgan Stanley, and government ownership of AIG.
Unsustainable debt is what broke markets in 1929, and 2008 and will likely be one of the factors when the markets tip over in the future.
I showed a chart of the high indebtedness of the country at our webinar, and last week also wrote about the huge mountain of debt that was being created with all that Capex spending. Sorkin spoke about this at length - if we want to succeed with all this Capex, we will be adding more debt at the corporate level and at the sovereign level - you need to be creditworthy to keep borrowing, which with a debt to GDP ratio of 120% looks scary.
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Too big to fail: In my opinion, OpenAI may become too big to fail. Since the US is competing with China in AI, the US will bail it out, that is a surety, and it will be at a huge cost to eventually tax-payers. Last week I had written about Uncle Sam backstopping Altman Sam, but we may be putting far too much credibility on a US government that is grappling with massive budget deficits, and political dysfunction, evidenced by a shutdown that lasted 44 days. Besides, the reopening of the government hasn't solved problems - it just kicked the can further down the road. While it’s safer for governments to carry debt (since they can issue currency), dysfunction undermines the credibility of sovereign debt. Investors increasingly view firms like Microsoft, Alphabet, and Meta as safer than certain sovereigns. Meta borrowed $30Bn with rates ranging from 4.2% (5 years) to 5.75% (maturing in 2065!) last week signaling a regime shift where corporate credit is perceived as more stable than sovereign bonds amid populist politics. Big tech doesn't have power or enforceability of any kind, but it has credibility and accountability with a stock market that rewards and punishes with equal ferocity.In my opinion, understanding that the AI race is essentially, at its core a sovereign race, the US will eventually emulate the Chinese model of a public/private partnership and be joined at the hip. Just don't be sure of who's in the driver's seat.
Politicization of the Fed: Similar to the current situation, in the 1920s, Fed minutes and notes consistently showed a diffident and hesitant Federal Reserve paying heed to how their actions would look or sound.
Volatility: The crash takes years in the making, but the last year, 1929 had insane volatility. The most dangerous leg of the bull market is usually the last one. For example; for the full year, 1929 was only 19% down, (January to December) but the drawdown was 57% from the peak, which means the crazy run in 1929 started upward and went up by 89% before dropping 57%!! There is a tipping point when everyone heads for the exits. The Black Mondays don’t happen at the peak - they happen after the initial drops.
Speaking Up: Businessmen spoke out against the administration, and they were not afraid to voice their opinion unlike now. In Sorkin’s opinion that is going to be a problem if there are no checks and balances.
4.3% unemployment is a far cry from 10% after the Great Financial Crisis of 2009, and 25% in 1932 during the depression. But this is going to be a key gauge, in the next few years. GDP is growing but only in a very few sectors - The AI sector is 20% of the GDP growth - we would have been flat without it. In my opinion, we're far from 1929, but there are ominous signs such as the similarity of debt creation with $3Tn in estimated Capex in the next 5 years needs to be monitored very clearly, and we cannot afford to slip into a non-compliant, free for all recklessness that characterized the roaring twenties, nor can we discard all checks and balances. That would be crucial in my opinion, and Michael Burry's risk mitigation options on Palantir and Nvidia is a good strategy.
