New York (CNN) — Artificial intelligence is a game-changing technology that’s already transforming how the world lives and works.
Yet AI can also fuel a market meltdown, a recession – or both.
Timing is everything. Money is pouring into AI so rapidly that it’s outpacing the ability to turn a profit. This unsustainable mismatch must come into balance, one way or another. The recent blow-up of a wildly successful AI-focused hedge fund demonstrates the risks and rewards of the AI boom.
Those risks are magnified by how incredibly expensive it is to build the AI revolution, where companies are scrambling to buy cutting-edge chips and build data centers the size of dozens of football fields.
“I absolutely believe the technology is transformative. But that doesn’t mean you won’t go through irrational exuberance at some point,” Max Gokhman, head of AI and digital asset solutions at investment firm Franklin Templeton, told CNN.
Timing is critical in deciding whether the AI boom endures – or if it ends in tears like past asset bubbles.
Will the gobs of money being spent to build out AI bring real returns before Wall Street’s patience runs out?
$500 billion financing arrangement
For now, the heavy hitters in finance are still going headfirst into AI.
Nvidia, the $5 trillion AI infrastructure superstar, just arranged $500 billion in financing from Apollo, BlackRock, Goldman Sachs and other Wall Street firms to bankroll customer orders for its cutting-edge chips.
Nvidia CEO Jensen Huang even argued that AI compute – the hardware and software underpinning AI models – is transforming into an “investable class.”
It’s a sign that many on Wall Street still believe in an AI-driven future. Investing in the technology has been complicated by its rapid developments; an emerging price war between open and closed AI models; and many supply chain bottlenecks – from access to chips and local opposition to data centers to the enormous power needs of the buildout.
‘Will end badly’
Nvidia’s blockbuster deal is a reminder of an innovative, and arguably dangerous, characteristic of the AI boom: circular financing.
In circular financing, one company pays money to another (in the form of a loan, investment, lease or other financial support) in exchange for that second company buying the first’s products.
It’s one of those things that works – until it doesn’t.
During booms, these arrangements can create a virtuous circle. But they can also fuel speculative bubbles by creating the illusion of rapid growth — and those bubbles eventually burst.
It brings back bad memories of the dotcom bubble, when some telecom equipment companies lent money to customers to buy their gear.
“Circular financing will end badly,” Gokhman said. “You are living on not just borrowed time, but levered time.”
But Gokhman said he’s still a believer in the AI boom and doesn’t think leverage has gotten to alarming levels, at least not yet.
AI-focused hedge fund goes bust
As in the late 1990s, the AI boom has allowed some investors to make fortunes, even as others experience sudden disaster.
Late last month, Situational Awareness, a little-known hedge fund focused on AI investments, imploded after hits highly leveraged bets blew up.
Run by a former OpenAI employee, Situational Awareness was forced to sell most of its portfolio at a steep discount to Citadel. The AI hedge fund is still up big over the past two years – just not as much as it had been.
Tellingly, Situational Awareness didn’t run into trouble because it was wrong directionally on its belief that AI is for real.
The problem was that thesis got derailed by a temporary loss of momentum in AI stocks – and that derailment was magnified by leverage, which magnifies both gains and losses.
AI’s math problem
Torsten Slok, chief economist at Apollo Global Management, warns that the math in the AI space doesn’t add up yet. The massive profits at the top of the AI food chain are driven by investors, not customers, he said.
“Capital can bridge the gap for a while, but not indefinitely,” Slok wrote in a report last week. “And therein lies the risk: Will the ROI show up for AI’s end customers fast enough to sustain the spending that is generating those upstream margins?”
After analyzing profit margins in the S&P 500, Slok found no evidence that AI is boosting the profitability of healthcare, consumer staples, energy or real estate.
However, Jeetu Patel, president and chief product officer at Cisco, said it’s hard to equate the AI revolution with the dotcom bubble because supply was built ahead of demand in the late 1990s.
Patel, whose company is building infrastructure supporting the AI boom, expects AI agents to go mainstream, allowing demand to continue its explosive growth.
“The demand is there (today), and supply is massively short on power, data center capacity, compute, memory and network,” Patel told CNN at Ai4, an industry conference in Las Vegas, this month. “We’re in the very, very early infancy.”
AI is the dominant force in the economy
The stakes are massive – and not just for little-known hedge funds gambling on AI stocks. The US economy has become more reliant on AI and its enormous spending.
The eye-popping gains of Nvidia, Micron, Alphabet and other AI stocks have helped inflate the net worths of millions of Americans by lifting the value of their retirement nest eggs, college savings plans and brokerage accounts.
“Without the AI boom, we probably would be in a recession,” economist David Rosenberg said during a recent episode of the “Excess Returns” podcast.
And timing is everything in booms and busts. As economist John Maynard Keynes famously said: “The market can remain irrational longer than you can remain insolvent.”
Consider what happened to Julian Robertson, the legendary hedge fund investor.
In the late ‘90s, Robertson correctly identified the massive dotcom bubble. But his bets against overvalued tech stocks blew up because the Nasdaq kept going higher and higher.
Robertson eventually shut down his Tiger Management hedge fund in March 2000 – just as the Nasdaq was beginning what would become a historic crash.
“Just because you think things are frothy doesn’t mean it’s time to get out,” Franklin Templeton’s Gokhman said. “The best returns occur when the party is about to end.”
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