From the absolute return mavens at Ruffer:
AI IS SET TO TRANSFORM OUR LIVES IN THE DECADES AHEAD.
But the market’s current optimism about the coming productivity revolution is being exaggerated by investment flows and feedback loops which are mechanically driving prices away from the fundamental reality. Such self-reinforcing market dynamics have in the past created extreme overshoots. And the bigger the overshoot, the larger the eventual correction.I WAS RECENTLY REMINDED OF A CLIENT’S POINTED REMARK TO JONATHAN RUFFER IN 2007: “All my clever friends are losing money, all my stupid friends are making money. And, if you think that is a compliment, it isn’t!”
So I hesitate before presenting a Review piece which may seem too clever by half. Yet now, of all times, we need to explain the basis of our continuing caution. What follows is just one component of a broader bearish thesis.A QUESTION OF INTELLIGENCE
Singularity is the artificial intelligence (AI) optimist’s dream. It is the concept of artificial superintelligence – one that surpasses the brightest human minds in practically every field, including scientific creativity, general wisdom and social skills.
Singularity promises untold benefits to the world, helping to solve some of our biggest problems. Ironically, the market’s optimistic reaction to the potential advent of superintelligence looks far from intelligent, with complex self-reinforcing patterns of investor behaviour mechanically distorting asset prices. This is driving what I refer to as anti-singularity: single stock dispersion rises as equity index correlations fall. Index correlation is the degree to which individual stocks in an index move together. High correlation indicates that stocks in the index tend to move in the same direction, ie there is a common systemic risk driver. Conversely, low correlation implies the absence of systemic risk from stock markets.
A brief technical aside: when thinking about correlation, we can look at implied correlation (what market pricing of derivatives implies about expected correlation) or realised correlation (what the actual correlation has been over a given period). The two should obviously be related as speculators will trade the relative price of implied correlation to expectations of its realised path.
In 2024, the implied correlation reached its lowest level since 1990, when the data set began, and it remains near that low today (Figure 1). This is market anti-singularity.
What is going on? Has something happened in the world which makes markets more immune to systemic forces? I doubt it. And it certainly doesn’t seem like a world which is short of systemic risks: wars, revolutions, nuclear threats, Trump II, political paralysis and power vacuums all over the place.
But investors always find a reasonable narrative to justify market extremes. In this case, the rising weight of mega-cap technology companies, which has a depressing influence on index correlation, is justified by the rise of AI, which will drive a productivity revolution. Thus the economy will enjoy much higher real growth without inflation, meaning interest rates can fall and earnings can outpace expectations. Initially, the very largest (mainly tech) companies are deemed the winners. At the centre is Nvidia, whose monopoly on chips gives it the immediate profit tsunami as the space race for compute capacity amongst all the mega-cap tech names accelerates.
Nvidia’s profit growth is real. And the mega-cap tech companies are also highly profitable. Their R&D spend gives Nvidia its profits. But they all get rewarded for this spending – so far, at least – with higher share prices. So this is not a profitless bubble like the dot.com blowout of 1999. Nor are their valuations as extreme as the Nifty Fifty’s in the late 1960s and early 1970s.So, say the bulls, why can’t the index move higher? And why can’t this happen with low correlations? After all, it is being driven by the largest companies, which will accrue most of the benefits.
In this version of the story, singularity optimism should logically drive anti-singularity in markets.
We think the more likely explanation is that implied correlation is simply a residual variable, the depressed output of different, more powerful market forces acting on the other variables from which correlation is derived.
I don’t want to ruin readers’ experience with a Greek laden maths definition of correlation. The key point is that correlation is a function of the volatility of both the index and the single stocks, and of the weights of those stocks in the index. In this equation, implied correlation uses implied volatilities, and realised correlation uses actual historical volatilities....
....MUCH MORE
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