AI Bagholders

This week has been a continuation of last week, as the tech unwind continues, while the defensive and less crowded sectors stay strong.  Breadth has been relatively strong, yet the markets trade weak.  Another week that debunks the old-fashioned technician's belief that bad breadth is bad for the market, and good breadth is good for the market.  

The AI hype which at a fever pitch in May and June, has resulted in a monster bull trap, leading to big losses for those late to the AI trade.  I keep hearing the same thing from retail.  How can the SPX be only down 2% from all time highs while all these AI stocks are down anywhere from 30 to 60% from all time highs?  Its because the inflows keep flowing into equity index ETFs, keeping a bid for SPX, while retail and hedge fund flows into tech are drying up as AI equity supply ramps up, putting downward pressure on AI stocks.  

Some similarities to 2021 over the past few months.  The scale of the pain this time is much greater, as retail investing is now much more pervasive.  Just another warning sign of pain to come for 2027.

Here is a picture of how AI has done versus the SPX.  High beta momentum is basically the speculative names in the AI trade.  Down 41% from the late June highs, while SPX is down just 2% from its more recent October highs, and above the levels seen in late June.  

We have not seen this kind of underperformance among a group of high beta momentum names vs the SPX since 2000.  Even more perverse, has the been the strength in the defensive and less popular sectors of the market, while tech is getting killed.  

On Thursday, Oct. 22, the worst day of the week for the SPX, down 95 points, here were the sector breakdowns:

This kind of extreme dispersion among sectors on a big down day is rare, with SPX equal weight up 0.5% or more and NDX down 2.5% or more.  Precedents were mostly in 2000 and 2001.  

The market is giving you some very obvious hints that the peak of the AI bubble is behind us, and the consequences of the AI bust are in front of us.   The market internals for the AI bubble in 2026 is closely following the pattern of the dotcom bubble in 2000.

The hyperscalers and OpenAI/Anthropic continue to try to raise more capital despite the challenging environment for AI right now.  META dropped a little dilution bomb in their earnings filing, warning of possible huge amount of capital to be raised.  Zuck went all in on the metaverse and failed.  Is this his AI version of the metaverse gambit?  

OpenAI is now targeting a lower valuation to raise more private equity capital.  

We are getting close to the point where the capital markets will start closing off for giants in the AI space like OpenAI and Anthropic.  They have shut off the IPO window for the neoclouds.  Its only a matter of time before they shut it off for the bigger players when it becomes more clear that the economics for the AI business model is worse than advertised.  There is a lot of hype about AI making employees so productive, but a lot of that productivity is going towards bullshit production.  AI generated images, cookie cutter analysis, mediocre articles and papers, etc.  Most of this is low value, which means AI compute will need to be priced low (low margins for OpenAI and Anthropic) to attract sufficient demand.  

There are gigantic compute commitments for 2027 and 2028 for the two LLM giants as data centers come on line.  You are looking at a potential credit disaster if the demand for the compute isn't sufficient, as I suspect will likely be the case.  That is a contrarian take because almost everything I hear is about the insatiable demand for compute from 15-minute AI experts like CNBC's Josh Brown.  

This bull market started in October 2022, has taken the SPX from 3491 on October 13, 2022, to 7844 on October 6, 2026.  That's a 124% return plus dividends in 4 years.  That's a huge move for an economy that's growing this slowly.  In the next bear market, investors may take comfort in seeing Treasury bonds rally while stocks fall, thinking that there won't be a repeat of 2022.  That's right, the next bear market won't be like 2022.  It will be a stock focused bear market, not a bond focused bear market.  There won't be much comfort in seeing their much smaller bond portfolio rally a few percent while their much bigger equity portfolio goes down 30-50 percent.   

BofA client flows for the weekend ending October 16.  Institutions have been heavy sellers in October.  

BofA clients were heavy sellers of tech for the week ending October 16.  Need to see more of this to get a short term bottom.

Retail is still buying the dip in semiconductors, as of Oct. 21.

Hedge funds have been driving the tech led selloff.  Can't tell anymore if hedge funds are the smart money or the dumb money.  They used to be the dumb money when retail only had a small footprint in the market.  Now that retail has gotten so big in the stock market, taking the mantle of dumb money, hedge funds are now a trail mix of both smart and dumb money.  Not as much signal to be gained from hedge fund positioning as in the past.  

Bonds continue to squeeze higher as CTAs cover shorts, and long tech/short Treasury bond pair trades get unwound.  The bond market has finally found a bull catalyst(the AI bust) which is actually a bear catalyst for stocks.  AI is the elephant in the room, sucking out all the oxygen, putting sticky inflation and the Fed hiking cycle into the closet where no one is paying attention.  I believe the past 2 weeks are a preview of next year.  AI will be the dominant driver for both stocks AND bonds in 2027.    

You still have not seen any signs of capitulation in the dark pool data. The 2 significant bottoms in 2026, in late March and late July had big drops in the DIX, getting down towards 40%.  Aside from one day (Oct. 15), DIX has been fairly high during this tech selloff.  

Nothing notable in the COT data as of Oct. 20.  Speculators remain heavily long NDX futures.  

The market had quite a strong bounce (stronger than expected) from Monday to Wednesday, shaking the convictions of some bears.  Having a smaller position makes it much easier to hang on to positions and withstand some heat.  Wednesday turned out to be a huge head fake.  The sudden enthusiasm over SPCX's revenue numbers and a possible SPCX/TSLA merger was enough to set the bull trap.   Thursday took back 3 days of gains in just a few hours.  Now that the market is closer to SPX 7600, there isn't as much downside to play for.  Covered half on Friday, and will the rest ride until Monday/Tuesday.  

Do not want to be short after FOMC on Wednesday, and the slew of tech earnings coming out Wednesday/Thursday of next week.  The bearish news flow for AI is getting heavy and the seasonal calendar is turning more bullish.  Base case is that the we make a bottom sometime next week, and then bounce.