Quantum Computing Questions

I readily profess that my working knowledge of computing goes back to FORTRAN IV - yes, punchcards and all! Therefore, today I use computers as a black box: I input stuff and I get back stuff, and I know nothing of what happens in between, or how it is done.

So, I have a question: will quantum computing eventually make "regular" computing obsolete?  I asked AI and it said no, it won't and that I should think of quantum computing as a "truck" used for carrying very heavy loads and regular computing as a "car" used to carry the week's groceries.

But I wonder... back in my own ancient days a computer center was a huge airconditioned room with dozens of disk drives.  Today, its computing power and capabilities fit in my phone! If back then I had asked the computer center manager the equivalent question, I am sure he would have given me the same answer as AI: use your HP calculator for your daily needs and come to us for the "heavy" stuff.

So, dear reader, will quantum computing become tomorrow's standard? Will qubits kill bits or will they live happily ever after side by side? And if so, what does this mean for today's GPU darlings? 

If any of you have answers I will be very grateful to hear them! Thank you in advance!

H.

The China Syndrome

 Almost from the start of this blog what seems eons ago I pointed out that sending manufacturing to China in the name of consumer affordability and corporate profitability was a serious strategic mistake.  Events have proven me right.  Just look at what is happening in the auto industry in the US and Europe.

What industry is next? Semiconductors and AI.  Reuters just reported that China is rapidly achieving its own AI chip technology, almost a decade ahead of projections. Given the current drunken craze in this sector, the news ring a bell of sobriety.  China is determined not to be left behind in anything, let alone AI.

Can the West compete? Yes, of course. But not in a face-to face bruising battle.  The results of the Trump tariff war prove it - China used its muscle and won, no way to hide it.

So, play smart. Give up the consumer spending model and focus on quality, not quantity.  

Payrolls In The US

 The Bureau of Labor Statistics announced its loooong awaited non-farm payroll numbers today, delayed due to the government shutdown.  Here is the most relevant chart:

My observation: looking at the 3- month numbers (most relevant because of the long shutdown), it's all about (a) the loss of government jobs and (b) the gain in just one category, private education and health services.  Bottom line: jobs are significantly stronger than the headline number where it really matters, the private sector.

The Fed will be looking very carefully at this, I'm sure.

High Prices For US Stocks

Something has been bugging me for several weeks now: prices for US listed stocks are very high.  I mean absolute prices, not valuations based on P/E, P/B, etc. For example, yesterday's price of a single Tesla share was $475, likewise for Microsoft, also at $475, Meta was $647, etc.  Doing a bit of quick research, the median price for S&P 500 stocks recently was approx. $120 and for NASDAQ 100 it was $245.

By comparison, a study by the Fed showed that in 2000 the equivalent median prices were $29 and $25.

Does this mean anything practically? Yes, and no.  No, because it is the total market cap that really matters.  And yes, because the higher they fly the longer the way down.  Meaning, the absolute losses for a shareholder are now potentially significantly bigger.

Was there a similar past occurrence in US markets? Yes, in 1929: for example, the price of RCA (aka "radio") was around $550 in September 1929.  It ended up at $15 in 1932.

I don't mean anything by the above, it's just a weird observation.

Bank Required Reserves For US Banks? Zero

 A kind reader (thanks AKOC) asked what are the required reserves for US banks - ie deposits at the Fed or currency in their vaults.  As of 2020 the answer is..zero.

Here is a helpful chart.

So, why zero?  Because except for macroprudential reasons, holding reserves doesn't truly provide any benefit.  Instead, banks must conform to a Liquidity Coverage Ratio - to hold high quality liquid reserves assets (HQLR) in amounts that allow them to pass liquidity stress tests.  Such assets are short term TBills and reverse repos, etc.  If you want more info on what are considered HQLR assets, see here.

So, even though "reserves" as such are no longer required it doesn't mean that banks can operate at full-risk-tilt.

 

Canary In The Mine

 Back to sudden debt.. lots and lots of zooming debt, and potentially in lots of trouble.

Open AI has borrowed $96 billion up to now, with major lenders being SoftBank, Oracle and a bunch of private debt funds. But, it turns out that Open AI is being rapidly overtaken by Google - not exactly a surprise, given Google’s massive data supremacy.

Taking a look at SoftBank and Oracle stocks… they are down sharply from their recent bubbly tops: SoftBank is down 30% and Oracle 45% while our blast-from-the-past 5 year CDS (Credit Default Swap) for Oracle has gone from 45 to 125 recently. Likewise, SoftBank CDS jumped from 200 to 300 in the last two months.  Note that Oracle's debt is rated BBB and Softbank's BB+, not exactly stellar ratings.

And there is a lot of AI credit exposure to shadow banking out there, too.  But just because it’s in the shadows doesn’t mean the “real” banking world is immune. In the end, all banking is connected, one way or another.

The Ultimate Meme

One chart best captures the AI meme stock nature of equity markets right now: SoftBank owns a considerable chunk of OpenAI equity, currently unlisted.

Before pulling back recently, SoftBank stock zoomed from $20 to $88 in just six months. It is currently trading at $55.

PS If all AI data centers announced for the US are actually built, their electrical power requirements will reach ca. 30-50 GW by 2030. To put this number into perspective, that’s a minimum of 10 new Palo Verde nuclear plants. Palo Verde is, by far, the largest nuclear plant in the US. It took 12 years to build and cost $6 billion.

Today, an equivalent plant will cost at least $35 billion due to inflation and additional regulatory demands. So… a MINIMUM of $350 billion and at least a decade to build. That’s before NIMBY even comes into play.

So… how realistic are AI growth projections? I’m speaking as an engineer here…

Bitcoin and S&P 500

 In these frothy days I view cryptos and stocks as two sides of the same risk coin - pardon the pun.  I'm pretty sure that many risk-hungry speculators are leveraging one position against the other.  Therefore, performance in one drives performance in the other.

Here is a one year chart of relative performance of BTC (purple solid line) and SPX (bars).  Recent weakness in BTC is not reflected in SPX, at least not to any great extent.  BTC is down 9% while SPX is up almost 9%.  I expect this 18% spread to narrow. 

 

Market Rout? Really??

 Yesterday S&P 500 fell a mere 0.92% - and yet the news today talk about a "market rout".  What does this mean to me?  That "investors" (ie speculators) have become completely used to a market that always goes up and any drop, no matter how minor, is considered an abnormal, extreme move.

Another sign of froth..

Treasury Basis Trade

The US Treasury basis trade consists of buying a Treasury bond in the cash market and selling the underlying futures contract. The difference in returns, the arbitrage, is the “basis”.

The cash bond position is financed via  overnight repo, while the futures contract has its own leverage built in.

Because the basis spread is very small these positions are in the hundreds of millions, even billions.  Therefore, huge leverage is applied 10X, 20X even 50X. The basis trade has become a staple for dozens of hedge funds, most all of them based in the Cayman Islands.

Here’s a chart with ESTIMATED amounts, put together by AI from various sources.

In just 5 years the basis trade has apparently grown tenfold! Is this concerning? Yes, it is. The amount of Treasury debt utilized in basis arbitrage is now huge and helps absorb part of increased Treasury issuance - but it can evaporate in short notice. For example, repo rates could rise, or futures margin requirements  increase.

For sure, if the basis arbitrage becomes unprofitable then a huge supply of Treasury bonds will have to find alternative investors.

PS  Read the following write up by the Fed  - they estimate the size of the basis trade to be around $1.8 trillion.

The Pools of 1929

 In the months before the Crash of 1929 the phenomenon of “bull pools” gained great popularity. A bunch of wealthy individuals would pool their money and proceed to pump up stocks on the NYSE, often with the cooperation of the floor specialists.  The manipulation was rampant and, astonishingly, often public: many pools were announced in the press in advance in order to induce wide participation by the gullible public.  It was a kind of Ponzi scheme, where those who got in early and got out in time made money.  After the pump came the dump, of course, and the rest lost everything.  Think "meme stocks".

What is today's equivalent?  To me, at least, the constant announcement of enormous triangular AI investments between the usual suspects looks like bull pool redux.  Time will tell.

From TIME magazine, May 30, 1932

Pools. Any Wall Streeter knows, but few Senators do, how pools are run. Because the risks are great, the pool’s sponsor usually invites only his richest friends to form a syndicate. Each shares in the profits (or losses) in proportion to his subscription. Each usually makes a cash deposit for the pool manager to use as margin in his trading operations. Each is pledged to strict secrecy. With dictatorial powers, the pool manager begins accumulating stock, buying a little more each day than he sells. Stock is dumped if the price rises noticeably. When the manager has the stock he wants, publicity is shot out, bullish rumors about the company appear, the stock is “tipped,” for it is now advantageous to whisper the existence of the pool. The stock is churned over & over, bought & sold to attract attention. When outside buying begins, the pool manager drives up the price by concentrated buying. Outside enthusiasm grows, amateur traders hear a big rise is in prospect. Most pools do not play for large advances but for small profits on large blocks of stock. When the profit in sight seems satisfactory, the pool manager starts selling more than he buys, transactions increase by leaps & bounds. Canny chart readers sell too, for they readily spot the end of a pool movement by very heavy turnover with little change in price.

Sociopolitical Risks

 Following the Democratic sweep in yesterday’s elections, it is a good time to ponder socioeconomic risks facing the US and their likely impact on markets.

In a nutshell, America has never been more politically divided and economically polarized than today. Mr. Trump’s presidency is not its cause but a result of this division, a result of decades of drawing apart. On could even say that this era is reminiscent of the time before the Civil War.

I believe markets have not taken into account the risk of a sudden Black Swan appearing over America. And we do know that Mr. Trump is especially fond of “swan barbecue”…

Zero Day Options

 According to CBOE data almost 60% of all SP500 option daily volume now comes from the most extremely speculative and leveraged instrument of them all: Zero Days To Expiration options, or 0DTE for short. While they do have uses for institutions (eg index fund balancing), they are now used mostly as lottery tickets.

Apparently, these have now become very popular with retail “investors” who have piled into them in force during the last few months and are causing large distortions in volatility.

Since options market makers must hedge their intraday exposure on 0DTE, they are forced to buy (or sell) the underlying index or individual stocks, magnifying the intraday moves.

This explains the recent erratic behavior of indexes - they seem to spike or fall off a cliff within seconds.

One more layer of unregulated leverage - what could possibly go wrong…?

Addendum: after writing the above I realized I had seen this before, figuratively speaking. This is the 21st century equivalent of “bucket shops” which were hugely popular with punters in the early part of the previous century. The similarity is really uncanny.. see Reminiscences Of A Stock Operator.

Margin Debt Soars

The amount of margin debt in the US has soared to a new high of $1.13 trillion in September (data: FINRA). Some will say that we should look at it as a percentage of total market cap, and I agree. 

However, I have a different point to make. Look at how fast margin debt has increased in just a few months: up 30% since the beginning of the year and 50% in the last 12 months.  This is an indication of froth created mostly by retail speculators who are piling in to make a quick buck.

Does not look good to me…

Leverage and Risk Transmission Mechanisms

 The Great Debt Crisis of 2008-10 was the result of inordinate leverage created by arcane derivative instruments like debt tranches, Collateralized Mortgage Obligations (CMO), Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS). Some of them were even further leveraged, eg CDO squared and cubed.  The degree of interconnection was extraordinary and once one or two dominoes fell, the result was a disaster.

Fast forward to today. Are there similar leverage and risk transmission mechanisms in place? Yes, there are.

1. Exchange Traded Funds (ETFs): once a tiny portion of markets, they are now very popular with retail investors and speculators alike. The biggest ETFs are index trackers, and they MUST buy or sell to follow the underlying index. There are literally thousands of them, with assets estimated at $11 trillion for the US market alone - that’s a massive 20% of total market cap. To make it worse, a mere 10 companies account for 40% of the entire S&P 500 index, which itself is capitalization weighted. Therefore, a very large percentage of stock owners who MUST follow the index are currently sitting atop an extremely narrow market. The operational market leverage risk is unprecedented. By the way, many of the ETFs are 2x and 3x trackers, using futures and options, so there is even more leverage involved.

2. Algorithmic trading. By definition, algorithmic trading is mechanistic. Create a “formula” and follow it, again and again. A massive 70-80% of all daily trading volume in US equities is now algo based and, more worrisome, some 40-45% of this is retail. Algo is, therefore, another layer of “hands-off, brains out” market participation. Like all algorithmic models, algo trading is optimized to perform well under current conditions and is based on current assumptions. This is strongly reminiscent of the debt “tranching” model which was based on flawed assumptions and precipitated the Great Debt Crisis.  

Put everything together: ETFs, algo and an extremely narrow market. The leverage risk transmission mechanism is, in my opinion, very dangerous and prone to a China Syndrome incident. Can anyone throw a switch to prevent it? Can it be done fast enough to stop a meltdown?

Final word: a market exhibiting the above characteristics can be very easily manipulated.