Misallocations of Capital

By Steve Ayer on February 10, 2025

These past few weeks have been a watershed moment in the economy and the markets.  Not only was President Trump sworn in, which was followed by landmark executive orders creating massive change and uncertainty surrounding much of those changes, but we’ve also seen an obscure AI company out of China, Deepseek, potentially upend the AI narrative that has become so pervasive within the hearts and minds of the investment community over the last few years.

Unfortunately, as is always the case with moments like this, things are not immediately fully understood and may take weeks, several months, or possibly even years to fully grasp the entirety of what has recently taken place as there are still many unanswered questions with limited details right now.  It has been like drinking out of a fire hose while being surrounded by market volatility and uncertainty abound, but the importance of these events should not be taken lightly.

I am going to, mostly, stay out of the political maneuvers over the past few weeks in this writing, though there will be a lot shared over the coming weeks and months about how it is impacting daily life and markets.  Instead, I am going to focus mostly upon the markets with a perspective that is global in nature and has been unfolding over the years while seemingly culminating over the past few weeks.  The markets are always extremely complex, so moments of clarity should be grabbed hold of and shared; that is what I am going to do with you today. 

Here is the bottom line:  There has been a gross misallocation of capital in some markets over many years that we’re in the midst of unwinding, but are still in the early stages of it. 

What does this mean?  What does it imply for future markets, if it’s correct?

Bonds:

Bonds are at the heart of the misallocation of capital story, and it’s very easily and factually traced back to 2008, with the onset of QE (Quantitative Easing) by the Federal Reserve in the wake of the financial crisis back then.  The Fed, along with many other central banks across the world, began to print money and buy bonds at that time, which then caused other investors to buy bonds and create a bond market that was dramatically overvalued because it was being manipulated by the authorities.  This is a misallocation of capital in the bond market, which then created strength in the stock markets as well as the economy.  The biggest problem with central banks printing money, from my perspective, was that they continued to do so far beyond the risk of recession and maintained their printing of money to stimulate the markets and the economy during economic expansion, even with a robust stock market.  In other words, the Fed and other central banks just kept printing money and buying bonds, which caused investors to do the same, because why fight the world’s most powerful institutions when they have the ability to create money and buy more bonds?  This was a grotesque misallocation of capital, which ultimately resulted in inflation and the crashing bond market over the past 3 ½ years.  These last few years actually resulted in the worst performing bond markets in history and a lot of people lost a huge amount of money in the bond market as a result of this the gross misallocation of capital (MAC) by the central banks of the world.

Inflation cycles in the past have come in waves, so many analysts feel as though there will be another inflationary wave at some point in the future and I am one of those people who believe that as I wrote about in my paper; The Long Term Pillars of Inflation –https://strata.hightoweradvisors.com/blogs/insights/the-long-term-pillars-of-inflation, which I wrote almost two years ago now. 

At this time, what’s most important right now about the MAC into bonds in the past is how massive the bond market is and how the distortion in bonds has also created a waterfall effect of misallocations of capital in other markets because of the initial manipulation of the bond market.  In other words, the bond markets of the world are incredibly influential and important to the rest of the world’s financial markets and their stability, thereby directly or indirectly impacting all the other liquid global markets of the world and their behavior in a meaningful way.  So, as the bond market has been manipulated and distorted over many, many years with a gross MAC, this has massively distorted other markets and decision making as well!

Cryptocurrency:

Let me just come out with this right off the bat here and share what is a very controversial perspective on cryptocurrencies: 

In my opinion, cryptocurrency is the largest financial bubble of all-time. There, I said it!  In other words, I believe that it is the most egregious, most grotesque misallocation of capital in the history of mankind.

Many folks would say that this is an outrageous statement and completely way off base, that I don’t understand the market and that I am totally wrong, and that’s fine, but before you send any hate-mail, just let me share a few ideas about this with you.

As the massive MAC took place in the bond market as mentioned previously, it directly led to rates being artificially held down too low, which, in turn encouraged people to buy things that they normally couldn’t afford, but more importantly, take risks that they also wouldn’t normally take with their investments.

I witnessed this first hand and continue to witness it first hand to this very day and it goes something like this:   When bond yields are too low, people want to get a higher return, so they tend to take on more risk because why not, other markets are going up and the true risk isn’t seen or felt that dramatically because the markets always ultimately go up anyway, don’t they?  The Fed always comes to the rescue and prints money, right (see my Pavlov’s Market blog from early last year – https://strata.hightoweradvisors.com/blogs/insights/pavlovs-market)?  What people seem to always lose sight of is when risk is not being seen or felt in the moment, it doesn’t mean that it’s NOT there, its just means that it’s lying latent until it manifests.  So, when rates are down, people take a little of their money (or a lot) that should have gone into bonds, a more conservative investment under a normal/non-manipulated environment, to purchase other things that they can get a higher return on (a more aggressive investment).  In other words, the central banks of the world practically forced people to take more risk because of artificially low yields.  In the decades past, money would have flowed almost exclusively towards stocks, especially after the carnage in housing in 2008 and beyond, but with the advent of cryptocurrency and its unique attraction to essentially get some money out of the traditional financial system, it too began receiving a large amount of the more aggressive money flow that would have normally gone into bonds and stocks. 

People will argue that crypto is this new technology that will change the world; maybe that’s true, and in some ways it already has.  When people argue about why it’s good to purchase crypto, they say that you can get out of the world’s financial system/control through crypto, meaning that you can get out of the control of the US Dollar or the Euro or any other currency amongst technology benefits (like the safety of blockchain), etc., but what happens when the US Government or other governments across the world adopt a Central Bank Digital Currency (CBDC) of their own – NOT a cryptocurrency, so please don’t misunderstand this – NOT using a cryptocurrency, but actually converting their own currency to a fully digital currency.  That is, the Euro or the Yen or another currency becoming fully digital without the circulation of cash within their systems?  

Does anyone really believe that the world’s governments will encourage competing currencies from the crypto space or even more outlandish, adopt a cryptocurrency or basket of them as their own legal tender currency?  If one does think so, I would strongly encourage them to do a lot more research on the topic and, honestly, I think that I’ll just leave it at that. 

Perhaps CBDCs will never materialize either, but right now, there are over 130 central banks testing CBDCs.  Also, think about this; if a country issues ONLY a CBDC, without allowing any cash in the system, then that country will collect much higher taxes because at that point, there is nothing that can’t be tracked and taxed.  The estimates are that any country moving to a CBDC will increase their annual revenue significantly by simply eliminating cash in their system.  When looking at many countries’ sovereign debt levels across the developed world, I find it very hard to believe that governments won’t do everything that they can to increase tax revenues, especially when pressure from the markets arise because of their high debt levels.  So, CBDCs will be a solution to the debt problems in the future and government’s CBDCs will then directly be going head-to-head with cryptocurrencies at that time and ideas that go head-to-head with the government don’t usually work out too well. That’s the big picture stuff, but let’s now dig into some of what has been transpiring in this market recently.

Coming back to a real cryptocurrency coin called Fartcoin, which is one of over 13,000 cryptocurrencies that have been created over the years by random people hoping to make a quick million or billion, as crazy as that sounds.  Fartcoin was truly created as a joke along with Dogecoin and many other cryptocurrency coins out there, however, what is not a joke, is that Fartcoin recently reached a valuation that exceeded $2 billion a few weeks ago while Dogecoin, also created as a joke, recently had a valuation of over $50 billion. 

What purpose do each of these jokes and other cryptocurrencies serve?  A few of the larger ones like Bitcoin may have some minor uses as a medium of exchange, but it’s quite honestly few and far between.  That may change for a broader base of cryptocurrencies in the future to possibly being accepted in significantly more locations for payment or being some amount of a store of value (though I am not sure how much) as Bitcoin has, but for the VERY strong majority of coins out there, advocates simply admit that they are just for speculation purposes, which is, honestly, quite an admission.  So, that’s it????  Buy this coin or that coin because maybe you can make money on it until the greater fool comes along to drive the price higher and you can sell it at a higher price?  Essentially, yes, and these speculative forces have driven useless cryptocurrencies up to outlandish valuations, creating the largest misallocation of capital in history…, in my opinion.

I once read a book called “Extraordinary Popular Delusions and the Madness of Crowds”. This book was written in the 1800s and highlighted many past financial bubbles throughout history and one of those was the “Tulip Mania” that occurred in Europe in the early/mid 1600s.  During this tremendous MAC event, tulips became worth the equivalent of thousands of dollars in today’s money as people entered into a frenzy, a mania that ultimately fed into people’s emotions enough for them to pay ridiculous amounts of money for a flower that soon died.  Having said this, at least people got a flower from the outrageous amounts of money that they spent, whereas in most cryptocurrencies today, all that people get from it is being sold an idea that it will be worth more in the future than it is today, which is a little like musical chairs or a owning a mirage.

Human nature is always constant, which is why history always repeats.  We’re the same stupid people today that we were hundreds of years ago and thousands of years ago, meaning our nature is the one constant throughout history and that is why the study of the book, “EPDMC” is so fascinating.  The bottom line is that history repeats constantly and although the actors change, human nature doesn’t.  The same patterns evident of the Tulip Mania in the 1600s were the same that we saw in the Dot.com bubble and now the cryptocurrency bubble. 

It certainly is fascinating, but the last thing that I want to share here is that nobody can time the end of these manias.  As a matter of fact, Fartcoin could launch higher from here along with Dogecoin and other cryptocurrencies as President Trump has embraced the sector or some other event causes animal spirits to rise even further in the cryptocurrency space.  My intent here is not to give a recommendation on buying or selling cryptocurrencies, but to simply show how speculative the sector has become with useless coins created as jokes being worth significantly more than meaningful companies or entire sectors that actually have value or the future potential to create something that has value.

Now, I want to bring this back to the manipulation of low interest rates for almost two decades because it was that misallocation of capital that also helped to create this one.  With interest rates higher and having a good probability of rising in the future for many reasons (see the Long Term Pillars of Inflation paper I wrote almost two years ago now), this potentially biggest financial bubble in history/greatest misallocation of capital in history should also burst at some point just as the bond market bubble burst.

AI:

Finally, with the revelations of Deepseek bursting on the scene recently, it appears that AI and technology in general could be another potential MAC present in the market today.  There may be other candidates like the US Dollar and others, but let’s dive into this AI possibility now.  

If what Deepseek says is true, then many US tech giants may be dramatically misallocating capital toward hardware to build out their AI platforms when they could be spending a fraction of their expenditures to create similar outcomes.  This perspective is uncertain at this point, but at the same time, the one thing that most everyone who has analyzed Deepseek’s platform has agreed on, is that its technology is solid and it performs as well, or possibly better than, other AI tech platforms out there.  Over the coming weeks and months, the market will answer these questions above and determine whether or not there has been a MAC by the big tech companies, but that is not my specific focus for this paper.  Instead, I’d like to dig into why this spending along with investments in the big tech stocks could be a MAC. 

The origins of this, you guessed it, can also be traced back to the bond market manipulation.  So, it begins with the same exact reason for buying crypto as it is for buying into technology stocks (the Magnificent 7, in particular), but in defense of investing in tech stocks, their earnings have been strong and consistent over the years along with their margins being great.  These tech companies have made tons of profits and rewarded shareholders, so you might say, how could this be a MAC? Each of the companies have huge amounts of cash on their balance sheets and then decided to spend some of that on AI to get ahead of their competition, so on the surface, it doesn’t appear to be a misallocation of capital or egregious in any way.  But let’s think about this more deeply. 

Over the years, investors took some of their bond investment money and invested in tech stocks instead of crypto and that caused the share prices of those companies to rise which, in turn, gave more power and wealth to those companies, which also in turn, then gave them greater ability to do more marketing and put more money into R&D and become even more powerful.  The end result of the waterfall of the MAC in the bond markets also propelled tech stock prices higher which then became a positive feedback loop, all built upon the bond market’s initial misallocation of capital.  This has resulted in bigger profits and very expensive tech stocks from a valuation perspective, even with most having modest growth rates today vs what they used to be. 

Up until the last few weeks, there has been an aura of invincibility surrounding the stocks of the Magnificent 7 and beyond in the tech space.  This has translated into a perspective of “American exceptionalism”, meaning that the US is simply superior to the rest of the world in quality of workers and companies and that because of this “fact”, that you just need to own US stocks and primarily the big tech companies and nothing else.  The reasoning goes on that AI is a long-term trend and it’s only getting started. With the US companies being so dominant and so far ahead in spending, that nobody will ever be able to catch up to them, the logic has been just buy the tech stocks and US stocks and don’t worry about their valuations because they are just going to keep going higher.

Right now, “the top ten companies in the US represent approximately one third of the market cap within the US S&P 500 index, which is a level of concentration that we’ve never seen before.”  Louie Gave of Gavekal Research.

Louie goes on to say, “maybe I’m wrong…, but I believe that a lot of the outperformance was linked to this idea that a lot of these companies (the large tech stocks)…, could spend their way to creating massive, unassailable motes (for their AI leadership throughout the world)…, that you could spend your way to building a monopoly, for all intents and purposes.  I believe this belief has just been shattered (because of Deepseek).”

So, coming back to the argument for a MAC, not only have the companies themselves spent hundreds of billions of dollars of investor capital on AI development where the barriers to entry may have just been dramatically levelled, but it’s the MAC from investors into these stocks that helped create this in the first place.  Now, we have a very small group of expensive tech stocks that make up a huge percentage our overall stock market spending massive amounts of capital, with all of this exponentially, potentially creating layers of MAC. 

It’s also VERY interesting to note that the correlation between cryptocurrencies and the technology sector has been strong over the last decade, so when one of them is strong, the other tends to follow and vice-versa over the years, meaning when one of these breaks, look for the potential for the other one to break as well.

There is so much complexity to the markets and these theories, but I do want to leave you with two optimistic thoughts:

First and foremost, if my examples of gross misallocations of capital begin to unravel beyond the bond market, then ultimately, investors will begin to look elsewhere for other companies, sectors, and indexes that are cheaper and a better, more productive place to put their money.  This, in our opinion, is bullish for many asset classes and indexes across the world, going forward.

Secondly, if AI is about to become more of a level playing field, with lower barriers to entry, then this means that the average company will soon be able to utilize AI without spending that much money to increase its productivity, thereby increasing their margins and profitability as well. This, in turn, also reinforces the fact that many other asset classes and indexes across the world could see a productivity boom and, therefore, a profitability boom in the wake of recent AI revelations.  This is essentially an extension of the first point above, it just may take a little time to get there and along the way we could see a fair amount of volatility in markets.

Thank you,

Sincerely,

Steven M. Ayer, CIMA®, AIF®
Managing Director, Partner

Hightower – Strata Wealth Partners
1 American Wharf, Suite 2B

Norwich, CT 06360
(p) 888-992-9690
(c) 914.924.4784
(f) 914.206.4293
sayer@hightoweradvisors.com

Author of “Choosing Simplicity”