Artificial intelligence (AI) and ChatGPT have taken the world by storm, capturing the attention of investors and dominating the stock market performance. Today, the positive trajectory of the stock market is predominantly driven by the power of AI and GPT, as a select group of companies with advanced AI/GPT capabilities, including Microsoft, NVIDIA, Google, Apple, and a few others, experience a significant surge in their stock prices. These companies recognize the immense profit and productivity potential offered by this groundbreaking technology.
However, while the impact of AI and GPT cannot be denied, it is essential to shed light on the darker side that accompanies their rise.
GPT, in particular, has unveiled a new dimension that raises concerns. The speed and comprehensiveness of GPT can be exploited by malicious actors to create and disseminate fake images and content. Such malevolent individuals can then use social media and mainstream channels to manipulate markets, triggering both rallies and crashes.
In essence, GPT has become one of the most powerful tools in the hands of market manipulators, inside traders, and geopolitical adversaries. A recent incident serves as a compelling example of this threat. On May 22, a story emerged on various media platforms, including ZeroHedge, Facebook, and Twitter, displaying an image of a large building near the Pentagon engulfed in flames, alongside speculation of a terrorist attack. As a result, stocks began to plummet. Within minutes, it became apparent that the image was fabricated, evidenced by irregularities in the building's windows. In truth, the entire story was a hoax generated by AI.
Investors must brace themselves for more instances of AI-induced panic capable of manipulating markets.
A significant portion of stock trading is now executed by computer algorithms that rely on keyword analysis of breaking news. The previously mentioned incident exemplifies computer-generated panic triggering stock sell-offs based on fake images and news, with one computer reacting to information provided by another computer. This computer-versus-computer scenario, fueled by the advanced weaponry of AI and GPT, highlights the potential dangers that lie ahead.
Present-day stock markets, along with other markets such as bonds and currencies, can be described as "automated automation." To elaborate, stock investing consists of two stages. The first stage involves determining the preferred allocation among stocks, cash, bonds, etc. This stage encompasses decisions regarding the amount to be invested in index products or exchange-traded funds (ETFs) and the level of active management required.
The second stage revolves around the actual buy and sell decisions, such as when to enter or exit the market and when to seek refuge in safe-haven assets like Treasury notes or gold. What many investors fail to realize is that both of these critical decisions are now entirely entrusted to computers. This goes beyond automated trade matching, which has been prevalent since the 1990s. Instead, computers now make portfolio allocation and buy/sell decisions autonomously, relying on algorithms without any human involvement. This has become the norm in the market.
Over 80% of stock trading is currently automated, with a majority of it being attributed to index funds (over 60%) and quantitative models (under 20%). Consequently, "active investing," where investors actively choose the allocation and timing of their investments, represents less than 20% of the market. Even active investors still rely on automated execution for their trades. As a result, human "market making" accounts for approximately 5% of total trading. This trend is driven by two prevailing misconceptions.
The first fallacy revolves around the belief that "beating the market" is unattainable. This notion leads investors to favor index funds that mirror market performance. However, it should be noted that it is possible to outperform the market with robust models, although this task is far from easy.
The second fallacy assumes that the future will resemble the past over an extended period. This belief is responsible for traditional asset allocations, such as 60% stocks, 30% bonds, and 10% cash, which are deemed suitable for long-term financial planning. Unfortunately, Wall Street fails to acknowledge that a substantial stock market crash of 50% or more, similar to those experienced in 1929, 2000, and 2008, just before an individual's retirement date, can have devastating consequences.
However, there is an even greater threat that remains largely unexplored. In a bullish market, passive investing amplifies the upward momentum as indexers flock to popular stocks like Nvidia, Google, and Apple. Conversely, a minor market decline can quickly transform into a panic-driven stampede as passive investors simultaneously rush to exit their positions, paying little attention to the fundamentals of individual stocks.
The consequences are akin to yelling "Fire!" in a crowded theater. AI could be the source of a false alarm that sets off a chain reaction, compelling investors to abandon stocks en masse. Index funds would hurriedly divest from equities, and passive investors would desperately seek active investors to step in and buy. Unfortunately, there would be an acute shortage of active investors or, at the very least, an insufficient number to make a substantial impact. Consequently, stocks would plunge without any support, resulting in an uncontrollable market crash resembling a runaway train with no brakes.
This situation underscores the intricate nature of complex systems, with the market serving as a prime example. Complex systems possess a formal property wherein the magnitude of the worst possible event is an exponential function of the system's scale. Therefore, when the scale of a complex system doubles, the systemic risk does not double. It may increase by a factor of 10 or more. The emergence of AI-generated "fake news" only serves to amplify these market movements.
As AI technology continues to advance, making it increasingly challenging to distinguish reality from fiction, incidents like the Pentagon building fire fabrication will become more difficult to debunk. It is imperative for investors to grasp these technological advancements before their portfolios suffer significant damage.
One thing is certain: the threat posed by AI and GPT is not going away anytime soon.
Stay alert, stay informed.
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