Leverage in the AI trade is even scarier than the debt used for its build-out

The sharp selloff in South Korean stocks — with massive follow-through across US tech stocks on Tuesday — is a useful reminder that the leverage involved in the AI <trade> can be a bigger near-term risk for markets than the leverage involved in the AI build-out.

South Korea’s Kospi is dominated by SK Hynix and Samsung, two of the three members of the high-bandwidth memory triumvirate along with Micron (which reports earnings on Wednesday).

An eagerness to embrace risk in a bid to get rich quick is not a uniquely American phenomenon. South Koreans love leverage.

Data from the Korea Financial Investment Association shows that margin loans have been going straight up and to the right:

Total assets in 11 Korean-listed ETFs that boast single-stock leveraged exposure to Samsung or SK Hynix in their fund names are up from under $3 billion since their launches less than a month ago, touching north of $10 billion heading into the most recent session. You’d need to win Squid Game about 340 times to amass the amount of assets these funds have been able to boast in such a short period. 

So, to a certain extent, Korea’s world-beating rally is fueled by using borrowed funds to make leveraged bets. Leverage squared!

(Yeah, there’s a lot of talk about foreign selling of South Korean stocks today too, but that’s nothing new — exchange data shows consistent divestments this year.)

It goes without saying that the above chart understates the leverage. The twists and turns of leveraged ETFs linked to the Kospi as a whole are heavily skewed by the performance of these heavily-weighted members.

High-flying AI stocks like Sandisk, Credo Technology Group, Lam Research, AXT, Micron, Corning, Applied Optoelectronics, Western Digital, Marvell Technology, Arm Holdings, Coherent, ASML, Arista Networks, Astera Labs, and Seagate Technology Holdings are all seeing heavy selling pressure in early trading.

What caused this rout? Who knows.

High leverage means you don’t (or shouldn’t) have to think too hard about why massive moves happen, particularly when nobody was asking too many pointed questions about why these same stocks were seemingly going up 5% per day in perpetuity. Play with matches and you get burned, or, worst case, start a fire.

That being said, Monday’s selloff in the Mag 7 heavyweights may have set the stage for some pain in Korea that turned more violent due to the leverage in the trade (sort of a chicken-egg conundrum, given how the Kospi’s drubbing is hitting the Nasdaq this morning).

Maybe it’s taking some chips off the table in light of the group’s hot run just before Micron’s earnings, which could be a catalyst for profit-taking.

In addition, a major leveraged ETF tied to SK Hynix recently changed how it gets its exposure, leaning more into options from swaps. That’s certainly something that introduces the potential for more tracking error, and hints at the difficulty in finding counterparties willing to take the other side of the trade at a reasonable cost.

Just yesterday, Dean Curnutt, founder of the Alpha Exchange and Macro Risk Advisors CEO, flagged this ETF’s change as “not something that will work out well,” adding that the product was “the center of the storm for an unwind in the semis/chips component of the AI trade that is approaching.”

Pretty darn good timing, that.