When Leverage Goes Wrong on Wall Street

0:01Travis Hoium:No margin calls for the next hour. Motley Fool Hidden Gems Investing starts now.

0:09Travis Hoium:Welcome to Motley Fool Hidden Gems Investing. I'm Travis Hoium joined today by Lou Whiteman and Jason Moser. Guys, we've got to start with the news of the week. Lou, that is situational awareness getting a margin call. The hot investor of 2026 is now out of the equity markets. What in the world happened.

0:30Lou Whiteman:Yeah. So let's talk about this because this is fun. First of all, situational awareness, the AI focused hedge fund founded by, I hope I can send this right, Leopold Aschenbrenner, I think it is. Now, Leopold has a heck of a history already. I mean, it's almost like the Forrest Gump story here. All right, guys. He was at FTX with Sam Begman-Fried. He was at OpenAI and then he went off and he actually just wrote, I think it was a substack or something talking about situational awareness, basically that AI was going to eat the world, got a lot of buzz, and he turned it into a hedge fund. His hedge fund, same name, situational awareness, focused on AI bets.

1:07Lou Whiteman:And, you know, as the tide was rising, so too did his portfolio. The fund borrowed heavily to multiply its returns. We don't know exactly how much, but we know this because the fund's return were better than the underlying assets that it was buying in terms of their returns. So there's obviously leverage at its peak. It soared from a couple hundred million to 20 billion in assets, up 440 percent in the first half of the year. But guys, we've seen

1:32Travis Hoium:in the first half of the year. I want to highlight this. The first half of the year, which ended exactly one month ago today.

1:38Lou Whiteman:Yeah, yeah, yeah. But we have all seen this movie enough times to know what happened here. You know, the AI infrastructure trade has taken it on the chin of late. Some of the situational positions, you know, these companies, Micron, SK Hynix, CoreWeed, they were down big and short positions that they also took on betting against software. Like they were basically in on the AI is going to eat all software. So short software companies to the ground. Those started turning against it too. The banks that provide leverage called, said hi to avoid liquidation. The firm negotiated a rapid fire sale to Citadel.

2:15Lou Whiteman:Don't cry for Leopold though. He retained the private assets include, and this is the last scene of the movie here, including a$5 billion stake in Anthropic. He still has that. But yeah, a heck of a week. Lots to learn here. This is actually, I think there's a lot of, I don't know if JMO and I are going to be building similar portfolios, but I still think there's a lot we can learn here.

2:36Travis Hoium:I want to start with the margin piece of this because I think this is important for investors to understand. This is why we talk about not using margin. but I want to explain a little bit of the math behind it before we get to the Citadel buyout because I think that is also really interesting that they've become the villain in a lot of circles, but they actually may have saved the day. But Jason, the math on this, just on a basic sense, I think that we, the reporting is that he was about 4x levered. So$20 billion fund, let's just use that simple math, owns$80 billion worth of stocks. If those stocks go down 25%, you have nothing left.

3:16Travis Hoium:All you have is your debt. Your equity is now zero. That's how you get in trouble really, really quickly because you're leveraged on the upside when things are going well. Like Lou said, you can have a 400 % six-month run. By the way, I think that 430-something percent number was after fees. So the real return was probably well over 500%. But this is this is where a, you know, a big move. But these companies aren't going bankrupt, can can get you in a lot of trouble. Sure. Yeah. And I mean, that's I think so. I personally I don't invest, you know, on margin. I don't use debt to invest. It's just it's just not my style.

3:57It's not what I do. And I think part of that is at the end of the day, you don't really control what's going on. Right. You don't ultimately call the shots at some point. If you have any sort of thing that shifts in the market for whatever reason, I mean, you're you're completely out of control. Right. Somebody else is going to call you like like Lucetta bank calls us. Hi, how are you? We'd like our money back, please. And you have there's nothing you can do. And so and so I think it's always worth remembering that, yeah, it can really amplify returns as things are going well. But when the tide turns, it can be catastrophic, to say the least.

4:36And I mean, I think this is just an interesting story. Just I this Ashen Brenner himself, like he was not a trader, not an investor, not a dumb guy, clearly very well educated and obviously had some interesting jobs along the way. It does kind of remind you of that Dunning-Kruger effect, though, right? I mean, you just sometimes maybe you think you're a little bit better at something than you really are. And I'm sure he was feeling great. I saw it on social media. I mean, apparently, you know, he was having a day. Yeah. And fast forward to today. And I mean, it's pretty much yesterday's news. But I mean, to lose point, too, don't cry for him.

5:19I mean, he's still doing just fine. At private stakes and companies like Anthropic. I mean, he's going to walk away from this doing just fine. but it's certainly made for a lot of headlines this week for sure.

5:30Travis Hoium:Yeah, and the fund does still exist. I think he sent a letter to investors overnight and actually said they're still up 80 % for the year. So that Anthropics stake is doing a lot of work there. Lou, I want to talk about a couple of the mechanics here because this is one of the things I think a lot of people have gotten confused about or think there's market manipulation going on. I'm going to try to walk through this and see if you agree with sort of the number of events that happened here. So a bunch of these positions, which people, they have to file 13F. So we know some of these public positions that he held, at least as of the end of the second quarter.

6:06Travis Hoium:Actually, those aren't even out yet. No, no, it's first quarter. We would only know through the end of the first quarter. But it's relatively well known, at least some of the positions, and that he has a leveraged portfolio. So these stocks start to go down. What then ends up happening, and I'm saying that this is not new because Jim Cramer wrote about this in Confessions of a Wall Street Addict, which I think was published in the late 90s. Other hedge funds start to smell blood in the water. They start to go, oh, somebody's in trouble. And guess what? When your stocks are going down and you have, let's say that$80 billion number is the number, you can't just go to the market and say, you know what?

6:44Travis Hoium:I'm going to take my bets off the table because if you start selling in bulk, it's going to just exacerbate the problem even worse. So you have people betting against you, going short against you. Your valuations start going down. That's what you're talking about. Eventually, the banks, the brokerage calls and goes, hey, you know that$60 billion that you owe us? You got to come up with that money. We got to figure something out. And that seems like that's what started to happen as early as last weekend. I think so.

7:12Lou Whiteman:And look, you know, yeah, a lot of people like to bag it, but this is a competitive industry. And look, even if you didn't have the 13F, Leopold's doing a lot of interviews. He's talking about a couple of trends. We're all smart in this room. We probably could have guessed some of the stocks that he was in. And look, if your favorite football team finds out that the cornerback for the other team has a bad knee. Yeah. And they start throwing to that side. Is that cheating or is that just smart or somewhere in between? Right. So if I don't think Citadel or any of these big investment companies, they weren't even saying let's target situational awareness.

7:48Lou Whiteman:They were looking at the market and saying this is a very what they call crowded trade. There's a lot of people using leverage. I bet that there or it was a reasonable thing to say, like, if there's pressure here, it could it could snowball. And this is where we want exposure. So I don't think it's even like a vast conspiracy. Let's put Leo out of business or something like that. It's just this is how market dynamics work. A trade gets crowded and people say a market is always two people with different opinions coming at a fair price. The crowded or more crowded one side of a trade gets, the more appealing the other side looks.

8:27Lou Whiteman:That's what a high valuation is. So, yeah, you can see Citadel as a villain here because they probably saw this coming and they probably have, well, now slowly or orderly liquidate a lot of this and get their money back quick. Or you can see them as a hero because one of the things and I don't want to make them a hero. But one of the things I think as individual investors, we always talk about do not panic in a downturn because there's a lot going on. But if Citadel or someone hadn't have stepped in, the other option here was to liquidate, to sell$80 billion worth of positions.

9:00Travis Hoium:And now you're talking about, yes, some of these stocks are down 50, 60%, but they could go down another 50, 60, 70 % really quickly.

9:07Lou Whiteman:Really quick. And frankly, it should be temporary. It's just an influx of supply and it puts supply and demand. Always the real takeaway here from this story, all the way back to long-term capital management and before that is, is the reason we say do your best not to panic in a downturn is because there is a lot going on that isn't tied to long-term price appreciation and fundamentals. So if you're focused on price action and not fundamentals, you can really get bit. I mean, there's some times where you just need to sell, but so often in these panics, there's more to it going on than And everybody hates this stock and it's going to zero.

9:48Lou Whiteman:And that's why literally sitting on your hands tends to be the best thing you can do in a panic, even though every fiber of your being says, get out, run. Jason, I'm going to give you the last word. What did we learn this week? I like the idea of sitting on your hands. I think that Lou said it perfectly. I mean, their emotions are difficult to control in investing, but it is a crucial, crucial part of being able to invest successfully over the long haul. And when you see headlines breaking out like this, you see markets reacting with volatility. It's easy to say I've got to do something. But for the most part, in most cases, the best action is just inaction.

10:33Just keep investing every time you get paid, put that money in your index fund. If you own individual stocks and you know why you own them, then feel good about that. But oftentimes the best action is an action.

10:47Travis Hoium:Yeah, I think this is where I keep going back to a lot of these long term foolish principles that they work over years and over decades. And that is the most reliable way to not only compound wealth, but also to even beat the market long term. And the investors that we're talking about here, whether you're talking about Citadel or whether you're talking about situational awareness, are playing a completely different game. And that's another thing to keep in mind is that you as an individual investor are not doing the same things that they're doing. Citadel is making markets. This was a great opportunity to make a market and maybe make several billion dollars along the way.

11:26Travis Hoium:But it doesn't necessarily mean that these businesses are broken or anything like that. So focus on that long term. Anonymity is a good thing. Like, you know, I don't want to be the guy on social media making headlines and people talking about my fund and what a genius I am. I'm OK just kind of flying under the radar, just kind of doing my thing. Anonymity is a good thing. Maybe maybe next week, Lou, we should talk about what a genius Jason is on the show. Please don't. Let's not do that. Let's not do that. When we come back, we are going to talk about hyperscaler earnings. You're listening to Motley Fool, Hidden Gems, Investing.

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12:54Travis Hoium:Welcome back to Motley Fool and Jim's Investing. We had a huge week of earnings from a lot of the biggest companies in the world, the big tech companies, the hyperscalers, as they are known. And Lou, what has been absolutely crazy, if you look at a chart, I have a chart up right now of Microsoft, Meta, Google, Amazon, and Apple. And they go completely opposite directions. For the week, we have Microsoft up 19%. Amazon is up 14%. Most of that is today. Meanwhile, Apple down 9.4%. and meta down 9.6%. What did we learn? Why are these stocks diverging so much right now?

13:33Lou Whiteman:So I'm going to carve out Apple because they kind of chose not to play in a way here. So I think for them, there might be separate things. But I think with the hyperscalers, what's going on is right now, the market has one question for these companies and the answers varied. And what we saw was the stocks react based on the answer. The question is, when ROIC, when returns, all right? Now, to be clear, I don't think the market is is yet punishing spending. That was kind of I saw headlines about that, but I don't think we see that, you know, spending bad. I think some to some extent, especially for some of these.

14:10Lou Whiteman:Toning down spending might be appreciated, but I don't think that right now it's if you're if you're if you don't lower your capex, your stock is just sent to the toilet.

14:20Travis Hoium:That seemed to be the story last week with Alphabet, right? Yeah. Yeah, but they went negative free cash flow, but but they have recovered since then. So that was what I was keeping an eye on this week, too. Yeah.

14:30Lou Whiteman:Yeah. I mean, I don't think they're punishing CapEx. I think there needs to be a clear sign that these management teams have just a map to get to the pot of gold at the end of the rainbow. And Meta, based on its current business and its history with the metaverse, I think they have the least credibility on that front. You know, they may get there, but if you look at their history, if you look at what they've said so far, they have not articulated why all of this will end up in a happy ending. Microsoft and Amazon, they've done a little better telling that story. And they also have, I think, the most diversified revenue streams, which that's the best story to tell that everything is going to end up OK.

15:08Lou Whiteman:I really think that that explains the divergence. I think it's just where are we going with all of this, guys? I think Lou's right on the meta part. I mean, that to me, like right now, the market is just the market. It's actually like excited to hear these companies raising CapEx guidance. They're going to get Microsoft. They're going to spend one hundred seventy five billion dollars a year. Alphabet's going to spend close to two hundred billion dollars in those numbers are going to increase next year. I mean, we've already seen Alphabet explicitly stated. I mean, their CapEx next year is going to be materially higher than it is this year in the market so far is going along with it.

15:46And I think when you look at companies like Microsoft and Alphabet and even Amazon, I mean, you're seeing at least some sort of path toward the returns based on the infrastructure investment in the utility that customers are getting from their AI investments. With Meta, you know, I kind of look at these investments in AI. It's two different ways to kind of view it. Is a company investing in AI, the infrastructure to provide all of these services and bells and whistles for us, the broader consumer? Or is it a company that is investing all this money in AI that really that that is just benefiting their business?

16:30I think with Meta right now, clearly that those investments are benefiting its business, right? Its core ad business, because that's really at the end of the day, all it really is still. Granted, they have three point six billion users, so I think they're in a pretty good spot. But you do wonder, at least in regard to the money that a company like Meta spending, where is that return going to be beyond just their core ad business? And I think with Amazon, with Alphabet, you know, I think we're with Microsoft, we're seeing that they're able to monetize this to a degree, which we just haven't seen with Meta yet.

17:07Travis Hoium:So is the idea there, Jason, that they have what you would think of as a platform, a cloud platform, so it can provide compute. Other companies can build on top of them. And that's if you look at Amazon or you look at Alphabet, a lot of that is actually coming from Anthropic, a lot of that demand. Whereas Meta is building compute and going, well, we'll figure out what to do with this later. And that's a unsatisfactory answer to the market. I would say that's unsatisfactory because it kind of rhymes with what's been going on with reality labs, right? To this point, and we've been hearing this for a lot of quarters now, is investments in Reality Labs.

17:44Eventually, it's going to pay off and the returns will be there. And it just quite honestly has not materialized to this point. And I think it's fair to assume going forward that you probably aren't going to see a return on that investment. I don't know if it's just we as consumers aren't there yet in regard to immersive technology. Maybe one day it will pay off. But to this point, it certainly has not. And I think those questions only grow a little bit louder when you start looking at all these investments they're making in AI. Hi.

18:16Travis Hoium:Lou, this seems like the questions seem to change every quarter about what the market is looking for. As you look at right now, we're starting to see phenomenal revenue growth. So I don't think there's any question that the revenue is coming in. More questions about what's the return on that invested capital, because if you're putting $200 billion in the ground, you better get some revenue out of it. When are we going to get real answers that are going to show up in the financial statements about if there is ROIC?

18:44Lou Whiteman:Better come soon. And I don't know. And in the market's defense, we're still early days. So if the market keeps asking different questions, maybe that's what it's coming. My biggest fear here, guys, is there isn't a lot of ROIC in the frontier models. And that's where all the spending is going, that most of the AI goodness will just come from lesser models. And that, I think, is the huge fear hanging out. But look, someone's going to make money off of this. And probably the companies with big cloud businesses that just can do that for whatever is going on. And I think that's probably the way I'd lean right now, just because you feel like there will be demand there, whatever, whatever the future holds.

19:20Travis Hoium:When we come back, we're going to ask Lou and Jason, which stocks they would rather buy. You're listening to Motley Fool, Hidden Gems Investing.

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