The intense volatility rocking South Korea’s chip-heavy stock market has come to America, but Wall Street has suffered only modest losses in response.
Can this continue, or will the slump in semiconductors and vulnerability among highly leveraged investors cause serious damage in the U.S. as well?
The benchmark KOSPI index - heavily concentrated in firms benefiting from the artificial intelligence boom, most notably the trillion-dollar megacaps Samsung and SK Hynix - is down more than 30 per cent from its peak only a month ago, and volatility has soared.
Daily moves of 4 per cent or more are now regular occurrences, and 30-day realized volatility has exploded to the highest since 1998.
Regulators in Seoul have ramped up efforts to curb these wild swings in equity prices, which appear to be fueled, in part, by heavily leveraged retail investors using exchange-traded funds (ETFs). These “mom and pop” investors were pulled in by the extraordinary AI boom, and many have been caught out by the rapid snapback.
Most longer-term buyers are still sitting on substantial gains, of course, with the KOSPI still up 55 per cent this year, following an annual gain of 75 per cent last year. But the same cannot be said of short-term punters.
According to Goldman Sachs, more than 1.2 million leveraged retail trading accounts in South Korea triggered margin calls as of July 13, with an estimated 320,000–360,000 accounts fully liquidated. Goldman’s strategists reckon this means around one in 30 adults in the country, or 3.4 per cent of the adult population, have received margin calls.
That could have a meaningful impact on Korea’s economy more widely. If many South Korean households are now sitting on losses, that could weigh on the country’s economy moving forward.
Given rising retail participation in U.S. stocks, exposure to the AI theme, and the rising popularity of leveraged vehicles, could Wall Street – and the broader U.S. economy – be in trouble as well?
The use of leveraged ETFs has exploded in the U.S. in recent years too. These products use futures or swaps to replicate bets with borrowed money, multiplying returns by typically two, three or even five times. But they magnify losses as well.
U.S. assets under management in these ETFs have reached a record US$218-billion, up 60 per cent since the end of March alone, according to Scott Rubner at Citadel Securities.
Leverage tied to technology ETFs has grown a whopping 136 per cent over the same period, while leverage linked to semiconductor exposure has nearly tripled. Combined, tech and semis now account for 67 per cent of all leveraged ETF assets under management.
Until recently, this was a boon for U.S. markets, which have benefitted hugely from the outperformance of chips, AI and tech.
As Rubner notes, some 19 cents of every dollar allocated to the S&P 500 is directed toward semiconductor companies, with 33 cents going to the ‘Magnificent 7’ megacaps and nearly 40 cents to the index’s ten largest holdings, most of which are tech firms.
Put all this together, and you get a “concentration of speculation” that magnifies the potential for a heavy drawdown when sentiment turns, says Bob Elliott at Unlimited.
“It’s just leverage working in reverse. Everyone loves it on the way up, but not so much on the way down,” he says, adding that he sees a “pretty high chance” of broader asset prices getting dragged down.
It’s worth noting that the value of assets under management in leveraged ETFs represents less than 1 per cent of total ETF and mutual fund assets, according to Goldman Sachs. But the direction of travel is clear.
Since 2021, the retail share of U.S. trading volumes in leveraged index ETFs has been roughly double the share for those tracking the same indices without leverage.
And margin balances - the amount borrowed by retail investors from brokers to buy stocks – at retail investment firms Interactive Brokers, Robinhood, and Charles Schwab rose to 1.8 per cent of customer assets earlier this year, a new record.
If you zoom out to all brokerage firms registered with the Financial Industry Regulatory Authority, margin balances rose to US$1.3-trillion earlier this year, or 52 per cent of gross customer balances, according to Goldman. That’s the highest share on record, and 6 percentage points above the previous record high set in 1998, although it includes institutional money and borrowing to fund short positions as well.
The chip selloff will be putting these positions under pressure. While the S&P 500 and Nasdaq are only 2 per cent and 7 per cent off their June peaks, respectively, the ‘SOX’ semiconductor index is 25 per cent below its recent high. That means it’s technically in a bear market, and 30-day realized volatility is the highest since 2003.
Retail and leveraged investors – not to mention the broader market – could be in for a tough few weeks. While there’s little risk that these juiced tech bets could lead to a financial crisis or systemic issue on Wall Street, given the depth and diversification of U.S. markets, there’s still enough smoldering tinder for investors to get burned.