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The question on every investor’s mind is, “Are we in an AI bubble?”
The market seems pretty frothy, primarily fueled by the mass adoption of artificial intelligence. Clearly, we are in a new paradigm – AI promises to change the very nature of our way of life. Something this big, even if it’s currently overblown, can’t be ignored.
Have stock valuations gotten ahead of itself? Interest in AI has hit an all-time high. During Q1 2024, 199 companies of the 500 companies that make up the S&P 500 mentioned the term “AI” at least once during their earnings call.
At the sector level, the Information Technology sector has the highest number (50) and percentage (91%) of companies citing “AI” on Q1 earnings calls.
For all of you tech stock owners out there, things are getting wild. Everyone is jumping on the AI bandwagon.
Well, why not? AI can be a significant productivity booster and even a driver of revenue growth. They are smart for taking advantage of this. In my opinion, companies ignoring this will pay the price in the future.
AI corporate use is already out there.
Amazon uses AI to optimize its delivery routes and to automate its warehouse operations. Netflix uses AI to recommend new shows and movies to you (sorry Netflix, for the 100th time, I have no interest in watching Atlas).
The longterm benefits of corporate AI are still unknown. How beneficial can AI be 5 years from now? 10? We could still be in the early innings on this thing.
Overrepresentation?
The question we face today is whether or not the market is too zealous on this technology. AI stocks have been on a tear, as you already know.
Of course, the tech sector is leading the AI charge – remember that 91% of tech companies cited AI in their latest earnings call. And AI is undoubtedly a growth engine for the U.S. economy.
If you were to buy a large-cap growth portfolio (not just a tech fund), nearly 60% of your portfolio is made up of the tech sector.
Vanguard Growth ETF
And three companies make up ~⅓ of the entire portfolio: MSFT (12.6%), AAPL (11.5%), and NVDA (10.6%). Concentration risk, anyone?
There is a ton of risk with this portfolio. I can’t tell you how many prospects and new clients come to us with a portfolio very similar to this. If not this exact ETF, a lot of its underlying positions.
This isn’t necessarily a bad thing. Anyone holding these positions has done well recently.
But we all know that the party can’t last forever. The music is going to stop (or slow down) at some point, and they don’t want to be the one left holding the bag.
Time to take some risk off the table.
Market Bubbles
In its simplest definition, a market bubble is when the price of an asset exceeds its intrinsic value.
When this happens, the market has a tendency to overcorrect itself with a sharp decline. Fear takes over when prices slide, and everyone rushes towards the exit. The problem in this scenario is that the exit door typically isn’t very big.
Some of the more famous market bubbles and the corresponding decline:
- Tulip Mania (1636-1637)
- Peak: Prices for single tulip bulbs reached as high as 10 times the annual income of a skilled craftsman.
- Crash: Prices collapsed by over -90% within a few weeks.
- Wall Street Crash (1929)
- Peak: The Dow (DJIA) peaked at 381 points in September 1929.
- Crash: The Dow fell to 41 points by July 1932, a decline of -89%.
- Japanese Asset Price Bubble (1980-2009)
- Peak: The Nikkei 225 index reached a peak of 38,957 points in December 1989.
- Crash: The Nikkei fell to 7,054 points by 2009, a decline of -82%. Only recently (March 2024) did the Nikkei finally break out of this slump. It took 35 years.
- Dot-Com Bubble (1995-2000)
- Peak: The NASDAQ Composite index peaked at 5,048 points in March 2000.
- Crash: The NASDAQ fell to 1,114 points by October 2002, a decline of -78%. It took 14 years before the NASDAQ would trade at these levels again. Crazy.
- Housing Bubble (2007-2008)
- Peak: U.S. housing prices peaked in 2006.
- Crash: Housing prices fell by approximately 30% on average by 2009. Certain markets experienced declines of over -50%.
- Bitcoin Bubble (2017)
- Peak: Bitcoin’s price peaked at nearly $20,000 in December 2017.
- Crash: Bitcoin’s price fell to around $3,200 by December 2018, an 84% decline. This price action seems to be the norm for crypto. An 80% decline? No sweat.
- COVID-19 Tech Bubble (2020-2021)
- Peak: Many tech stocks and cryptocurrencies surged to insane levels. Plenty of cash-rich, bored people YOLOing it at home.
- Crash: Significant corrections occurred in 2021 and 2022, with some tech stocks and cryptocurrencies losing over 50% of their value.
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AI Market Bubble?
Bubbles happen. It’s human behavior. No one wants to be left out, especially when there is money to be made. And there is money to be made in AI.
Each bubble is unique, but they tend to share the same characteristics: exponential price increases, widespread speculation, leverage, new technologies, and media hype.
Right now, AI stocks seem to exhibit a lot of these attributions.
- AI Price Increases: The 800-pound AI gorilla is Nvidia. This stock has gone from relative obscurity to a $3T company. Other AI companies are also surging in price: Microsoft, Alphabet, Amazon, Taiwan Semiconductor Manufacturing, Adobe, etc. These companies are the reason why you are looking at a 60% tech sector concentration risk in VUG.
- Widespread Speculation: When my Uber driver is trying to educate me on Nvidia and its economic moats, perhaps things are a bit out of hand. The problem is that Nvidia does have one hell of a headstart on everyone else. And as a result, they are printing cash. But this won’t last forever. Remember that Nvidia’s high-performance GPUs were originally made for gaming consoles. The rise of AI and machine learning was an unexpected opportunity.
- A great way to detect whether or not there is widespread speculation is common valuation metrics. Here are a few charts to help identify where we are in terms of overall market valuation. (AI is pushing the entire market, although I will also show those areas of the market where tech plays an outsized role).
S&P 500 P/E Ratio: The higher the ratio, the more expensive the market is. It’s currently not crazy expensive, but it’s also not cheap.
Note that VUG, The Lg Cap Growth fund mentioned earlier, has a P/E ratio of 37, notably higher than the overall S&P 500 (28.96). Interesting.
Schiller’s CAPE Ratio: This is a 10-year moving average of the P/E ratio. Note the two previous peaks (2000 & 1929) – this is not great company to be in.
- Leverage: The best way to analyze whether or not there is significant leverage out there is FINRA’s Margin Debt levels. Margin debt is the amount of money investors borrow from brokers to purchase securities. The higher this number, the more at risk investors are.
- New Technology: We are experiencing, without a doubt, the AI revolution. This technology is already changing the way we live our lives. According to recent reports, the global AI market is expected to reach $267 billion by 2027. It is also expected to contribute $15.7T to the global economy by 2030. Just as the Industrial Revolution shifted agrarian economies to industrial ones, and the Information Age transformed how we share and consume information, the AI Revolution will fundamentally change the way we live and work.
- Media Hype: No need to spend too much time on this one – AI is dominating all forms of media – print, broadcast, streaming, social, influencers, podcasters, blogs, and more. The Information Age has made sure we no longer miss anything newsworthy.
Probably a Bubble
The question of whether or not we’re in an AI bubble is difficult to know. Everything is 20/20 in hindsight, but it’s difficult to tell where things stand when you’re in the middle of it. In my opinion, there is a good chance that we are in some sort of a bubble. Asset prices are frothy, and there is a lot of AI hype out there. Things like this result in price crashes. The trillion-dollar question is when.
However, we are still in the early innings of the AI Revolution. This thing has room to run. Things can get frothier.
Just know that the party can’t last forever. Don’t be too greedy and stay invested, my friends.
