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As stocks continue to march higher, there is little doubt that we are close, if not already in, bubble territory. Of course, there is no definitive metric that tells us whether or not we have crossed that line. But if you look at valuation metrics, they tell quite a story.
Just about every major valuation metric is signaling that large-cap stocks are expensive. Price/earnings, price/sales, CAPE, earnings yield spread; all signal overvalued territory.
AI in the Driver Seat
This, of course, is almost entirely fueled by the AI boom. As mentioned in my earlier post regarding the AI arms race, since ChatGPT was launched in November 2022, AI-related stocks have accounted for:
- 75% of S&P 500 returns
- 80% of earnings growth
- 90% of capital spending growth
We don’t know what the market and economy would’ve looked like if not for the AI boom. Suffice it to say, it would not have been as stellar. Economic growth would’ve been weak, and stock returns paltry. But I suppose the same could’ve been said during all previous technological revolutions.
And AI is, without a doubt, the next major technological revolution. We’re already seeing it in rising productivity numbers and the surge in corporate investment. It has the same energy as the early internet era, when everyone sensed a seismic shift coming but few understood just how big it would be. But disruption cuts both ways. A recent Harvard study shows AI is wiping out junior roles, particularly in professional services and knowledge-heavy industries.
A client put it well after attending a conference: when parents ask Tim Kapp (an educator in AI) which fields their college-age kids should pursue, his answer is simple and blunt: “Welding.”
As with all forms of progress, the creative destruction of AI will be messy in the short term but beneficial for all in the long run.
Of course, long-term optimism doesn’t stop investors from questioning business decisions today. The AI trade has worked out quite well thus far. The Mag Seven has been betting big on AI, though investors are starting to wonder: what if the AI bet doesn’t pay off? Which of these companies will win this war? Is this CAPEX justified at these price levels? What kind of revenue will all of this spending generate?
Not All Gloom
I believe we’re in the middle of a bubble, not just normal ‘frothy’ market behavior. However, that doesn’t necessarily mean that a big crash and recession are around the corner. Keep in mind that bubbles can last a lot longer than anyone expects. We are about 3 years into the AI boom. The internet boom lasted for 5-7 years. The housing boom lasted about 10 years. For all of this to correct itself, we either need prices to fall or earnings to increase. Of course, we want less of the first and more of the second.
The difference between the AI boom and the internet boom is that today’s AI-related companies are making a lot of money. Remember that most internet companies in the late 1990s had little to no revenue. They were content to set all their cash on fire while having a massive valuation. Conversely, AI-related companies have real, impressive earnings growth.
Innovation cycles like this often overshoot before fundamentals catch up. AI is still in its early stages, and everyone is still figuring out how to use it. It looks like we are still in the adoption phase. Some companies will overextend themselves. And some companies will go bankrupt. But that is the nature of innovation cycles. Markets tend to run ahead of reality before fundamentals have a chance to prove (or disprove) the optimism. Some firms will justify today’s valuations. Others will not survive the next downturn.
What To Do
Now more than ever, discipline must be maintained. If you’re worried about Nvidia or Meta pulling back, your portfolio might be over-exposed.
A few things to think about:
- Avoid concentrated bets. Yes, the Mag Seven have carried the markets. That doesn’t mean they are guaranteed to do so forever. History suggests the opposite. Concentration feels awesome on the way up, but not so much on the way down.
- Don’t do something stupid like sell all of your stocks and buy T-bills. Here’s why. We continue to overweight U.S. equities because U.S. companies still lead in innovation, profitability, and resilience. Betting against American productivity over the long term has a poor track record.
- Maintain exposure to winners in a rules-based way. We do this through a momentum sleeve. Momentum is about allowing market leadership to reveal itself and systematically tilting toward those leaders while they are winning, whether it’s AI-led or not.
- Frothy markets tempt investors to “just be all-in.” The problem is that no one ever knows when markets will turn. Risk controls feel unnecessary right up until the moment they become completely necessary.
- Your time horizon is really important. If you are retiring in 2 years, your risk tolerance will differ from that of someone who plans to retire in 25 years. The market does not care about your personal timeline, so your portfolio must. Make sure the two are aligned.
This is not the time to panic and do something rash. This is a time to ensure your portfolio is well-allocated. If it’s not, there is no time like the present.
