Over the last three years, AI-related stocks account for 75% of S&P 500 returns, 80% of earnings growth, and 90% of capital spending growth1.
Today, the five largest U.S. technology companies are now worth more than the combined markets of the Euro Stoxx 50, the UK, India, Japan, and Canada. The ten largest U.S. stocks represent nearly a quarter of global equity.
Given this backdrop, it’s no surprise investors are asking if we’re in a bubble. Making matters worse, recent market volatility appears to be fueled by headlines like these:
- Goldman Sachs and Morgan Stanley CEOs Warn of Possible Drawdown
- Wall Street CEOs Flag High Market Valuations, Pullback Risk
- Goldman Sachs, Morgan Stanley warn of a market correction
- Wall Street heavyweights flag risk of pullback in equity markets
So, is it true? Are we in a bubble?
Having invested through the dot-com crash, I now rely on four necessary conditions for a bubble to form.
The first is a major technological revolution or shift in financial practice. There’s no question AI checks this box.
The second is easy access to credit, because when money is cheap and available, dumb ideas percolate. I’m 50/50 here because “moonshots” aren’t a thing just yet, but if interest rates fall further, we will be watching this very closely.
The third is that people must have already forgotten about the last bubble. Yes, there’s some FOMO investing (Fear Of Missing Out), but Gen-Xers and older still feel their dot-com scars. Perhaps that’s why today’s valuations are fueled by revenue, rather than just hype.
The fourth is the abandonment of time-honored methods of security valuation. As bubbles grow, assets can’t be valued using price-to-earnings or even price-to-sales, so they turn to fake ones to justify the mania (my favorite from 1999 was “price to website visits”). I’m not seeing any of this just yet.
Add it all up, and we don’t believe AI is a bubble. Not yet, at least. There are obvious signs of excess (like Quantum Computing), but there’s also a reason why NVIDIA’s market cap is almost the same size as Japan’s stock market. They produced over $165 billion in revenue in the past year and turned more than 60% of that into profit.
Regarding market pullbacks and recent volatility, both are features, not bugs, of a well-functioning equity market. They shake out speculation and lay the groundwork for the next upward move. We saw this after Liberation Day, and we’ll almost certainly see it again.
We just don’t know when it will happen next.
That’s why we plan for corrections before they occur. Staying diversified in our equity allocations. We own a lot more than just a handful of mega-cap growth stocks in our portfolios. We also keep a healthy allocation to fixed income and other investments that prevent our clients from seeing their portfolios go down in lockstep with the market.
These shielded investors after Liberation Day, and we expect their efficacy to remain intact even if AI does turn out to be a bubble.
The bottom line is that every major innovation cycle, from the railroads to the internet, experienced periods when prices outpaced reality, corrected themselves, and then resumed their long-term ascent. The real risk in each was not the volatility but how people reacted to it.
But don’t just take my word for it. Peter Lynch, one of the greatest investors of all time, said it best…
“Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.