Artificial Intelligence and Investing: Is the Excitement Generating a Stock Market Bubble?

History serves as a guiding light, enabling us to navigate the complexities of the present by drawing parallels with the past. Despite the knowledge that past performance isn’t necessarily indicative of future outcomes, we often find comfort in these correlations. Today, many parallels are being drawn between the present enthusiasm for technology, especially Artificial Intelligence (AI), and the internet fervor at its dawn.

We recently had the pleasure of conversing with Professor Jeremy Siegel, renowned for his extensive contributions to understanding historical equity performances. He posits that the current technological environment of 2023 contrasts starkly with the dot-com bubble burst of 2000, particularly in the contexts of valuation and fundamentals. This perspective ignited our curiosity and motivated us to delve deeper.

Looking back to the late 1990s, the zenith of the dot-com era exhibited certain striking characteristics:

• The mere addition of “.com” to a company’s name catalyzed a rapid ascent in its share price, irrespective of tangible business prospects.
• New metrics, such as webpage visits or clicks, emerged to justify business progress in the absence of profits or sales.
• Despite many leading internet companies lacking positive earnings, numerous large-cap names in the S&P 500 reached a staggering price-to-earnings (P/E) ratio of almost 100x. Dreams of astronomical future profits underpinned billions of dollars in market capitalization.

Fast forward to 2023, and we observe a discernibly different landscape:

• Companies are indeed incorporating “AI” into their names, yet the phenomenon is not widespread. Moreover, these companies generally have solid business reasons for doing so.
• Investors are eager to gauge AI integration and data engagement by firms. However, the tech bubble’s lessons have imbued a sense of caution, making it unlikely for investors to disregard earnings or revenues anytime soon.
• Major indexes such as the Nasdaq 100 Index and the S&P 500 Index are driven by large companies with substantial revenues, cash flows, and earnings. Even though investors may scrutinize a company like Nvidia for its high valuation given anticipated growth, there’s no denying Nvidia’s tangible success. It’s already the leading provider of graphics processing units (GPUs), which are critical for AI operation.

Consequently, despite the potential for a near-term market correction and a concurrent AI hype cycle, we observe no glaring indications that broad technology-focused stocks are veering towards a bubble.

To gain a more comprehensive understanding, let’s dissect some numbers:

Figure 1, representing an ‘Expanded Tech’ sector, offers valuable insights. This sector includes companies like Meta Platforms and Alphabet, along with Amazon.com, Microsoft, and Apple. It encapsulates a wide range of tech entities:

• During the 1998-2000 tech bubble, the S&P 500’s forward P/E ratio exceeded 55x, driven by euphoria and soaring prices.
• Comparatively, the current forward P/E ratio stands below 30x at 28.4x, which, while not inexpensive, is not exorbitantly high.
• Interestingly, despite higher real interest rates back in 2000, the current multiple expansion is occurring alongside an uptick in interest rates, a challenging feat for stocks to achieve.

Figure 2 sheds light on the valuation of ‘other stocks,’ which are not tech-related:

• These stocks never exceeded a 30x forward P/E ratio during the tech bubble.
• Currently, the expanded tech part of the S&P 500 sits at a forward P/E ratio of 16.7x, not overly expensive but also not cheap.

Our conclusion, thus far, is that a bubble isn’t merely a ‘bit expensive’ or ‘kinda expensive’situation. Rather, it represents a scenario where prices significantly outstrip fundamentals. Returning to the classic forward P/E ratio, we don’t observe such a deviation currently.

However, we should address the AI hype cycle and its potential impacts on market dynamics. We recognize that thematic equities’ performance often moves in waves, and navigating these waves requires strategic allocation to certain themes and an understanding that these themes will experience periods of positive and negative returns over a longer-term cycle.

Evaluating whether these themes are effective often involves more than simply examining share price performance. Take Nvidia, for example. The company is currently forecasting quarterly revenues of approximately $11 billion, indicating a 12-month run rate exceeding $40 billion. Watching the actualization of such trajectories is crucial. Similarly, monitoring companies like Microsoft and Alphabet as they innovate and introduce new offerings for their customers is also significant.

Signs of potential overexcitement or ‘froth’ could manifest in a more vigorous IPO market, particularly for AI-specific companies. While this may happen in the future, it isn’t evident yet. It’s crucial to remember that while the possibility of a future bubble isn’t off the table – humans, after all, are susceptible to behaviors that create bubbles – we currently do not observe one in the making.

In summary, even though the market excitement around AI is undeniable, the data doesn’t suggest we’re in a bubble situation akin to the dot-com era. Yes, we’re witnessing high valuations in tech, but these are backed by solid business fundamentals, proven products, and real revenues. Therefore, while we should remain vigilant and carefully watch market dynamics and company performance, it’s essential to separate hype from real, tangible business growth.