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Over the past few months, the Bank of England and the International Monetary Fund have joined the many voices urging caution over the surge in AI- driven stock valuations within the tech sector. Both institutions have flagged the risk of a market correction, citing stretched valuations and a level of investor bandwagon jumping that is reminiscent of the dot com era. IMF Managing Director Kristalina Georgieva cautioned that “uncertainty is the new normal”, while the Bank of England noted that AI-focused tech firms appear particularly vulnerable to a sudden shift in sentiment. More recently, the CEO of Google’s parent firm Alphabet, Sundar Pichai, has warned of ‘irrationality’ with regards to spending on AI and said that ‘no company is going to be immune’ in the case of a correction. As AI spending continues to dominate market narratives, these warnings raise a critical question: are we witnessing the rise of a transformative boom- or the inflation of a speculative bubble?
When a groundbreaking and far-reaching new technology disrupts markets enough, the resulting excitement leads to a reaction from investors who see the opportunity for significant returns. As a result of the buzz around the companies adopting this technology, the price investors are willing to pay to own a stake in them (the market valuation) begins to far exceed what they are intrinsically worth on paper (the book valuation). The gap that is created between the market and book valuations is either our bubble, or our boom.
Which one it is depends on how we can explain this ‘valuation gap’. In the case of a boom, it may be due to a range of things. For example, intangible assets such as patents, brand reputation, customer loyalty, or a skilled workforce all have no intrinsic value but offer strong, well-founded growth potential that would explain the gap. Similarly, strong earnings projections as the result of an established cashflow and robust business model would be a good justification.
On the other hand, another common cause of the valuation gap is simply down to positive investor sentiment, or ‘hype’. While hype will be present to some degree even in a boom, it is likely to explain most of the valuation gap in a bubble.
In the latter case, if certain information casting doubt on the value of these hyped-up companies starts coming to light, eventually investor sentiment will start to turn and then the backing behind the gap disappears. Stocks begin to tumble with no real value to fall back on, eventually reaching a breaking point. All out panic selling ensues, and the bubble bursts. If it had grown big enough, the shockwaves can be devastating.
A perfect example of this – that I’ve already alluded to – is the dot com crash at the turn of the millennium. As the potential of the world wide web started to dawn on investors in the 90’s, valuations of tech companies skyrocketed almost solely on the back of sentiment. The companies prioritised growth over profit, promising great things without the cashflow, business model, or vision to back it up. As a result, when companies started to fail to deliver on their promises, investor confidence waned, and the rest is history. The NASDAQ, heavily weighted with tech stocks, lost nearly 80% of its value between March 2000 and October 2002 – marking one of the most dramatic market corrections in history.
The question around whether there is an AI market bubble or a boom comes back to how we explain our valuation gap. Is it the result of genuine, well founded business fundamentals, or is it just hype?
Unfortunately, the intangible nature of these factors means that they are extremely difficult to put values to for even a single company – and impossible market wide. To say how much of the valuation gap is made up of each is to guess.
If we can’t explain the gap, can we instead look back at the dot com crash and draw comparisons to see if we’re headed down the same road? If we assume the answer is yes, we could look at one of the major driving forces of the dot com bubble, which was the frenzied entrance of new companies into the web sector, known as IPO mania.
An IPO, for those that haven’t seen The Wolf of Wall Street, is an Initial Public Offering – an event where a company’s shares go on public sale for the first time. The IPO mania of the dot com era meant there was an unprecedented influx of new web companies entering the market. A sceptic may suspect that some aimed to make a quick profit from the investors who were pouring money into any company with the word ‘internet’ in their value proposition. But, regardless of intentions, many new entrants had very little in terms of established cashflow, with their valuation gap being almost completely down to hype. One company, Netscape (whose IPO in 1995 is often cited as the spark of the bubble), saw their stock prices almost triple the day of their IPO.
Jumping to now, while new AI startups are undoubtedly springing up, the effect of this seems to be less impactful, at least for the time being. The leaders in AI have overwhelmingly been the existing big tech powerhouses, like Nvidia, Microsoft, and Google. This makes sense, given the higher barriers to entry for AI. Companies must have significant capital to pour into AI infrastructure, as well as into the high skilled human capital that keeps it running. While AI has seen a hefty amount of funding from the venture capital sector, this funding simply cannot compete with the resources that the existing tech giants have on hand to throw around.
However, as new discoveries are made that reduce operating costs, we could see AI’s barriers to entry fall. If, as many suspect is the case, we are simply standing on the surface of the AI iceberg, there could still be plenty of opportunity for a repeat of IPO mania in the future and an AI market bubble, if there isn’t one already.
It is also entirely possible that existing AI firms, as well as those that are yet to come, will, for the most part, be able to deliver on their promises and go on to generate massive profits, thereby justifying their valuations. One point of view to consider is that markets are betting the utility of AI will favour owners and shareholders over labour in the long- term, replacing it rather than complementing it, thereby creating a marketplace where AI firms are able to generate the profits that will justify their valuations.
What this means is that the market may be predicting a future where AI leaders profit from automation at the expense of workers, over one where AI simply improves the productivity of the existing workforce. While it does paint quite a grim picture of the future, this scenario would be likely to soften the impact of any future correction.
Many analysts hold strong beliefs that there is an AI market bubble and that it will burst at some point in the future – but to try and guess exactly when this will happen or how severe the effect would be is a fool’s game. An investor might be overcome with worry and sell up for cash, then spend years waiting for a downturn that could never come, meanwhile their money is missing out on growth and being eroded by inflation. This is a common enough scenario to have prompted economist John Maynard Keynes to summarise the flaw in the plan “markets can stay irrational longer than you can stay solvent”. History agrees, as previously we have seen markets stay overvalued for years before a correction occurs.
We also agree and therefore believe that the only thing to be done is to continue investing into a globally diverse portfolio of equities that provides exposure to worldwide markets, balanced with a proportion of fixed interest assets that provides security for any shorter-term needs. We believe that the market is efficient at incorporating information into its prices over the longer term, so even if there is a short-term correction, the market will return to its upward trend in time.
It may seem a lazy solution to say that the answer is to do nothing, but history shows it is the best one. A Morningstar report from 2023 compared the performance of two strategies, both receiving a modest regular investment of $10,000 per year into a global portfolio, over the course of the preceding 20-year period. The study showed that a strategy where the regular payments were immediately invested and held outperformed one where they were kept in cash if the market’s valuation gap grew too large, then only being invested once the gap reduced. This essentially mirrors the strategy of an investor suffering from bubble paranoia. At the end of the period, the buy and hold strategy had earned $80,000 more.
This result is reinforced further in a study by JP Morgan, also in 2023, which concluded that missing the 10 highest performing days in any 20-year period can cut the total return generated over that period by 50%. Missing the 20 highest performing days over the same period can cut returns by 70%. A buy and hold strategy will ensure that you are invested for every one of those high performing days, while a timing strategy introduces the risk of missing out.
We can’t predict when the bubble will burst or even say with certainty if there is one at all. The only thing we can do is draw comparisons to when something similar has happened in the past – which could itself be cast in doubt given the vastly different market landscape we have now as compared with 25 years ago. Basically, we don’t know anything for sure.
Our investment strategy is designed specifically to account for that fact. We don’t over allocate to AI while it’s on the rise, so we won’t be disproportionately affected if a bubble bursts. Similarly, we don’t under allocate in case it never happens. In fact, we don’t make any conscious decisions with regards to allocation on this level at all – we simply let the market do the work for us.
We know that this laissez-faire strategy can be unsettling during market downturns, so we aim to work with clients to manage those moments and reassure them that staying the course isn’t just a passive strategy, but a proven one too. If there is one thing history and experience have taught us, it’s this: in uncertain times, discipline – not prediction – is the investors greatest asset.
This blog post is intended for information only and does not represent personal financial advice. But if you would like to speak to one of our Chartered Financial Advisers, please get in touch. Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed – you may get back less than you paid in.