AI Bubble Fears: Are We Heading for a Dotcom Redux?

What's Driving the AI Bubble Talk

Whispers of an AI bubble are growing louder, echoing the dotcom era's inflated valuations and unsustainable hype. The question is, are these fears justified, or are they simply the cautious musings of regulators and market veterans? A closer look reveals a complex picture of both opportunity and risk.

The current anxieties stem from the extraordinary surge in global stock market values. Since early April, global shares have jumped by a staggering $28.6 trillion, fueled by AI exuberance and receding fears of tariff wars. To put that in perspective, this increase nearly equals the entire annual economic output of the United States. Moreover, valuations of unprofitable tech companies have doubled since April, drawing stark parallels to the dotcom boom.

Why It Matters

Warnings about a potential bubble are coming from various corners, including central bankers and the International Monetary Fund, which recently drew uncomfortable comparisons to the dotcom era. Their motivations vary. Regulators, like the US Federal Reserve and the Bank of England, are tasked with maintaining financial stability. For them, sounding the alarm is a way to prevent unchecked enthusiasm from misallocating capital and creating undue investor risk.

Market participants who have witnessed previous crashes also offer valuable insights. The number of active investors who remember the dotcom bubble is dwindling. That's significant because history shows that financial market crashes are more likely when fewer participants have experienced such events firsthand. This suggests a collective amnesia or a dangerous belief that "this time is different." What gets widely underappreciated is how share ownership and direct wealth exposure have ballooned in recent years. US savers now have 30 per cent of their wealth in shares, this equates to almost $42 trillion.

The Bull Case for AI

Despite the bubble concerns, some credible arguments support continued optimism. The companies driving the AI revolution, such as Amazon, Microsoft, Google, Meta, and Apple, are already generating substantial cash flow from their existing cloud, commerce, and chip businesses. These earnings underpin the appeal of owning these companies, even if the long-term payback from their massive AI investments remains uncertain.

Furthermore, while a small number of US tech giants appear overvalued, markets in other parts of the world, including the UK, are less expensive, even after accounting for lower earnings potential. This offers a potential safe haven if AI expectations fall short.

Our Take

The challenge for investors is to weigh these competing arguments. There's no doubt that AI hype has fueled significant market gains, particularly in the US. The valuation of the US stock market, driven by AI hyperscalers, is now more than two standard deviations above its long-term average. A widely-followed measure of how expensive the US stock market is, the Shiller price-to-earnings ratio, is hovering around 40, a level only seen during the peak of the dotcom bubble.

However, the AI landscape differs from the dotcom era in key ways. Many of today's leading AI companies have strong existing businesses that generate real profits. The dotcom boom, in contrast, was largely fueled by speculative bets on unproven business models. This difference provides a crucial buffer against a potential market correction.

Implications for Investors

Ultimately, the AI market presents both opportunities and risks. Investors should remain cautious and avoid getting caught up in the hype. Diversification is key, as is a focus on companies with strong fundamentals and proven business models. It's also crucial to remember that market sentiment can change quickly. In the UK, as well as in Japan and a number of EU countries, there has been a rapid transition away from defined benefit pensions towards defined contribution schemes, where the saver holds the investment risk. A reassessment of value in an increasingly passive investment market where an initial negative catalyst can feed off itself in a way that is hard to stop. While AI holds immense potential, it's essential to approach it with a healthy dose of skepticism and a long-term perspective.