Was There an AI Bubble?

I remember cab drivers giving me stock tips in 2000 before the dot-com bubble burst. In hindsight, that was a pretty good leading indicator of a bubble! Artificial intelligence (AI) stocks today feel different, though. Many have real businesses behind them, with cash flow to match. Who remembers the Nifty Fifty? Investors were enthusiastic about these stocks in the 1960s and 1970s, driving valuations sky-high. Then came the crash. What’s next for AI and tech stocks today, and have we experienced a bubble in that sector in recent years?

Whether a concentrated position or a large sector allocation, many of our clients are overweight in these stocks. The debate we find ourselves in is whether they will continue their rapid ascent – current growth rate assumptions driving stock prices suggest the market believes they will. What’s next? Let’s begin with how we got here. The favorable financial market conditions since the 2008 Financial Crisis offer an important short-term history lesson, as the next 15 years could look very different from the last.

We’ll start with our takeaways and then explain how we reached our conclusions:

1. We may have lived through a bubble,a period in which asset prices greatly exceed their intrinsic value. While it’s too soon to say definitively, the enthusiasm and valuations surrounding tech stocks, fueled by an extended era of ultra-low interest rates, could be considered bubble-like.
2. Exciting and profitable companies don’t always outperform the market. When we examine the implied growth rates that create these stocks prices, we’re left asking: Can we reasonably expect those growth rates to continue in a financial environment that looks very different from the one that enabled their rise?
3. We believe in evidence-based investing. The best strategy to help preserve and grow the wealth created over the past 15 years remains broad diversification.If there were a reliable way to identify and time bubbles, that would be one thing. But in the absence of such a strategy, we continue to advocate for diversification – across U.S. and international markets, with allocations to private markets for some investors – and a tilt toward factor-based investing, which seeks to identify quantifiable characteristics that have historically boosted returns, unlike speculative bubble-chasing.

Note: We recently recorded a podcast on this topic if you’d prefer to listen: Episode 26 – Was There A Bubble in Artificial Intelligence Stocks?.

Diagnosing a bubble

We’ll focus here on the largest stocks, especially the so-called Magnificent Seven: Apple, Amazon, Google, Meta (Facebook), Microsoft, Nvidia, and Tesla. We reference these companies often, and for good reason. Their performance has dominated U.S. equity markets in recent years.

A decade ago, the 10 largest stocks comprised about one-sixth of the S&P 500 index. Today, they account for nearly 40% of the index’s total market valuation. Notably, their valuations exceed their earnings. As of June 30, the top 10 companies represented 38% of the S&P 500’s valuation, but only 32% of its earnings.

Source: JPMorgan Guide to the Markets

The rapid increase in Magnificent Seven earnings is meaningful, but as the chart above shows, valuations have outpaced earnings. The story many investors tell is that the big tech companies are the primary winners from the emergence of artificial intelligence – and there’s little doubt that AI is a world-changing technology.

Another important factor over the last 15 years has been an extended era of incredibly low interest rates. In fact, from 2008 to 2015, and again from 2020 to 2022, the Federal Reserve’s target interest rate was held near zero – a level never seen prior to 2008. In addition, during this period, the Fed launched multiple bond purchase programs, known as quantitative easing, which drove interest rates even lower across the economy.

Even from 2015 to 2020, the Fed’s target rate only rose to 2.5%, which is quite low by historical standards. The yield on the 10-year Treasury, a benchmark for longer-term interest rates, barely rose above 3%.

Debt-fueled borrowing

Consider this: in 2009, Microsoft had $3.75 billion in long-term debt. By 2019, it had $63 billion. In 2009, Apple had no long-term debt; by 2019, it had $92 billion. This was very low-interest-rate cheap debt, and it was rational for the companies to take advantage of it, but a surge in debt, nonetheless. This borrowing helped the companies invest in new technologies, grow their headcount, and ultimately contributed to the surge in their earnings.

The ultra-low-interest-rate era ended abruptly in 2022, when the Fed began rapidly (some would say belatedly) raising interest rates to combat a surge in inflation. One thing that’s very clear in the data: The rise in interest rates coincided with a sharp end to the decade-long hiring binge at the Magnificent Seven.

Source: Bloomberg, Apollo Global Management

A bursting bubble?

The effect on tech stock prices since 2022 has not been nearly so clear. They continued marching higher for several years, even after hiring slowed and low interest rates ended.

As of writing, we’re several months past the sharp decline in U.S. markets that occurred in April, and many stocks are performing well again. Microsoft and Nvidia have reached new peaks, and Meta is near a peak too.

Apple and Tesla, however, peaked in December and are now down 20% and 35% respectively. Google and Amazon peaked later, in February, and are down 15% and 10%, respectively.

This is a mixed picture, and that’s the key point. Even if you had perfectly identified a bubble in real time, would you have known to sell Apple and Tesla in December and hold Google and Amazon until February? Would you have known to hold these stocks for several years after interest rates began rising? Selling out in 2022 would have meant missing a tremendous run in 2023 and 2024, one that is far from being erased.

We are here now. Looking forward, the question may be: how much of your portfolio allocation do you want in stocks that have appreciated significantly in the ripe financial market environment of the recent past? Part of the answer may depend on your confidence in the sustainability of growth rates in a market shaped by higher borrowing costs and increased volatility.

Stay invested, but if you’re not diversified, take some winnings off the table

We favor a strategy of broad diversification over trying to time the market and pick winners and losers.

We know bubbles will likely occur. With a broad diversified strategy, we maintain exposure to any stocks that grow to the size of the Magnificent Seven. But if trends reverse, as they most likely do, we’re protected by broad asset allocations that limit exposure to any single stock. At Mercer Advisors, we offer many solutions to help clients diversify out of concentrated stock positions tax-efficiently, with investment decisions always guided by a financial plan that incorporates tax and estate planning.

We also recognize that artificial intelligence is no longer a “new” story. We don’t necessarily expect the winners of the last decade to remain the winners of the next.

But we have the humility to admit that we don’t know for sure. We believe, the best approach, bubble or not, is to remain invested.

Click here for past insights about the recent market volatility and other interesting topics. Not a Mercer Advisors client but interested in more information? Let’s talk.

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