A handful of stocks have enjoyed spectacular performance – those seen as the main winners of the rapid rise of artificial intelligence (AI). This has led investors to question whether we are in a bubble. We look at the evidence and say what it means for investors.
This article is for information only and not personal financial advice. If you’re not sure what’s right for you, a financial adviser can help.
Definition of a bubble
Before debating whether we are in a bubble, we need to know what one is.
A classic definition is an ‘upward price movement over an extended range that then implodes’. While it’s hard to disagree with this definition, it means we have to wait for the implosion before confirming we were in one.
Prize-winning economist Eugene Fama offered a more practical definition in his Nobel Lecture:
an “irrational strong price increase that implies a predictable strong decline.”
As a pioneer of the efficient market hypothesis, he then rejected the very idea of bubbles on the basis that the declines are unpredictable.
But this certainly hasn’t persuaded everyone they are a mirage.
Ingredients of a bubble
Authors William Quinn and John D. Turner set out the ingredients of a bubble in Boom and Bust: A Global History of Financial Bubbles.
In an investment bubble – whether the 1720 South Sea Bubble or the 2000 dotcom boom – euphoria spreads like fire. And a fire requires three ingredients:
fuel
oxygen
heat – plus a spark.
In a bubble, the fuel is easy money, or low interest rates. The oxygen is marketability, making it easy to trade. Heat is provided by speculators who spin stories to attract novice investors.
The spark? A new technology heralding unimaginable progress – trains in 1844, the internet in the late 1990s, and AI today. Or it could be government policy – encouraging low-income buyers in housing bubbles in the US, Ireland, Spain and the UK earlier this century.
A bubble checklist
Bubbles are a popular hunting ground for academic research.
What’s agreed is that strong returns alone do not predict future crashes. Nor is there a magic formula for spotting bubbles and knowing when they’ll burst.
But there are clues to let investors know that we’ve potentially entered bubble territory. One study looked at 40 episodes from around the world and found these common features.
Increased stock volatility
New stock issuance
High valuations
Disproportionate price rises from new companies
Bubble stories
While academics tend to focus on the numbers, stories matter too. The classic tale is that of Joseph Kennedy Senior, who was working as a stockbroker in 1929. When he heard a shoeshine boy offer stock tips, he figured that the boom was about to end. He sold his holdings and went short on the market, making a fortune as the Wall Street Crash unfolded.
Readers of the Wall Street Journal recently shared their stories of more recent events. No shoeshine boys, but tips and hints from gardeners, janitors, mechanics and strippers, acting as omens of the dotcom bust and the Global Financial Crisis.
For one reader, the sell signal was a visit to his local bar, the night before a big game. The regulars had switched from the sports channel to the business news.
At the height of the dotcom bubble, 95 listed companies added dotcom, dotnet or internet to their name. The impact? An average of a 74% increase in share price over the ten days before and after the name change.
In April this year, shoe manufacturer Allbirds announced it would shift to becoming an “AI compute infrastructure” company, renamed itself NewBird AI, and saw its share price rise over 500%.
So, is it a bubble?
As an investor who managed funds through the Asian Financial Crisis, the dotcom boom and bust, and the Global Financial Crisis that was triggered by the sharp rise and fall in US house prices, I do believe in bubbles.
The AI story provides the fertile ground needed for a bubble to grow: a transformational technology with unknown winners.
The market today ticks a couple of the items on the checklist above too. The best performing stocks have seen rising volatility. The IPO of SpaceX raised billions from retail investors – and institutions too. It’s said Anthropic and OpenAI are planning to follow soon.
The valuation picture is a little more mixed, with price-earnings ratios well above average but below those seen at the peak of the dotcom boom, helped by rapid earnings growth. And Nvidia, Microsoft, Apple and Alphabet, whose share prices have soared, have been around for decades now. Although, past performance is not a guide to future returns.
Also, knowing you’re in a bubble is very different from profitably trading one. Economist Robert Shiller, who collected his Nobel Prize on the same day as Eugene Fama, warned that stock prices were irrationally exuberant in 1996. The US market went on to double and only peaked in 2000.
So, my judgement is that we may well be in bubble territory. It could be in its early stages, or it could be about to burst.
Therefore, I continue to suggest a diversified portfolio – balancing any investments in the potential AI winners with those from the wide range of stocks that have been left behind over the last few years. Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in. Investing is for the long term, typically 5 years or more.