The AI Bubble: Why Tech Stocks May Face a Painful Reckoning

The AI Bubble: Signs of Trouble Ahead

The technology sector, particularly companies associated with artificial intelligence (AI), has seen an unprecedented surge in investor interest and stock valuations. Many signs point to a bubble forming in AI and tech stocks that could have painful consequences when it eventually bursts. Let's examine the key indicators of this bubble and explore potential investment strategies for the road ahead.

Hallmarks of a Bubble

Several classic signs of a market bubble are evident in the current AI frenzy:

1. Extreme consensus and complacency
2. Stocks driven by perception rather than fundamentals
3. Traditional valuation metrics breaking down
4. Increased concentration and risk-taking by investors

Extreme Consensus

The level of agreement among analysts and investors about AI stocks is unprecedented. For example, out of 61 analysts covering Nvidia, widely seen as the top AI beneficiary, not a single one has a sell recommendation. This degree of consensus is statistically improbable and indicates a dangerous level of groupthink in the market.

Perception Driving Stock Prices

Stock prices are being massively influenced by perceptions of whether a company is on the right or wrong side of the AI trend, rather than by fundamental business metrics. Many companies are attempting to capitalize on this by emphasizing AI in their communications, regardless of its actual relevance to their business.

For instance, over 200 companies in the S&P 500 mentioned AI on their recent earnings calls, far more than could realistically be considered AI companies. This mirrors similar behavior seen during the dot-com bubble, when companies would see huge stock jumps simply by announcing internet-related initiatives.

Breaking Traditional Metrics

The AI bubble is causing disruptions to long-standing investment norms and metrics. For example:

• The Nasdaq had to perform a special rebalance due to over-concentration in a few tech stocks
• Morningstar announced plans to rework their style boxes because major index funds have essentially become growth funds
• The 10 largest US stocks are all growth stocks and make up 40% of the market, the highest concentration ever

When established rules and processes start being adjusted to fit the current narrative rather than questioning if the narrative itself might be flawed, it's a major red flag for a bubble.

Increased Concentration and Risk

Many investors have unknowingly taken on much greater risk and concentration in tech stocks:

• Supposedly diversified indexes like the S&P 500 now have over 30% of assets in tech
• Covered call ETFs are making concentrated bets on tech stocks, often with misleading promises of downside protection
• Passive index funds are automatically allocating more money to the largest tech stocks as they grow, creating a self-reinforcing cycle

Why the AI Bubble May Soon Burst

While the long-term potential of AI is significant, there are several reasons to believe the current bubble may be nearing its breaking point:

1. Unrealistic growth projections
2. Massive gap between expected and planned AI spending
3. Historical patterns of overestimating short-term impacts of new technologies

Unrealistic Growth Projections

Projections for AI adoption and growth echo similarly unrealistic forecasts seen in previous tech bubbles. For instance, telecom companies in the late 1990s invested heavily in fiber optic infrastructure based on projections that internet usage was doubling every 3 months. This led to massive overbuilding, with only 2.7% of laid cables being used three years later.

Today, we see similar hype around the rapid user growth of tools like ChatGPT, leading to enormous investments in AI infrastructure like data centers. However, the actual planned spending by businesses on AI adoption is far lower than what would be required to justify these investments.

The AI Spending Gap

There is a huge disconnect between the AI revenue required to justify recent stock market gains and the amount potential customers are actually planning to spend:

• The market cap increase of the five biggest tech firms implies expectations of $300-400 billion in additional annual revenues
• Actual analyst projections for AI revenue at these companies fall far short of this figure
• Only 5% of businesses currently use AI in producing goods or services, with just 7% planning to adopt it in the next 6 months
• Business investment in computers and software is only projected to grow 5% this year, slower than the long-term average

Historical Patterns

History shows that we tend to overestimate the short-term impact of new technologies while underestimating their long-term effects. This pattern has repeated with many transformative technologies, from the telegraph and railroads to the internet.

It's likely that AI will follow a similar path - revolutionary in the long run, but with a more gradual adoption curve than current hype suggests. This adjustment of expectations could lead to a painful period for overvalued AI and tech stocks.

Factors That Could Amplify the Downturn

Several market dynamics could potentially make an AI bubble burst more severe than many expect:

1. The rise of passive investing
2. Concentration in tech-heavy ETFs
3. Surge in tech-oriented covered call ETFs
4. Growth of AI cryptocurrencies
5. The Japanese yen carry trade

Passive Investing Amplification

The massive shift towards passive, market-cap weighted index funds has created a self-reinforcing cycle that could work in reverse during a downturn:

• As money flows into passive funds, they must buy more of the largest stocks, driving prices higher
• This makes those stocks an even larger part of the index, leading to even more buying
• In a downturn, this process would work in reverse, potentially accelerating selling pressure

Tech ETF Concentration

Dedicated tech ETFs have seen record inflows, with levels in 2024 on pace to surpass the peaks seen before the dot-com crash and the 2022 tech selloff. This concentration of bets on tech stocks could lead to more pronounced selling if sentiment shifts.

Tech-Oriented Covered Call ETFs

There has been explosive growth in tech-focused covered call ETFs, with many investors incorrectly viewing these as lower-risk income investments. These funds may provide minimal downside protection in a sharp downturn while limiting upside potential in any recovery, potentially leaving investors with significant losses.

AI Cryptocurrencies

The speculative frenzy has extended to AI-related cryptocurrencies, with the market cap of this category growing from $1 billion to $40 billion in just 18 months. This type of speculative excess often marks the late stages of a bubble.

Yen Carry Trade

Low interest rates in Japan have led to a large "carry trade" where investors borrow in yen to invest in higher-yielding assets like US tech stocks. The unwinding of this trade could amplify selling pressure across markets.

Investment Opportunities in a Post-Bubble Environment

While the bursting of an AI bubble could be painful for many investors, it may also create opportunities in overlooked areas of the market:

1. Japanese yen
2. Small-cap stocks
3. Value stocks
4. International stocks

Japanese Yen

The yen could benefit from multiple scenarios:

• It would likely strengthen as US interest rates fall
• An unwinding of the yen carry trade would boost demand for yen
• It could serve as a safe haven in a US recession scenario

Small-Cap Stocks

Small-cap stocks are currently very cheap compared to large caps and could benefit from a reversal of recent trends:

• They've been disproportionately hurt by rising interest rates
• Many future AI winners may be smaller companies not yet on investors' radars
• Historically, users of new technologies often become bigger winners than the initial enablers

Value Stocks

Value stocks have been out of favor and have limited exposure to the AI hype. They could see renewed interest if money rotates out of overvalued tech stocks. Value stocks also tend to hold up better in market downturns.

International Stocks

International markets have lagged behind US tech stocks and could benefit from a reallocation of capital if the AI bubble bursts. They offer diversification and potentially more attractive valuations.

Conclusion

The current AI frenzy exhibits many classic signs of a market bubble, including extreme consensus, unrealistic growth projections, and increased speculative activity. While AI will likely have a transformative long-term impact, the short-term expectations and valuations appear unsustainable.

Investors should be cautious about concentrated bets on AI and tech stocks, particularly through leveraged or income-oriented products that may not provide expected downside protection. Instead, consider diversifying into areas like small-caps, value stocks, and international markets that have been overlooked during the AI boom.

Remember that bubbles are inherently unpredictable, and timing their bursting is nearly impossible. However, being aware of the risks and preparing for potential outcomes can help investors navigate the challenges and opportunities that lie ahead in the evolving AI landscape.

Article created from: https://www.youtube.com/watch?v=74GJFjgGqms