Is There an AI Bubble in the Market or Not?

Recently, I’ve come across several opinions suggesting that there’s an AI bubble in the market. Let’s break it down a form our own opinion.

What Are Market Bubbles Generally Characterized By?

We will focus solely on the stock market, as that is where the AI bubble would occur.

A market bubble is a situation where stock prices rise significantly to disproportionate levels compared to their real or rational value. The problem, of course, lies in determining the real value, but we’ll come back to that later.

Further growth is then fueled by speculation and irrational behavior of investors who expect prices to continue rising.

What Generally Contributes to the Formation of a Market Bubble:

1. Extreme Price Growth: Rapid and significant price increases that far exceed the average historical trends of the overall market or a specific segment.

2. Hype and Media Interest: Increased media coverage and general public excitement associated with a particular asset or theme. This often includes stories of quick wealth, further amplifying the hype, attracting even those who do not usually invest.

3. Broad Public Participation: Increased involvement of retail investors and the public in the market, often without sufficient risk awareness, entering the market late, often at the peak of the bubble, when institutional investors are already starting to exit.

4. Speculative Behavior: Investors buy assets with the expectation of future price growth rather than based on the fundamental value of the assets.

5. Access to Cheap Money: Easy access to credit and low interest rates support speculative investments and rising asset prices.

What of the above applies to the current market situation in connection with the AI boom?

Certainly, we see big tech companies at elevated valuations, and it’s not just them, but most companies that are involved in the supply chain of the entire spectrum of infrastructure and services needed to meet the extreme demand for computing power, cybersecurity, and more. So, it’s not just about the semiconductor segment.

It is definitely true that the AI boom is getting above-average media attention. Articles cover topics ranging from extreme demand for resources to new and emerging possibilities for AI applications. This, of course, drives interest from investors and the public, and has certainly pushed even casual investors to put money into some “trendy” company.

Undoubtedly, speculative buying is happening, and situations arise where someone enters the market at elevated valuations or invests in a company based on something they’ve read, which may not even turn into a profit. And yes, the AI boom or hype will certainly leave some investors at a loss, but this is a normal occurrence.

What is not currently in play is the availability of cheap money. As we know, the Fed is keeping rates at elevated levels; although after the recent CPI macro data and labor market developments, the first rate cut seems to be approaching, possibly as soon as September, but the relative unavailability of free cash is keeping trading volumes at average, currently even slightly below-average levels.

So why is anyone talking about an AI bubble? Well, there could be various reasons, but if we stick purely to what we see in the market, it’s definitely the elevated valuations of the tech sector.

Why are tech companies currently valued so highly, and are they really overvalued? Looking at the average historical trend of individual companies, we can see that in the last year and a half, charts have generally deviated from their historical average trends, which in the long-term perspective usually correspond to some gradual average growth in the company’s price based on productivity growth, inflation, etc.

What I mean by this long-term trend can be best illustrated by looking at a company like Microsoft (MSFT) in the chart below. MSFT has been on the market long enough to withstand fashion trends, bubbles, and so on. If we look at the chart and the average long-term trend, which I personally mark in the charts of companies I follow, we see that despite significant corrections or even bear markets, the price has long oscillated symmetrically around the marked trend line, moving upward to the right. Currently, we see that it is again at an elevated level, near the upper edge of the channel or some upper peak, and as history suggests, it would be logical for the chart to make a symmetrical move down along the marked arrows, somewhere toward the 320 level.

The problem is that this would only make logical sense in terms of a natural gradual growth of the company driven by innovation, already mentioned productivity, rising living standards, inflation, and pressure on rising wages. However, there’s no guarantee that this will happen. Some pullback will certainly come, but when is anybody’s guess.

The key question to label this situation as an AI bubble is whether these elevated valuations are disconnected from the company’s real value or not. MSFT currently has a P/E ratio of 39.30. Is that too high? Well, I wouldn’t want to wait 39 years for a return on my investment, but is it realistic for MSFT’s revenue to grow and for the P/E to drop? That’s certainly possible, at least partially, and more importantly, these companies will always have a higher multiple.

And is it even high now? Let’s look at Nokia, which has a P/E of 25 - who of you would guess that compared to MSFT? And let’s check a few others from the AI hype: NVDA 75, AMD 265, SMCI 51, AAPL 35, ASML 53, PANW 48. We see that the only extreme case here is AMD, but keep in mind, it recently had a P/E over 1,000.

Looking at companies like NVDA, TSMC, and others, these firms currently have such massive order books that they can’t produce enough, allowing them to continuously raise prices, with revenues growing at hundreds of percent annually, accumulating billions in profit.

Also, consider that once this boom cools down, these companies will be left with massive cash reserves, which they’ll want to put to use. So, even if there’s a bubble burst, these firms will be sitting on huge cash piles that they can reinvest through acquisitions, new businesses, buybacks, etc.

For me personally, what’s missing to fulfill the fear of a market bubble is the reckless investing in companies in the hope that they’ll do well in the future. Exceptional revenues and profits are already there.

And one more important thing: look at the latest earnings from some companies that reported good results yet were fairly harshly punished by investors. If there were a bubble, we would see more enthusiastic buying after such results, not substantial sell-offs.

Examples include PANW in February, ZS in February, META in April, AMD in April, SMCI in March, and others.

Where to Invest for the Rest of the Year?

If we continue discussing the AI hype, we will likely see accelerated growth in many companies for some time. The well-known names are already at elevated valuations, so the question is whether to invest in them now. Renowned analysts warned against investing in NVDA at levels of 500, 600, 700, saying it was stretched, and look where NVDA would be today without the split - at 1,240 and even reached 1,400. On the other hand, these elevated valuations increase the risk of loss or reduce the potential for gains compared to the pre-AI boom.

If you’re considering investing in smaller companies, startups, etc., it’s crucial to thoroughly analyze their business model, understand it well, and assess how likely they are to succeed. If they fail to turn a profit before the AI boom cools, they could experience substantial sell-offs.

Personally, I don’t face this problem because we don’t trade stocks in our fund, so we don’t have to evaluate a company’s potential years into the future. We focus on an options writing strategy, where it’s enough to estimate over a two- to four-month period where a specific stock is unlikely to move, allowing us to profit. This is much easier than pinpointing the exact direction for stock investments, where even a small error puts you at an immediate loss.

With traditional stock investments, you start at the current spot price and need the price to move in the right direction away from you.

In our approach, we start the investment or speculation relatively far from the current price, giving us much more room for error. We can be wrong about the direction of the underlying asset’s price movement and still collect 100% of the profit that we lock in at the start of the trade.

Is There an AI Bubble in the Market?

Whether there is an AI bubble in the market or not, stick to the following rules and approach your investment decisions consistently and without emotions.

• Certainly, especially tech companies, are currently at elevated valuations, so you must be cautious when investing in them and thoroughly analyze their business and potential.

• Market sell-offs and corrections will definitely come - this is completely normal.

• Invest only with funds you can afford to lose.

• Consider hedging your positions, for example, through options.

• Be prepared for a longer investment horizon. If you invest in stocks and select companies that succeed in their business and grow, you will see returns.

• Don’t jump blindly into companies based on investment recommendations you read somewhere without understanding their entire business and being able to evaluate their prospects for success yourself.