By Josh Katzowitz, WCI Content Director

I wasn’t an investor during the dot.com bust of 2000 when internet startups drove a huge economic expansion that exploded in catastrophe at the turn of the millennium. But I did buy a house at the peak of the housing bubble about five years later and watched the value of my home drop by tens of thousands of dollars when the bubble burst in 2008, thanks to subprime mortgages and other risky lending practices.

If you've been investing for any length of time, you've probably experienced bear markets and perhaps you've gone through the aftermath of a broken bubble. You tend not to forget them.

These days, as I watch the S&P 500 and the NASDAQ continue to reach record highs throughout 2024, thanks mostly to the dizzying ascent of The Magnificent Seven (Nvidia, Microsoft, Alphabet, Meta, Amazon, Apple, and Tesla), I wonder when the bull market will stop running so hot. I wonder if artificial intelligence will be to blame. And I wonder if there's anything investors can or should do about it.

When compared to the US and global markets, AI-connected stocks have achieved 30% better returns since the beginning of 2023, while Nvidia and Super Micro Computer Inc. have risen by 784% and 1,008%, respectively (in the past five years, Nvidia is up a staggering 4,300%).

Depending on which financial expert you ask, we might be in an AI bubble now, where the rapid acceleration of machine learning in the past few years has allowed stocks like Nvidia, Microsoft, Alphabet, and Meta to soar high in the sky. But every time I look at the markets and see the S&P inching closer to 6,000 or the NASDAQ eclipsing 18,000, I wonder when, like Icarus, these stocks will fly too close to the sun and come crashing back to earth—and bring the market with them.

Should we be worried about an AI bubble in the market?

 

Are We in an AI Bubble?

How can we define a bubble? US News and World Report notes that during a bubble, “the exuberance for stocks can transition from rational to irrational. The market loses sight of the fundamental reasons stocks were rising to begin with, and investors start buying simply because stock prices are rising. Further gains are driven by FOMO, or fear of missing out, rather than realistic expectations of future earnings growth.”

It might be difficult to tell the difference between a bull market and a bubble when you’re on the inside looking out of a rising market. It stands to reason that the AI industry will need to continue to rely on a chipmaker like Nvidia and service providers like Microsoft and Meta to propel itself forward. That puts those companies in a better position to last for longer than those that defined the dot.com era could.

Maybe we didn’t need (or want) Pets.com and eToys during the dot.com era. But a company like Alphabet could be vital for decades to come. If the fundamentals of the Magnificent Seven are sturdier than the online startups from a quarter-century ago, the bubble might be constructed from sturdier material that is less likely to pop today.

Still, some financial analysts think this bubble is more precarious. Research firm Capital Economics thinks it’ll burst in 2026 because of higher interest rates and higher inflation.

“Ultimately, we anticipate that returns from equities over the next decade will be poorer than over the previous one. And we think that the long-running outperformance of the US stock market may come to an end,” Capital Economics' Diana Iovanel and James Reilly said in July 2024, via Yahoo Finance. “ . . . American exceptionalism may end in the coming years.”

But others aren’t buying that type of apocalyptic prediction.

“When we had the internet bubble the first time around . . . that was hype. This is not hype,” JPMorgan Chase CEO Jamie Dimon told CNBC in February. “It’s real.”

More information here:

I Asked the AI Bot That’s Taking the Internet by Storm for Financial Advice — Here’s How It Went

 

Could an AI Bubble Burst?

Maybe we’re in an AI bubble. Maybe we’re not. Maybe we’ll know for sure 10 years from now. But let’s say we are in a bubble that’s expanding faster than it should. Could it burst, leaving those who invest in the market (whether it’s through individual stocks or with index funds that have grown so heavily weighted by The Magnificent Seven) in a potentially calamitous position?

To answer that, let's look back at the dot.com bubble to see how the current AI status compares.

Bubbles tend to form when investors are overly enthusiastic about particular equities. Speculation further fuels the bubble. Eventually, it becomes clear that the value of the companies can’t match the enthusiasm and expectations of their investors. When that happens and investors realize the stock is overvalued, the price can drop precipitously, and the bubble bursts. That’s when investors (and companies) can lose a bunch of money.

As noted by JP Morgan, the five largest tech companies in 2000 (Microsoft, Cisco, Intel, Lucent, and IBM) had oversized forward price-to-earnings (P/E) ratios (which compares the stock price to the company’s profit divided by the number of shares in the market). The higher the number, the more optimism one can have in the company. But if the forward P/E ratio is too high, that could mean there’s “excessive enthusiasm.”

In 2000, the average forward P/E ratio of the five biggest tech companies was 59. Today, the average forward P/E ratio for the five biggest tech companies (Nvidia, Microsoft, Amazon, Meta, and Alphabet) is 34.

Writes JP Morgan:

“Data shows that in 2000, analysts expected 30% earnings-per-share growth from the tech leaders of the day, while today’s analysts expect 42% growth. That’s a more solid foundation for stock prices.

“On this basis, Wall Street thinks today’s AI leaders will deliver better earnings growth than it expected from dot-com leaders even as the AI stocks trade at much lower prices as measured by the P/E ratio.”

On a more micro level, Reuters compared the valuations of Nvidia today and Cisco at the turn of the century. Nvidia trades at 40 times the forward earnings estimates. Cisco’s number was 131. That leads analysts to believe that the AI-generated bull market is on more stable ground than it was during the dot.com era.

There’s also a higher barrier to entry into the AI market, which makes a difference, according to Johns Hopkins business professor David Godes. Presumably, that will lead to less fluff and better business fundamentals in the market.

“There were websites in the late ‘90s that just made no sense,” Godes told QZ.com. “There was nothing complicated about the technology . . . [Today] it’s harder for an MBA student without technical training to put together a business plan and go out there and start [an AI] business.”

Not everybody is such an optimist, though.

“The euphoria in Big Tech stocks in recent weeks and months is absurd, and investors seem to be forgetting what took place in the years leading up to the 2000 tech stock collapse,” David Bahnsen, chief investment officer at the Bahnsen Group, told US News and World Report in July 2024. “The combination of technology and communication services stocks now make up almost half of the S&P 500's market cap, which is frightening and certainly unsustainable.”

As I love to say, nobody knows anything.

More information here:

Your Crystal Ball Predictions for 2024

 

How White Coat Investors Should Think About an AI Bubble

Having said all that, let’s ask some in the WCI community about the potential of an AI bubble. Should we be worried about it? Should we do anything about it? Should we even think about it?

I rounded up WCI founder Dr. Jim Dahle, WCI columnist Rikki Racela, and occasional guest writer/financial advisor Bryan Jepson at Targeted Wealth Solutions to get their takes on this idea of an AI bubble that could burst and cause all of us financial pain.

Here was our back and forth via email (some answers have been edited for length and clarity).

1) The stock market keeps going up and up and up, and so much of it is because of Nvidia and the other Magnificent Seven stocks. Do you worry about a potential AI bubble popping, especially from those individual stocks that seem to have so much sway? What do you suppose that would look like?

Jim Dahle: I have no idea what the future of any individual stock or the market as a whole is. My crystal ball always seems to be cloudier than that of everyone else. So, I have invested in a way that does not require me to have a functioning crystal ball to be successful. It worked. I think it is the best method to recommend to others, so I built The White Coat Investor to do so. All I know about Nvidia is that it made the graphics cards that allowed me to play computer video games, and when AI came along, it had positioned itself very well to be the main (sole?) supplier of the chips needed to do this powerful computing and that caused its price to go up very rapidly. Whether its stock price goes up more, stays about where it is, or goes down and when, I have no idea. Frankly, I don't believe anyone else does either. While an article talking about this might provide good clickbait to bring people to The White Coat Investor to become financially literate, it's basically just investment porn.

[EDITOR'S NOTE: That last sentence from Jim is a real kick in my teeth.]

Rikki Racela: Nah man, I don't worry about the AI bubble popping. I actually hope that if we are in a bubble, it pops soon as individual stocks like Nvidia are likely overpriced and are killing the diversification in my total stock market index fund. I worry the opposite—that this bubble will not pop for another decade or so and my money is going into something horribly overvalued and it will kill my long-term return when I retire in 22 years! If the bubble does pop, it would seem like the world is ending, and it might look like the tech wreck in the market similar to 2000-2002, but for me, it would be the equivalent of winning the lottery as I can now buy the US stock market cheap. As Bill Bernstein says about young investors like me, we should get down on our hands and knees and pray for a prolonged terrible bear market. I pray every day for a severe prolonged bear market, and I will only stop praying for a bear market five years before retirement.

Bryan Jepson: Individual stock investors should try to not just get caught up in the hype, but rather, they need to be comfortable in evaluating and understanding each company’s financial statements and fundamentals if they want to make an educated guess about what will happen to AI stocks—or any other stock for that matter—especially within the context of the broader economic data. Due to their size, NVDA and the other Magnificent Seven stocks play an oversized role in the direction and volatility of the S&P 500 . . . If investing in an index, it is important that you understand how the constituent components are going to affect the results. In a market-weighted index like the S&P 500, the ups and downs of the largest stocks are going to disproportionately affect its performance.

2) What, if anything, should investors do? Ride the wave with our index funds until it crashes? Put your head in the sand and lose the password to your Vanguard and Fidelity accounts? Do something else? I know we don't like market timing, but what if somebody is starting to get nervous?

JD: They should stay the course with their written investing plan. If they don't have a plan, they should make one . . . However, it's important to know that successful investors don't base their asset allocation on market valuations or current market conditions, much less gut feelings about what the market is about to do. That's a recipe for investment disaster. So yeah, we've got 25% of our portfolio in VTI, which is 5.5% Nvidia and about 25% Magnificent Seven stocks (so 1.4% and 6.3% of our portfolio, respectively). I can certainly live with that without panicking should one or more of those stocks go bankrupt.

RR: Investors should, as Nick Magiulli says, just keep buying. Yes, ride the wave with our index funds until it crashes and actually keep riding through the crash. In fact, during the crash, cut down on expenses and try to invest more in the market. Buy stocks on sale! If it helps you, yes put your head in the sand and lose the passwords to your accounts if you start to get nervous.

I would challenge white coat investors to do something different, though (here comes the neurological mumbo jumbo). Every time you see the market go up, start cursing. Seriously! Cursing is usually associated with negative things in our lives, and the pathways involving the amygdala (fear center) and prefrontal/insular cortex (anger) will be activated and you will learn that every time the market goes up, it is bad. Also, while you curse, think of yourself eating Alpo in retirement and your kids going to community college despite a Harvard acceptance because you are too poor. Silly imagery, yes, but it will teach your brain that the market going up when you are nowhere near retirement is a BAD thing using System 1.

And then when the market goes down, say “Sweet!” and think of your kids (assuming you love your kids), wife, and family. Usually I do this when I see on my iPhone the market is down. I yell “SWEET!” and then scroll through photos of my family and kids. I am activating the limbic system and nucleus accumbens, the happiness and reward centers of our brains, in response to the market falling. So, you are adapting your System 1 to fear the market going up and to feel happy and want to invest when the market is going down.

BJ: There is never a one-size-fits-all solution in personal finance or investing. That is why a personalized comprehensive financial plan is important. An individual’s investment strategy must take into account a lot of different things, including risk tolerance, time horizon, future goals, current available assets, income, etc. Consideration of all these elements is critical in designing an investment plan that will give you the confidence to weather any storms in the market. So, if an investor isn't sure what to do, it's probably time to consult a professional. A trusted financial planner can help mitigate the emotional and psychological stress that often comes from trying to time buying or selling investments. A professional should be able to see the whole picture and integrate all of that into a written comprehensive investment strategy that will help you sleep better at night.

3) What if somebody is set to retire in the next five years? Does the equation change?

JD: If your fear of loss is greater than your fear of missing out, that's a sign that your asset allocation is too aggressive and you probably need to dial it back a bit, whether you are 35 and won't retire for 20 years or 65 and planning to retire in five. Now is probably a pretty good time to do that, given that the market is up 15% or so this year. At least you won't be selling low to adjust to a less aggressive asset allocation.

RR: Absofreakinlutely! If you are about to retire in five years, the equation does change. Your asset allocation should include safe assets. You really should be buying bonds if you haven't already, and you should seriously consider having not just a total bond fund but a Treasury bond fund (or even 1-2 years of cash). If the bubble pops right at the time you retire, having to sell stocks low kills your retirement portfolio. You have to prepare for the sequence of returns risk. Also, if your bonds are locked in a target retirement fund (definitely in your tax-advantaged accounts) get out of it and have separate stock index funds and bond funds. It would really suck to sell stocks because they are locked with your bonds in a target date fund.

BJ: The equation may change depending on the investor's overall financial picture. Again, a comprehensive financial plan answers these questions. I know it sounds like a simplistic answer, but I can't overemphasize the benefit of a rigorously developed plan that can lead investors down the right path. For one investor, a pension, annuity, or some other source of passive income may increase their risk capacity and allow them to ride the market waves regardless of the time until retirement. For another investor, it may be time to start de-risking the portfolio to mitigate the sequence of return risk—the danger that the order of investment returns experienced over time can negatively impact the value of a portfolio, particularly during the time an investor is approaching and entering retirement.

4) Anything else worth discussing on this subject?

RR: Yes. If it bothers you that you might be investing in just a few under-diversified overpriced stocks when investing in a total stock market index fund, try adding a small cap value index fund. You are diversifying away from the major concentration of the large growth tilt of the total US market, and you will make Paul Merriman happy at the same time.

BJ: Always remember the tried-and-true investing principles: diversify, dollar-cost average, use the power of compounding interest, understand your risk tolerance and capacity, know your investment timeframe, don't panic, and have a written investment plan.

 

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Are you concerned about an AI bubble popping? Are you doing anything about it? Is it easy for you to ignore the current market news?

[EDITOR'S NOTE: For comments, complaints, suggestions, or plaudits, email Josh Katzowitz at [email protected].]