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I wrote about the potential AI equity bubble a couple of weeks ago. My high-level take was stock market valuations looked expensive but were not bubble-like. I gave a couple of reasons for this: first, it’s real earnings growth driving valuations today (rather than a jam tomorrow story) and, secondly, valuations are not at bubble-like levels yet versus history. I thought the problem, if it was to come, would be in the huge data centre build out currently underway. History (canals, railways, fibre-optic cables) suggests capacity will be over-built and the returns on it would prove to be low. And, ultimately, that would probably not be good news for the stock market. The 2000-era dotcom crash was really about the overbuild of cable networks funded by debt which could not be subsequently repaid. The real economy reacted to this debt crunch and US equity markets halved.
This week Goldman Sachs wrote their take on this question. It focussed just on the stock market side but it had some useful data on valuations. For instance, here are current market valuations versus a couple of notable previous bubbles. When you adjust for the fact that today’s valuations are supported by actual real earnings growth (28% year on year for the Magnificent 7 stocks) this does not look too bubbly to me yet.
That said, I chopped the Nifty Fifty comparison off from the bottom of their comparison chart. My reason is that the Nifty Fifty data was based on actual 2-year forward earnings, not market expectations, and so was not really an apples for apples comparison. Peak Nifty Fifty P/E valuations reached 42x at the end of 1972 which is not that far from the current 38x P/E for the US Magnificent 7 stocks. Also (ironically?) my AI (Gemini) generated this table of selected Nifty Fifty valuations at the peak:
What jumped out at me here is that the two technology-type stocks (Polaroid, Xerox) have effectively disappeared and even IBM is a shadow of its former self. McDonalds and Coca-Cola are, in contrast, probably more central to people’s lives today than they were in the 1970s. Technology stocks feel like they should have an extra discount on them because technology can and does change quickly making old platforms redundant. That logic makes Magnificent 7 valuations today look pretty comparable to the Nifty Fifty peak.
That said, I think you can overdo arguments by analogy when investing. It is tempting to mock people who say that this time it is different. But I actually think every time is different. The dotcom crash, 2008 financial crisis, and Covid have echoes of the past but all looked and felt unique to me. The challenges we face today are very different from those of the 1970s.
In that spirit, I think the big question investors face today is will AI progress keep being made at its current pace for the next few years? If you think yes, then we will need those data centres (and more) and we are on the verge of one of the largest positive productivity shocks in history. If that happens, equities, and US equities in particular, look like a buy to me even at today’s levels. If not, then the long-term picture still looks pretty good (the AI we have today is real enough to make some fundamental improvements to how we all live) but in the short term, we will have to deal with a data centre overbuild bust. Your one hope here is that the underlying economy proves as resilient as it did to the recent Covid and inflation shocks.
I am not sure anyone (AI researchers, data centre investors, newspaper columnists, me) really knows the answer to that question. We therefore continue to have feet in two camps. Around half our equity exposure (for our sterling clients at least) is in the US and is predominantly passive, giving us full exposure to its giant technology stocks. The rest is diversified around the rest of the world. The good news is there are plenty of other opportunities out there (including European banks and resurgent markets in China and Japan). This year that diversification has worked, with different themes delivering at different times of the year. I feel like, one way or another, we will all be hostage to how the AI story eventually plays out over the next few years. But the return of diversification and some real, non-US opportunities will, I hope, cushion the ride.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
