Are we witnessing another stock bubble?

Tech companies fronted by AI hype superstars NVIDIA and Microsoft have scaled new heights. Microsoft became the first company in the world to break the $3 trillion mark. Many technology companies have risen by hundreds of percent over the past 18 months. The world's main stock index, the S&P 500, has surpassed the level it touched in early January 2022. At the time, there was widespread talk of a stock market bubble.

So it’s fair to ask whether we are in a bubble again.

Investors have short memories, as the last bubble was only a couple of years ago. But the US stock markets have recovered in a U-shape to new peaks.

By the end of 2021, signs of stock market overheating were evident everywhere.  Even the characters in the Finnish soap opera Salatut elämät were sharing investment tips. The new electric car maker Rivian was valued at $130 billion with zero revenue. One young portfolio manager proclaimed that talk of a bubble was boomer nonsense. The late Charlie Munger diagnosed the stock market as crazier than it had been during the dot-com bubble.

At that time, growth companies, SPACs, hydrogen stocks and software companies were the ones in the biggest bubble. Meme stocks like Gamestop were the most extreme sign of the bubble, but now the meme stocks are stuck at the bottom.

This time, the stock market is being driven by companies associated with artificial intelligence. Terminology and trends (who remembers blockchains?) change, but human psychology does not. A typical feature of bubbles throughout history is that a new technology comes along and completely changes the world. The old laws of economics and investing no longer apply.

Although the impact of AI on the economy and on the profitability of listed companies is still very unclear, investors have already loaded considerable expectations for the share prices of the companies involved in the revolution.

The obvious business beneficiaries of AI so far have been NVIDIA, which sells computing power through graphics cards, and Microsoft, which integrates AI into its monopolistic software products. But AI requires more than just graphics cards: processors, memory and hard drives, as well as semiconductors.

Several semiconductor manufacturing companies (such as Intel, Samsung, Micron or Texas Instruments) have performed relatively modestly, and in some cases even suffered declining sales and poor guidance. For example, ASML, the pride of the European semiconductor industry, gave guidance that this year's sales would be at last year's level. This has not prevented the stock from reaching new highs. Perhaps investments will start to recover later on. Given that we should be on the cusp of a huge AI revolution, that seems a bit odd. I read a good “rant” on the subject in X, which is worth a look. In summary, the X user says that investors have completely misunderstood the capabilities of the technology. “Buyer beware.”

Of course, a rise in stock prices is not in itself a reason to cry stock market bubble, although the vertical rise in some stocks does raise doubts. Valuation levels in the US have also stretched again, in some places to eye-watering levels.

The valuation of the global semiconductor index, based on 12-month forward earnings forecasts, is at its highest level in the past decade, around 24x. In addition to the companies mentioned above, the index includes LAM, TSMC and AMD, a familiar name to gamers. The Nasdaq-100 index, dominated by tech giants, is trading at 26 times its forecast performance, which is not far from the bubble levels of 2021.

 

This despite the fact that interest rates, which are the gravitational force for equities, have risen sharply in a couple of years.

At the forefront of technological development, the all-around good company NVIDIA has quickly risen to a value of $1.5 trillion. That's almost triple the value of Tesla and half the value of Microsoft, even though NVIDIA makes $45 billion in revenue and Microsoft $220 billion. Of course, NVIDIA is expected to see explosive growth in the coming years. Even so, the stock is now trading at 50 times its multiplying earnings. The absolute size of that is already overwhelming. Especially since in recent years, you could buy the stock for less than 20 times earnings. Although an excellent company, I think it’s fair to ask whether it is now the best investment idea in the world.

While there is undoubtedly a lot of optimism around AI, the rise is by no means limited to the technology sector. Even the S&P 500 Balanced index is hitting new highs. As I have pointed out several times, stocks in many other countries have also been rising. Traditional financial companies such as Warren Buffett's Berkshire Hathaway, which owns energy, manufacturing and insurance businesses, or JP Morgan, America's largest bank, have also climbed.

Rise fuels more rise, because people tend to judge the soundness of stocks by their recent performance. This is an anecdotal observation, but I have seen a rare number of comments from retail investors about how it's not worth investing outside the US. The relative share of the US in the global equity market has rebounded to almost 70%, and as I have said before, a significant part of the increase in recent years can be explained purely by the stretching of equity valuation multiples.

And, of course, they can stretch even further. 

Experienced and bullish investment strategist Ed Yardeni has speculated that a late-90s style vertical rally in tech is a possibility for the S&P 500 index. Just like the internet was promised to be the key to the paradise of economic growth, AI is also expected to deliver revolutionary productivity gains (as I have previously touched upon, e.g. GS estimates that AI will accelerate productivity growth by up to 1.5% per year).

There is another similarity between today and the late 1990s. In 1998, the Fed, the central bank regulating monetary conditions, became alarmed by the slowdown in global growth and slightly lowered its interest rate. This was the final trigger for the Nasdaq tech rally. Just like then, the market is waiting and thirsty for interest rate cuts today. If the Fed were to do so, the prospect of a stock market bubble is highly probable in my view.

But I wouldn't blame the entire US stock market for the bubble today. Although the S&P 500 index is trading at 20 times the expected result, for the average company that figure is 16. Compared to the past, that doesn't look like a bubble. There might be opportunities beyond the market's star performers.

What's more, former hype stocks such as Tesla are feeling the pain. This is another indication that bubbles are a concern for a small group of stocks, not a widespread phenomenon in the stock market. Tesla’s stock has halved from its peak in the fall of 2021, and the company's latest investor call was entertainingly disastrous as Elon Musk envisioned Tesla surging to become the world's most valuable company with robotics and artificial intelligence. That may or may not happen. At the same time, Elon Musk wants more Tesla shares for himself, supposedly to keep the AI in check. What a load of bunkum!

Equities are also being supported by the macro-economy. According to the latest data, the US economy continues to grow at a rate of up to 3%. At the same time, inflation is falling. Slowing inflation combined with a strong economy is something of a paradise scenario for equities.

All in all, I would be wary of hype labels. Investors tend to overestimate how new technologies will translate into free cash flow. The economic picture is still muddled by massive stimulus. The reality without stimulus may look bleaker. Inflation still has the potential to make a surprise comeback and drive up interest rates. The more you pay for a stock today, the lower the expected future return. That also means a greater risk of being surprised negatively in the future. No one has a crystal ball to look five years into the future and see who the winners will be.

Read analysis and make good stock picks!