The AI Boom: A New Era or a Bubble?
Artificial intelligence (AI) has become one of the most talked-about topics in the financial world. For Americans, the euphoria around AI stocks has continued with the S&P 500 hitting a new high on Thursday. The world's most valuable company, Nvidia, is moving closer to a $6 trillion valuation. This surge in value is a boon for its founder and CEO, Jensen Huang, who recently accompanied Donald Trump on a trip to China.
This positive trend contrasts sharply with the gloom seen in the UK markets. The British pound, government bonds (gilts), and equities all experienced significant declines due to political uncertainty, especially with the possibility of Andy Burnham becoming Prime Minister.
Despite the current optimism, it's important to question how long this AI boom can last. If it is indeed a bubble, what happens when it bursts? There is a crucial distinction between the transformative potential of AI on the economy and its impact on financial markets.
It is entirely possible for a new technology to have a deep and lasting effect on our lives and work, but investors can still lose money if they invest at the wrong time. The dot-com boom of the late 1990s serves as a classic example, where many companies saw their stock prices plummet after the crash.
The key issue here is not the AI revolution itself, but rather the valuations placed on the companies driving it. Can these high valuations be justified? My concern is that everything must go perfectly for these companies to maintain their current levels. For instance, Nvidia, valued at $5.5 trillion, has a price/earnings (P/E) ratio of 46, which is quite high. Alphabet, the parent company of Google, is worth $4.5 trillion with a P/E ratio of 30, while Apple, valued at $4.4 trillion, has a P/E ratio of 36. In comparison, the S&P 500 as a whole has a P/E ratio just over 30, and a forward P/E of 22. The historical average for the S&P 500 is between 16 and 18. A significant drop in company earnings could be disastrous. If Nvidia misses its profit forecast in the next results, it might trigger a broader sell-off.
Another factor to consider is the potential rise in interest rates. The mood in the US has shifted from expecting no changes in rates this year to anticipating at least one increase. This change is a response to disappointing inflation figures and the possibility of the Strait of Hormuz remaining closed for several more weeks, which could push up inflation through the autumn.
Longer-term US yields have also climbed. If the cost of funding the massive investments needed to sustain the AI industry increases significantly, it could negatively impact profit margins. If credit becomes both more expensive and harder to obtain, it could lead to a sell-off.
In terms of the scale of a potential correction, a typical decline for the high-tech sector is an average of 40 per cent. After the dot-com bubble burst in 2000, technology shares, as represented by the Nasdaq Composite index, fell by 80 per cent. However, the valuations at the peak were even more extreme, and the index had risen by 600 per cent in the previous five years. Therefore, it is unlikely we are heading into that territory. Nevertheless, a bear market is defined as a fall of 20 per cent, and that seems increasingly likely. But when?
No one can reliably predict downturns, but my instinct suggests it is more likely to happen next year or later than this year.
What Does Claude Say About the AI Bubble?
Since we're discussing artificial intelligence, I asked Claude, Anthropic's free-to-use AI assistant, for its assessment. It examined the arguments about whether the downturn might occur in the next 12 to 24 months or if things might continue for longer—two to four years.
Claude's conclusion was that the "highest probability window for a meaningful correction based on historical tech cycle lengths" is between 2027 and 2028. So, there will likely be a significant drop in high-tech share prices in the next few years, but it's not imminent. While this prediction may be incorrect, it is at least reasonable and offers a welcome respite from the ongoing discussions about the fate of Sir Keir Starmer and his Chancellor Rachel Reeves.
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