This week’s blog is written by portfolio manager Ian Jensen-Humphreys
This week the Bank of England warned investors about the possibility of a sharp market correction, following a fast and furious rally recently – over the past 6 months, global equities have rallied over 25% from the trough shortly after “Liberation Day” in April. So, should we be worried? Are we in the midst of an equity market bubble?
A quick look back at history suggests that speculative bubbles come about as a result of irrational exuberance, often related to a technological breakthrough that promises huge future productivity gains and consequent profits (often far off in the future). The best and most recent example would be the “dot-com” bubble that burst in 2000, leaving in its wake the likes of Pets.com or Boo.com. Earlier examples include the bubble in railway stock prices in the UK in the 1840s and even the South Sea bubble in 1720.
This time around, the transformative technology is artificial intelligence (AI) and the poster child is Nvidia. Its market capitalisation rose above $4 trillion in July – for comparison, the current market capitalisation of the 73 companies comprising the MSCI UK was “only” $3.0 trillion at the end of September. As recently as October 2022, Nvidia was worth $280 billion – its share price has increased over 13 times in this period. Nvidia designs the powerful chips needed for the heavy processing required by AI models and hence have been in high demand by companies such as Meta and Google as they build out their AI capabilities.
These high prices have been accompanied by sky high valuations in US equities (although this is not the case in other regions). The price/earnings ratio (a standard measure of valuation) of the MSCI USA Index of large US companies is currently 28.9x – over the last 30 years it has only been higher in the peak of the dot-com bubble in 1999 when it reached 31.6x and the post COVID rally when it reached 33.6x. For comparison, the average multiple over the past 30 years has been 20.6x, and the lowest level (i.e. the “cheapest” market) was 9.8x in early 2009.
High prices and heady valuations do not necessarily cause concern in and of themselves, but there are other warning signs that the current growth extrapolated around AI is not sustainable. One key red flag is the vendor financing we are starting to see – essentially Nvidia (and others) are lending money to their clients so they can afford to buy their products. They will argue that they are helping to jump-start a market in an early stage, but is it fair to ask whether or not the natural demand would be there if Nvidia weren’t financing it? This is reminiscent of some of the behaviour from the late 1990s.
One final point to consider is the increased participation of retail investors in driving prices higher. Retail investors have become a much larger proportion of the volume in the US stock market, and they tend to focus on “household” brands and companies. We also see a large increase in the use of margin accounts (individuals borrowing to invest in stocks) but also call options on these AI or tech companies which are effectively providing leveraged exposure, a clear warning of excessive speculation. .
But this time it might be different…one key difference is that the dominant companies today have been generating consistently superior returns – there is somewhat of an anchor for their strong performance. For example, Nvidia’s earnings per share has increased over 1000% since October 2022, or over 140% per annum. This profile of superior earnings growth is replicated (albeit less spectacularly) across the entire global technology sector, which has compounded earnings growth of 2.3%p.a. over the last 10 years, compared to only 6.3% for the broader market. So, technology stocks probably deserve to trade at a valuation premium to the rest of the market.
Another reason to pause is that the extreme amount of investment poured into AI-related research and development has largely been financed from operating cash flows rather than debt. Companies are reinvesting profits from their existing businesses rather than borrowing to invest. This means that if the investments end up being unproductive, there are less likely to be downstream credit risks that spill out more broadly (to put this in context, if hardly anyone had had mortgages in 2008, the property crisis would not have spread to the banks and would have been much less likely to impact the overall economy). If we were to see a large increase in debt issuance to finance investment, that would be a further red flag.
The unfortunate reality is that it is very hard to know whether or not we have been in a bubble until after it has burst, and furthermore the underperformance from being too early to step away can be just as bad as from being too late – witness the value managers forced out of business in the late 1990s just prior to the burst of the dot-com bubble. .
We try to balance the risks with the potential opportunities by maintaining a diversified investment approach to markets, ensuring we don’t have all our eggs in a very small and precarious basket. We also trust the specialist managers to whom we allocate, to guide us best through this environment.
Ian is a portfolio manager of the Quilter Investors Cirilium and Creation Portfolios. Ian joined Quilter Investors in March 2020 from Seven Investment Management (7IM), where he was deputy chief investment officer. Ian also spent 15 years at Goldman Sachs in risk management and portfolio hedging strategies.
Ian is a CFA charterholder and has a degree in Physics from the University of Oxford.
Budget watch and the gilt market
We’re still over a month away from the November Budget, but policy and politics are already dominating headlines, particularly following the Labour Party conference.
