If you have been reading the financial press lately, you will know there is no shortage of doomsayers. Headlines warn of bubbles in AI stocks, private credit meltdowns, and that the UK and US are apparently teetering on the brink of default. Should we all run and hide? Probably not (yet), but caution is warranted.
Let’s focus on the first of the headlines above, the fear of an AI bubble bursting. A few weeks ago, in a previous blog, my colleague Ian Jensen-Humphreys argued that the recent run-up in AI-related mega-cap stocks is not a classic bubble. Why? Because it has been underpinned by strong growth in delivered earnings, not just hopes for future profits. However, it is worth pointing out that those earnings are themselves driven by speculative investment from elsewhere - think Alphabet and Meta - betting that AI will cut their costs and drive new revenue streams.
Is this really that different from the Dot Com bubble? You could argue the speculation is still there, but it has shifted up the chain from shareholders to corporates. Although the fact there are genuine earnings today is a definite improvement on the late 1990s/early 2000s.
So, while we certainly would not signal the ‘all clear’, the mega-cap rally in the US may have further to run. However, the story is less convincing in US small caps, where the rally has less earnings support and instead has been more of a ′trash rally′ of unprofitable companies. This is something we are more wary of chasing.
It is also worth noting that the AI theme itself has broadened. Paradoxically, ′old economy′ industrial and construction companies have benefitted recently. Data centres need chips, but they also need someone to build them. Suddenly, sectors that seemed far removed from AI are in play.
For investors, this means there are many ways to access the AI theme. There will be winners and losers in sectors that, a few years ago, were not obviously AI-adjacent. It is a theme that will drive the economy and markets for years, but in some pockets, it is likely overhyped, presenting opportunities to rotate out of expensive stocks and into cheaper ones without being a luddite and dismissing a game changing new technology.
Whether you think mega caps are in a bubble or not, there are other things to consider before either selling everything or going all in. Bubbles usually burst after the last sceptic throws in the towel and buys. At that point, there are not (m)any buyers left, so even a minor piece of bad news can trigger sharp share price declines. The fact that so many are warning of a bubble suggests it is not about to burst.
However, another way you could think about it is that while investor flows have broadened somewhat, with Asian and emerging markets being recent beneficiaries, an awful lot of money is still going into mega-cap US tech despite these warnings. If investors are reluctantly buying because they cannot bear the ongoing pain of being underweight to the recent winners, it may not take much for these reluctant buyers to become sellers again.
Looking longer-term, it is hard to see the dominant position of many of these firms continuing quite to the extent implied by current share prices, so we are not looking to chase the mega-cap tech rally from here. However, as the famous quote goes, ’the market can remain irrational longer than you can remain solvent‘, highlighting that timing reversals is fraught with difficulty.
Meanwhile, sizing positions appropriately is critical so a portfolio has several ways it can win, rather than betting the house on a breakdown in market momentum. Even the greatest investors only get it right a little over half the time, so a large dose of humility is always required.
CJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPHil in Economic and Social History from Brasenose College, University of Oxford.
