The "AI Bubble"

Summary

In this video, Ben Felix, Chief Investment Officer at PWL Capital, delves into the potential risks of an AI bubble in the US stock market. He examines the current market's high valuations and concentration, where a small number of stocks dominate. Using historical examples from Canada and Japan, Felix explores the dynamics of market bubbles and the importance of diversification. He emphasizes that while market concentration can be concerning, it doesn't always predict poor returns. The key takeaway is that a diversified, disciplined approach is essential for navigating the uncertainties of the stock market.

Takeaways

• 😀 The S&P 500 index is becoming increasingly concentrated, with just seven stocks making up 36% of its total value, a historic high in US market history.
• 😀 The total US market is also highly concentrated, with 32% of its value driven by just a handful of companies, raising concerns about diversification.
• 😀 Historically, stock price bubbles tend to form around revolutionary technologies (e.g., railroads, the internet), often leading to high valuations followed by painful crashes.
• 😀 While it's uncertain if we're in an 'AI bubble,' rapid investments in AI infrastructure have led to significant stock price increases, particularly in the US market.
• 😀 The stock market is showing both high valuations and market concentration, which are typically linked to lower future returns, although the relationship is not perfectly consistent.
• 😀 High stock prices during technology bubbles can be beneficial for the economy by funding the development and deployment of new infrastructure, despite the eventual crash.
• 😀 The Canadian market, despite extreme concentration in the early 2000s, recovered more quickly than the US market, providing a lesson in the resilience of diversified investments.
• 😀 The dotcom bubble of the late '90s caused massive losses in the US market, but diversified investments, particularly in value stocks, performed much better during this period.
• 😀 Global market concentration varies, with some markets (like Switzerland and Taiwan) having even higher concentrations than the US, but these markets still posted positive returns in the long run.
• 😀 Stock market concentration does not always predict poor future returns, as evidenced by historical examples in the US and Canada, showing that concentration can be a short-term issue rather than a long-term problem.
• 😀 Valuation levels, especially the cyclically adjusted price-to-earnings (CAPE) ratio, have a stronger correlation with future returns than market concentration, suggesting that high valuations today could lead to lower returns in the future.

Q & A

What is the main concern regarding the concentration of stocks in the S&P 500 index?

The main concern is that 36% of the S&P 500 index is made up of just seven stocks. This extreme concentration could lead to significant market risk if these stocks decline in value, as it could have a disproportionate effect on the overall market.

How does market concentration differ from market valuations in the context of investing?

Market concentration refers to how much of the market’s total value is concentrated in a small number of stocks, while market valuations measure how expensive it is to buy the expected future earnings of companies. Both can be related, especially when high valuations for a few firms increase market concentration.

What historical example from Canada illustrates the potential risks of market concentration?

In July 2000, Nortel Networks, a single stock, made up about 36% of the entire Canadian market index. The stock eventually crashed and became worthless, leading to a significant market downturn.

What makes the AI-driven rise in US stock valuations different from previous bubbles?

Unlike past bubbles, the rise in AI-related stocks is supported by rapid earnings growth, not just hype. For instance, AI stocks have accounted for 75% of S&P 500 returns, 80% of earnings growth, and 90% of capital spending growth since the launch of ChatGPT in November 2022.

Why is it difficult to determine if we are experiencing an AI bubble?

It’s difficult to determine if we are in an AI bubble because bubbles are only identifiable in hindsight. While current stock prices are high, there’s also genuine economic growth and investment in AI-related sectors, making it unclear whether the market is overvalued or if the growth is sustainable.

How have past technological bubbles, like the dotcom bubble, affected stock markets?

Technological bubbles, such as the dotcom bubble of the late 1990s, often lead to a rapid rise in stock prices followed by a painful crash. These bubbles may cause wasteful spending but also create infrastructure that supports long-term economic growth, despite the initial financial pain for investors.

What can investors learn from the Canadian market's recovery after Nortel’s collapse?

Despite the concentration of the Canadian market in Nortel, the Canadian stock market recovered by 2005 and delivered strong returns. The lesson is that diversification within the market—such as investing in value stocks—can help mitigate the risks of high concentration.

How did the US market perform after the dotcom crash compared to the Canadian market?

After the dotcom crash, the US market struggled for more than a decade, with little to no growth until 2013. In contrast, the Canadian market, despite its concentration in Nortel, recovered more quickly and performed relatively better during that period.

What does the cyclically adjusted price-to-earnings (CAPE) ratio tell us about stock market valuations?

The CAPE ratio measures stock prices against a 10-year average of real historical earnings. A high CAPE ratio suggests that stock prices are high relative to expected earnings, which typically signals lower future returns. When valuations are high, it’s wise for investors to moderate expectations for future returns.

Why might diversification help mitigate the risks associated with high stock market valuations?

Diversification helps because it ensures that an investor is not overly exposed to any one stock or sector, such as AI stocks in today’s market. Even if a few stocks or sectors underperform, the broader portfolio can still benefit from other areas of the market that may be doing well, thereby reducing overall risk.