AI Bubble - Are we there yet?

All bubble markets are overvalued, but not all overvalued markets are bubbles. Bubbles become cultural phenomenon. They permeate our everyday existence. Everywhere we go we see people talking about the markets and whatever innovation is driving the bubble. This is outside of the investment field itself. I mean, we're always talking about markets. But as I've mentioned before, in 1999 I saw that sports bars were watching CNBC on TV instead of sports. That meant we were in a Tech Bubble, not just an overvalued market.

So where are we now? After the Tech Bubble I developed a Bubble checklist comprised of five characteristics I saw in common across known bubbles of the past. In early 2024 I went through this list to see if we were in an AI bubble. The conclusion was "not yet." But I think it's time to revisit the list.

The Bubble Checklist

The checklist sets the conditions which have led to past bubbles. At the time I looked at several bubbles including the Tech Bubble (1999), the 1920s Bubble (1929), the Railroad bubble (1893), the South Sea Bubble (1720), and Tulipomania (1637). Since I developed this list in 2003 or so, we've had the Housing Bubble of 2008, which fit in with the others.

But the current market is not just a potential AI Bubble as I thought last year. It has now expanded to crypto. Crypto in early 2024 was still a fringe investment. Most institutions did not consider them securities, let alone proper investments. That seems to have changed now with Congress recognizing stablecoins, as we discussed last week, and the President's organization issuing it's own tokens. These two areas of intense speculation seem to be feeding off one another and are now spilling over to other parts of the markets and the economy in general.

1) Low Interest Rates and Excessive Leverage - Verdict: Yes

While the administration thinks rates should be 1%, real rates now are about average. So why do I give this a "yes?" Investors have found that even with positive real rates, rates are still low enough for them to finance high short term gains. We see this in Bitcoin, but also in other areas of the market including return of the so-called meme stock trade and currency markets. Corporations are buying Bitcoin to juice their valuation even though though crypto has nothing to do with their business. On top of that, the Non-financial leverage levels as measured by the St. Louis Fed remain elevated. The downward spiral when a bubble pops is due to forced selling to cover margin and other types of debt. That is now a potential problem.

2) Significant Economic Innovation and Productivity Gains - Verdict: Yes

The insidious thing about bubbles is that they are based upon a real promise. The internet, which fed the Tech Bubble, did change the world. Now we have AI and blockchain technology. Are they changing the world? Of course. But stock prices are discounting many years of profits by overpaying now. During the Tech Bubble, Cisco was expected to be the heart of the internet revolution and it was. But Cisco's peak price was $80/share (adjusted for splits) in 2000. Currently it's selling for around$66. The stock is still selling 20% below its old high despite 25 years of steady earnings and innovation. AI chip maker Nvidia may be facing a similar fate even if it delivers innovation as promised. Likewise the blockchain may change how we do banking, but would that justify Bitcoin's current price since we don't need Bitcoin to have a blockchain?

3) Innovations in Securities Markets - Verdict: Yes

These continue. Short-dated options and actively managed ETFs have been joined by fractional shares and other innovations which encourage speculators to trade. These speculators are not necessarily professionals. Just ordinary people with access to systems that make them feel like professionals. This was also true in 1999. I used to counter this by asking these amateur traders, "You know how to drive. If so, if I put you behind the wheel of this Formula 1 car, you can compete against the drivers in the Indianapolis 500?" That question still holds today. Markets are competitive. You're competing with pros. Having the same technology does not mean you have the same chance of winning.

4) Mini-Bubbles Develop - Verdict: Yes

The meme stock and currency trading I mentioned in (1) show speculation is alive and well. There's even an equivalent to the Beanie Baby craze of the 1990s with Labubus.

5) Moral Hazard - Verdict: Yes

Traders now talk about the "Trump put." The story is that the President follows the market and uses it as his measure of success. If it looks like it's getting "yippy," he'll step in and stop it from going down. He's done that all year, notably in April after Liberation Day. Belief is, he'll do it again. This is dangerous. It's perhaps the most dangerous idea out there. But it facilitates excessive risk taking and potentially explains why risk sentiment indicators have been steadily falling since late April. Investors are full speed ahead because they believe the President will save them if something goes wrong. If you believe that, fine. But it seems unlikely.

Conclusion

So it appears the bubble is forming. At it may be two bubbles growing side by side. If one pops, it'll probably pop the other one too.

But are we there yet? No. During the Tech Bubble these criteria were met in 1998. It took two more years for the crash to happen. The Great Crash of 1929 took at least 2 years to happen. So the conditions are here, but the timing is unknown. But when the bubble is about to reach its fully inflated levels, risk sentiment indicators usually flash warnings. We clearly don't have that now. But don't get complacent.

The Outlook

While MUSI is still at Fragile as I'm writing this, it looks likely the indicator will be shifting to Transition markets during the week. Transition means risks are balanced between the upside and the downside. While risk sentiment may be positive, macro fundamentals (global business conditions, interest rates and inflation) are negative. The market will probably hold up, for now. But taking extra risk would be pure speculation at this point.

Comments are welcome. And feel free to forward this post to anyone you think would find it interesting. Thanks for reading!

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