Is the Market Going to Party Like It’s 1998?

If an AI bubble is forming, it seems unlikely to pop soon?

Most of the financial bubbles in the years since the dot-com boom and bust have been driven by debt, low interest rates, or—in the case of meme stocks—Reddit, and liquidity-fueled speculation by investors stuck at home during the pandemic.?

Something more durable seems to be at work with artificial intelligence (AI) stocks. Like the internet, generative AI is an innovation that will affect nearly every industry. Some companies and investors are likely to reap large windfalls.??

But is the market getting ahead of itself? As asset allocators, we need to consider whether equity prices are once again reflecting too much enthusiasm over an exciting new technology.?

Given the parallels, I recently asked Grace Zheng, a senior quantitative investment analyst in the Multi-Asset Division, to help answer a simple question: What can the dot-com boom and bust tell us about whether an AI bubble—if indeed there is one—is getting ready to pop?

We examined the recent performance of AI-related stocks in comparison with the performance of tech stocks leading up to, and including, the internet bubble. For the underlying data, Grace employed recent research from State Street and Goldman Sachs, which use two different methods of determining what defines an AI stock.?

What defines an AI company??

To identify AI stocks, State Street selects a large basket of stocks that have exhibited elevated sensitivity (or beta) to mentions of AI in the media since 2015. State Street uses natural language processing to scan thousands of digital media sources each day and quantify the tone and intensity of specific narratives. Figure 1 shows the percentage of company-specific articles that discuss AI in a positive tone.?

(Wonkery alert): State Street’s process is rules-based. They run regressions on individual stocks to identify those that respond the most to positive AI news, controlling for market returns. This approach is more likely to select “pure-play” AI companies. While State Street’s AI basket includes Nvidia, it doesn’t include the other mega-cap tech companies that are putting the most dollars into AI, such as Microsoft and Google (Alphabet). The stock returns of these giants were driven by a range of factors besides AI over the period.??

The Goldman Sachs AI basket1, in contrast, is constructed by a team of sector analysts, based on fundamental analysis, liquidity requirements, and maybe judgment calls. As Goldman Sachs describes it, “[This basket] consists of companies that are pursuing artificial intelligence or can help enable new technologies across software, semiconductors, tech hardware, media, internet, and IT services.” The Goldman Sachs basket includes Nvidia, as well as Google, Apple, Amazon, and Microsoft.??

As shown below, the baskets’ returns are highly correlated, but State Street’s basket has outperformed Goldman Sachs basket over the last two years. In my view, this tells us something interesting and counter to the popular narrative: All else being equal, the AI factor may not yet be fully priced into the large-cap growth space. Keep in mind that most of the mega-caps have yet to recover their 2021 highs, despite the excitement over AI.?

State Street’s data looks somewhat bubblier than Goldman Sachs’, but Figure 3 shows that we’re nowhere near the point of when the internet bubble popped. Admittedly, there’s an arbitrary choice to be made as to when we start the clock on a bubble. But as Figure 3 shows, 1994 seems to be a good date to mark the beginning of the climb in tech stock prices.

Valuation trends demonstrate the same pattern. As shown in Figure 4, AI investors are hardly partying like it’s the peak of the internet bubble.?

Bloomberg data on the intensity of AI media coverage also shows that we haven’t reached the frenzy of the dot-com boom. If you feel that the cacophony of AI news is deafening, you don’t remember Pets.com, AOL, and Netscape—and you certainly never asked Jeeves anything. Current AI news coverage pales in comparison. Maybe we’ll know we’re closer to the top of the AI bubble when these capabilities dominate the Super Bowl ads. (“Crypto Bowl” of 2022, I’m looking at you.)??

The bottom line: If the history of the internet boom and bust is any guide, we may be a couple of years away from the bursting of a potential AI bubble.?

What this tells us as asset allocators?

The internet boom sheds light on other factors to consider. It suggests that growth could outperform value for the next six to 18 months. Overall, this exercise reinforces our earlier decision to close our growth underweight.

However, growth’s P/E remains in its 80th historical percentile relative to value’s—put differently, investors have only been willing to pay this much extra for growth 20% of the time. Should we get a pullback in growth relative to value, perhaps due to an upside surprise in inflation or interest rates, I suspect some valuation-aware investors who are currently underweight will want to move to overweight growth stocks.?

As a durable, transformative innovation, AI may foster the continued outperformance of the U.S. relative to other equity markets. Many of AI’s leading players are based in the U.S.—although not all of them, as our global tech team will be quick to tell you (think Taiwan Semiconductor Manufacturing Corporation, the UK’s ARM Holdings, and the Netherlands’ ASML Holding, among others)

(If you’re interested in the opinions of several of our tech-focused portfolio managers and analysts on how all this might play out for specific companies, as well as a description of what’s special about generative AI, I recommend “Generative AI Holds Promise and Peril for Investors.”2)?

REFERENCES

1Information on Goldman Sachs AI basket was retrieved from Bloomberg.

2T. Rowe Price. June 2023. Generative AI Holds Promise and Peril for Investors.?https://www.troweprice.com/financial-intermediary/au/en/thinking/articles/2023/q2/generative-ai-holds-promise-and-peril-for-investors-apac.html

Figures 1 and 2

MediaStats indicators from State Street Global Markets?

Figure 3

MediaStats indicators from State Street Global Markets

SPX IT series represented by S&P 500 Information Technology Sector GICS Level 1 Index from December 30, 1994 to December 31, 1998, and S&P 500 Information Technology Sector Net Total Return Index from annuary 1, 1999 to December 31, 2002.

Figure 4

MediaStats indicators from State Street Global Markets?

Price-to-Earnings (P/E) Ratio:?measures share price compared to earnings per share for a stock or stocks in a portfolio.

Price-to-Cash Flow (P/CF) Ratio:?measures the current price of the company’s stock relative to the amount of cash generated by the company.?

Figure 5

Bloomberg terminal: “By default, NT story counts are drawn from every story that appeared on the Bloomberg Terminal? over a 10-year period across all sources. Bloomberg has indexed all content from the sources over this 10-year period and backfills sources as they are added to the Terminal.?

You should see consistent results across all date ranges for this 10-year period, but the results may not match a search query performed via NSE <GO> or NLRT <GO>, as certain sources (e.g., scraped web content and some newspapers) expire from the search database after a few months or a year.”??

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