February 19, 2024 - 2:40pm
On Wednesday, Nvidia will report its quarterly earnings. Mind you, this may not make much of a difference to its share price. Nvidia’s stock is headed to the moon and, in a market awash with liquidity, not much will stop it for now.
The AI boom is reaching the sort of lofty heights that characterised history’s great bubbles, from the Dutch tulip mania to the dotcom bust at the turn of the millennium. Investors have now determined that Nvidia alone is worth more than the entire annual output of Spain. Add in the tech companies expected to profit most from the AI revolution — Nvidia along with Amazon, Apple, Alphabet, Meta, Tesla, and Microsoft — and the so-called Magnificent Seven are together valued at more than the stock markets of every other country on the planet. The American stock market’s spectacular performance over the last year, up more than a fifth, has been driven almost entirely by these seven companies.
We’ve been here before, many times. New technologies often produce bubbles — railways in the 19th century, automobiles and radios in the 1920s, the internet in the 1990s and now the AI boom, which was triggered by Open AI’s launch of ChatGPT late in 2022. Driving any bubble is the same conviction that the new technology will revolutionise the economy, combined with the fact that nobody can be sure just how it will do that. So narratives of transformation become self-sustaining, as the stock’s rise draws in ever more investors eager to join the ride, creating a self-propelling upward cycle.
In time, all bubbles burst. So will this one, even if most analysts seem to think it can run some way before the crash happens. The expectations embedded in the price for Nvidia alone would, if fulfilled, be pretty much without precedent. One analyst has calculated that to justify its current valuation, Nvidia would need to grow its sales tenfold while maintaining a profit margin of over 50%. Possible? Yes. Likely? One might want to instead consider a sharehold on the Brooklyn Bridge.
But there are two additional features to the AI bubble that are particularly concerning. One is the sheer volume of liquidity in the markets. Despite sharply raising interest rates, the Federal Reserve has been finding other ways to pump money back into the financial system, such as the liquidity measures it put in place during last year’s regional bank run. This sea of cash is actively chasing returns and inflating asset values, which in turn is complicating the Fed’s inflation battle: as share prices rise, more people cash out and take early retirement, reducing the labour supply and thus driving up wages.
But an even bigger concern may be the rise of passive investing, which for the first time accounts for half the market. Unlike active funds, which hire researchers to analyse company statements and inform investment decisions, passive funds merely assign the money to the market using a pre-set formula. On one hand, because they have lower costs, they can make investors more money. But on the other, they tend to follow the crowd, assuming as they do that the crowd has done its research. The resulting tendency is pro-cyclical: as a stock like Nvidia rises, more money rushes in and drives it higher.
Of course, this can work either way. When the AI bubble bursts, passive funds may automatically rush for the exits, worsening the fall. Just how the Fed might corral this crowd when it begins to stampede remains to be seen.
John Rapley is an author and academic who divides his time between London, Johannesburg and Ottawa. His books include Why Empires Fall: Rome, America and the Future of the West (with Peter Heather, Penguin, 2023) and Twilight of the Money Gods: Economics as a religion (Simon & Schuster, 2017).
jarapley
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SubscribeThere is still way too much money in the system (thanks to QE) but – given the inflation we experienced when the money went into the pockets of actual people who need it and spend it – pointlessly inflating the stock market is maybe the best place for it. Bad news for anyone trying to save for a pension though!
The most interesting observation in this article, for me, is that some people are retiring early on stock market gains and so tightening the labor market. I’m not sure I believe that.
I see many job postings for entry level jobs. But my impression is companies still don’t want to retain older workers because they’re perceived as expensive, and will take every opportunity to lay them off.
Investors gorge on cheap money while companies cut costs, including older workers. It’s familiar short term thinking.
Very good article. Absolutely correct about the effect of index funds. If you have any sort of international index tracking fund (which isn’t in itself a bad idea), you’ll be exposed to the “magnificent seven” tech stocks whether you like it or not. They have to buy them regardless of whether they are over-valued or not. It’s a classic positive feedback loop – a recipe for boom and bust instability.
Is it a bubble ? Yes. When will the madness end ? As with all bubbles, it’s impossible to say.
Can the Fed do anything to moderate the correction ? No. Nor should they.
Perhaps it will turn out like the telecom bubble of 2001 – there was so much over-investment in very high speed international telecom cables that we got to live off very cheap comms infrstructure for over a decade. But the AI chips don’t have as long a lifetime as telecom infrastructure. But some industries will thrive off the cheap surplus infrastructure when it does all burst.
Remember: the market can stay irrational longer than you can stay solvent.
While the article contains many worthy observations, the current valuation of Nvidia will only be proven by time. Of those Magnificent Seven, Apple, Microsoft, Amazon, Alphabet, and Meta are no longer new companies by any means and matured into the very high early valuations they enjoyed. If AI is as paradigm-shifting as predicted, Nvidia could also justify the confidence of its investors (I am not one BTW).
Also, while any perspicacious investor pauses soberly at the aggregate valuation of those seven companies, comparing them to the economic output of Spain is a weak analogy. I don’t at all mean to disparage the very admirable folk of the Iberian peninsula but, Spain is no economic juggernaut.
I am still waiting for the biggest bubble of the lot (Bitcoin) to burst.
It did burst but then it recovered.
Bitcoin is a gauge of excess liquidity in the market.
‘they tend to follow the crowd, assuming as they do that the crowd has done its research’
This is wrong. The boom in passive investment in index funds is based on a recognition that the experts don’t know what they’re doing. Hence passive investment has generally out-performed active stock-picking over the long term.
Passive investment juices those companies with the largest market cap for sure, but active investment generally allocates investment to duds and just a few outlying winners.
Passive investment worked well when its total funds were not such a large percentage of the overall market. You’ve missed the point that it becomes a dumb positive feedback loop once it becomes a large part of the overall market. At some point, the huge tracker funds start to lead rather than follow the market. This is nothing other than the so-called “momentum investing” that was all the rage around 2000.
And it is not based on the “recognition that the experts don’t know what they’re doing”. Some do, some don’t. What you are buying is a pooled, market average investment with a very low management charge. The big disadvantage of actively managed funds is the compounded high charges.
The key disadvantage of passive funds is that they have to the chase the market down when it falls. As we shall doubtless see.
Nvidia profits up 285 percent – bubble?
Advanced microchips compared to Tulips? or worthless dot com companies with no revenue like pets dot com? really? See a difference in inherent value maybe? you know, that the AI chips can build things that dramatically improve medicine (accuracy of detecting malignancy in various scans), engineering (huge leap in coding productivity), the list is endless.
As someone who was not born into the “dividend class,” I read these stories about bubbles and think (with the exception of the Great Depression), “I’ve never, ever read a story in the media about someone who was actually hurt by a bursting bubble” (e.g., becoming homeless). Why is that? I imagine it is because the sleight-of-hand accounting practices of the “dividend class” prevent harm to its members.