Why investors should be 'concerned' about an AI bubble

Key Concepts

Bubble Dynamics: Parallels between the current market run-up and the dot-com bubble, focusing on the role of groundbreaking technologies, widely held optimistic beliefs, and atypical market behavior.
Atypical Market Signals: Identification of unusual statements and actions as indicators of potential bubble formation.
Historical Comparisons: Drawing lessons from the dot-com era, including the performance of established companies like Amazon, Intel, Cisco, and Microsoft, and the fate of speculative companies like Pets.com and Infospace.
Current Market Parallels: Examining contemporary examples such as OpenAI's request for government backing of chip investments and Elon Musk's compensation package as indicators of atypical market behavior.
Revenue and Earnings in Bubbles: The observation that companies within a bubble can still report earnings and revenue growth, even as the bubble inflates.
Customer Behavior: The phenomenon of double ordering by customers as a sign of artificial demand and a potential bubble indicator.
Backlog Uncertainty: Doubts surrounding the certainty of large order backlogs, particularly for companies with limited historical revenue.
Catalysts for a Bubble Burst: The potential for deceleration in growth rates and news headlines as triggers for a market correction.
Investment Strategy During a Bubble: Recommendations for caution in adding to positions at perceived high valuations and considering defensive strategies.
Federal Reserve Policy: The context of a potential Fed easing environment and its implications for market dynamics.
Treasury Yields: The attractiveness of current Treasury bond yields as a defensive investment option.

Market Parallels: Dot-Com Bubble vs. AI Run-up

The discussion draws significant parallels between the current market surge, particularly in AI-related stocks, and the dot-com bubble of the early 2000s. Both periods are characterized by the emergence of groundbreaking technologies with the potential to fundamentally alter the global economy. However, a key element in the formation of a bubble, as highlighted by Michael Oor Jones, is a "widely held belief that is factually believed to be a correct and bullish and optimistic," which fuels speculative investment.

Atypical Market Behavior as a Warning Sign

Oor Jones emphasizes that when market participants engage in or express sentiments that are "really out of the ordinary or atypical," it serves as a strong signal for concern. He cites examples from the dot-com era, such as the serious discussion of Cisco, with a market cap of $300 billion, becoming the first trillion-dollar company, and Infospace's CEO claiming their company would reach that valuation. At the time, the largest market capitalization was around $80 billion, making these statements highly unusual.

In the current market, similar atypical behaviors are observed:

OpenAI's request for federal backing of chip investments: This suggests a reliance on government support for a critical technological infrastructure, which is not a conventional investment environment.
Elon Musk's trillion-dollar pay package: This represents an exceptionally large compensation, raising questions about corporate governance and valuation within the current market context.

These instances, while potentially justifiable within their specific contexts, deviate from typical investment norms and are seen as indicators of an overheated market.

The Misconception of Profitability in Bubbles

A common argument against the current market being a bubble is that unlike the dot-com era, many companies today are profitable. Oor Jones counters this by pointing out that many dot-com companies also generated revenue and profits. He uses Amazon as an example, which, despite being the most successful company to emerge from that era, saw its stock decline by over 90% after the bubble burst. Similarly, established companies like Intel, Cisco, and Microsoft experienced stock drops of 60% to 90%, even though they possessed strong fundamental businesses.

Identifying "Pets.com" and "Infospace" Equivalents

The "Pets.com" and "Infospace" of today are described as numerous smaller "AI companies" that experience rapid rallies based on news and headlines, often citing AI or partnerships. The critical point is that the specific companies that will ultimately fail or be exposed as speculative are often unknown until the bubble bursts. Oor Jones stresses that even high-quality companies with sound fundamental businesses are at risk when a bubble deflates.

Customer Behavior and Backlog Uncertainty

A concerning parallel drawn from the dot-com era is the phenomenon of customers "double ordering equipment." This artificial demand inflates reported growth. Today, a similar, and arguably more extreme, situation is observed with companies announcing "hundred billion dollar orders" for entities like Nvidia from hyperscalers. The concern is that these orders may come from companies that lack a significant revenue history or substantial existing revenue, leading to questions about the certainty of these backlogs being fulfilled and paid. This makes it difficult to have "100% confidence" in the projected revenue from these large order books.

Catalysts for a Bubble Burst

While the dot-com bubble burst occurred during a Federal Reserve tightening cycle, the current environment is one of potential easing. However, Oor Jones suggests that a bubble doesn't necessarily require a specific external catalyst like a rate hike. Instead, a "deceleration of the headlines, the stories, the growth" can be sufficient.

He illustrates this with Taiwan Semiconductor's reported October sales, which, while up 16.9% year-over-year, represent a deceleration from previous growth rates, especially on a larger base. He anticipates that as growth rates for AI-related technologies and the massive deals announced in recent months begin to slow down, investors will start questioning the underlying momentum. This mirrors the dot-com era, where the market peaked without a single dramatic event, but rather a gradual loss of momentum as growth stories faltered.

Investment Strategy in a Bubble Environment

Oor Jones acknowledges the difficulty in timing market tops but firmly believes the market is in a bubble. His primary recommendation for investors is to be "very cautious in adding to positions at bad prices," which he perceives as current valuations. While he doesn't advocate for immediate liquidation of existing holdings, he advises against increasing exposure at what he considers inflated levels.

He suggests that investors can protect themselves by:

Avoiding adding to positions at perceived high valuations.
Considering defensive strategies.
Waiting for more attractive valuations as the current speculative narrative subsides.

He notes that the current 43% rally off the April lows, coupled with the year-end approaching, presents an opportunity for investors to consider moving to the sidelines after a strong year.

The Role of Fed Policy and Treasury Yields

While the market is in a potential Fed easing environment, Oor Jones points out that the Fed's decision to lower rates next month remains uncertain. Furthermore, he highlights the attractiveness of current Treasury bond yields, with the 10-year yield at 4%, offering a "healthy yield for risk-free income." This presents a viable defensive alternative for investors seeking to de-risk their portfolios.

Conclusion

The core message is that while the current market surge is driven by a transformative technology like AI, it exhibits many characteristics of a speculative bubble, mirroring the dot-com era. Atypical market behavior, the potential for decelerating growth rates, and the uncertainty surrounding large order backlogs are key warning signs. Investors are advised to exercise caution, avoid adding to positions at inflated prices, and consider defensive strategies, potentially waiting for more favorable valuations before re-engaging with riskier assets. The current yield on Treasury bonds is presented as an attractive defensive option.