Are We In a Bubble?

Much like the Internet changed the world, so too will artificial intelligence. But with stock prices on fire lately, many are asking if we’re in a bubble that is ready to burst.

When people foresee a bubble, anyone that owns stocks is wise to listen up. Federal Reserve Chair Alan Greenspan famously warned about “irrational exuberance” in the 1990s to describe his concern that asset prices—specifically stock valuations—had detached from underlying fundamentals.

Technology stock prices exploded in the late 1990s. The adoption of the Internet led speculators to believe that companies with a website were going to dominate all future of commerce. One poster child of the “dot com bubble” was Cisco, which became the most valuable company in the market for a brief period.

Fortune magazine ran a feature article gushing about Cisco. Gracing their CEO on the magazine’s cover, the publisher asked, “Is John Chambers the Best CEO on Earth?” The article went on to describe Chambers as “brilliant” and suggested the stock was a must-own, even writing in the opening paragraph that “No matter how you cut it, you’ve got to own Cisco.”

That Fortune expose marked the peak of the market before it all came crashing down. The Nasdaq Composite peaked on March 10, 2000, reaching an all-time high of 5,048. It bottomed at 1,114 on October 9, 2002, a decline of nearly 78% over that period.

So, are we forming a similar bubble today?

We don’t think so, at least not yet, and here are a few reasons why.

First, the market can rally for years on optimism about the future before a bubble bursts. Alan Greenspan’s “irrational exuberance” warning was made on December 5, 1996. The Nasdaq closed around 1,296 later that day. However, it would climb another 289% over the next 3 years before the “dot com” bubble eventually burst.

Second, today’s tech leaders are flush with cash, unlike the debt-heavy “dot com” firms that were funded with borrowings and lots of promises. Some “dot com” companies were even reporting the number of “eyeballs” that viewed their website as a metric for investors to consider. Many large cap technology companies today carry no debt because of the staggeringly large amounts of free cash flow generated.

Third, profit margins are over 10% today, almost double what they were in the 1990s. We expect margins to expand further, driving profits higher. AI will surely reduce corporate costs. We’re experiencing its benefits at our own company. AI has allowed us to work faster, smarter, and more efficiently. Things that used to take hours can now be completed in minutes.

Fourth, the U.S. Federal Reserve has recommenced its rate-cutting cycle. Their economy is still growing, so they’re cutting rates because they’re able to, not because they need to. Stocks like lower interest rates. We expect the Fed to cut rates by 25 basis points at each of their next two meetings this year.

What if We’re Wrong?

Regardless of our assessment above, there are several things you should always do as an investor to manage risk.

Keep your position sizes reasonable. In other words, don’t concentrate your money amongst a few stocks. Make sure that you have exposure to multiple sectors within the market. For our clients, we own 25-30 securities across 11 different sectors. Owning the S&P 500 is not as diversified as you might assume. Afterall, the Magnificent 7 stocks constitute almost 35% of the index.

Watch the valuations on your investments. There are pockets of the market that are clearly overvalued. Just like Cisco once traded for 150x earnings, companies with those same valuations are ever-present today. We don’t buy these kinds of stocks for our clients.

We don’t see today’s market as a bubble, at least not yet. While valuations are higher than the historical average, companies are far more profitable, leaders are financially strong, and monetary policy is supportive to support this rally to continue. 

That said, bubbles are only obvious in hindsight — which is why discipline, diversification, and risk management remain key. Please reach out to us if you would like an assessment of your portfolio’s vulnerability to a market selloff.

-written by Jeff Pollock