Great innovations have pretty much always led to bubbles. The standard historical list includes railways, electrification, the automobile, radio, TVs, computers, wireless, and, of course, that internet bubble of the late 1990s. But you don’t need to go that far back to see that smaller bubbles have occurred in shale oil production, housing, and even Mary Jane. Artificial intelligence (AI) certainly fits the mold, and it may be a BIG one because it’s a BIG innovation.
Narrowing the historical field to innovation bubbles, there’s a generalized path that keeps recurring. The new technology creates a large amount of displacement, ushering in a “new paradigm” that will change the world. This is followed by a boom, then euphoria as fear of missing out (FOMO) increasingly dominates investor behaviour. Some cracks in the new paradigm arise, leading to big up-and-down swings. Then it all unravels as the bubble pops.
It is kind of rubbish, though. The duration of bubbles can range from months to more than a decade. The speed and height of the rise differ so much. Some bubbles lift up the entire economy, then let it down in the end, triggering some sort of recession. Some don’t and really have no broader economic impact.
Here are our thoughts on bubbles and AI:
Is AI a Bubble?
We believe it is.
The narrative is certainly strong enough. Price gains are an interesting one, which actually is very different than the late 90s. The dotcom bubble had tons of pure plays and IPOs that would jump 50%, 100%, even 150%.
One argument that AI isn’t a bubble – or isn’t near its peak – is the lack of pure play companies. That could change with OpenAI’s IPO. But this bubble may have grown within already very large tech companies, somewhat masking its rise.
There’s no lack of grandiose projections, such as OpenAI committing to $300B of cloud services from Oracle, which is estimated to have $25 billion in cloud revenue in 2025 (that would be a 12x). This is partially financed by a $100B investment by NVIDIA in OpenAI, some solid circular financing.
One argument that this isn’t a bubble is that CapEx spending has been largely driven by existing cash flow from companies. But that’s changing quickly as debt and other financing are becoming more common. Morgan Stanley projects $2.9 trillion of CapEx on data centers over the next four years, with half coming from tech company spending and the other half from private credit, bond issuance, asset back securitization, and private equity.
Here are some fun numbers: Morgan Stanley estimates AI infrastructure spending will reach $2.9 trillion over the next four years. According to ChatGPT (irony), hyperscale data centers enjoy operating margins in the high teens. If we say 20% operating margin and 20% tax to generate a 20% ROI in four years on a $2.9 trillion spend, you would need about an extra $3.6 trillion in revenue by 2028. That’s $440/year from every person on earth.
There’s already a high level of retail participation, as just about everybody is already very long this bubble. We see a lot of advisor models, and one of the more common themes is a high U.S. equity weight. This weight is certainly highly tilted to names or strategies that are geared to the AI spend.
Are We in the Boom or Euphoric Phase?
This is the question that matters most, and nobody has an answer.
Our current view is that we are past the initial boom phase and likely in the euphoric period, given many of the points above. However, this phase can last a long time, and there are more tailwinds today than headwinds. As users of various AI-enabled tools, we continue to find use cases that increasingly enhance our workflow. In fact, we’re already paying more than the $440/year. This trend may continue even if/when the bubble deflates.
What Does This Phase Potentially Look Like?
We believe it will be exciting.
During the last three years of the 1990s tech bubble, the NASDAQ rose by over 300%. But it also endured 11 corrections measured by drops of greater than 10%. That’s almost four corrections per year.
This AI bubble is different; perhaps with fewer pure plays, it may be less volatile. Or perhaps it’ll be bigger, so the swings could be bigger. But we would expect to see big swings, up and down, as enthusiasm rises and wanes. There is simply not enough clarity on the path forward to provide much stability.
We are positive on this space, and in our equity mandate, own three names with pretty direct exposure, including Microsoft, Alphabet, and Cisco. And we love the tools. As for $2.9 trillion in data centers, we have our doubts. If that much compute is required, we believe they will find more efficient models, as that lift may prove too much. For now, though, that CapEx boom is real.
One fear we do have is a learned response from large-cap technology companies. If a large tech company missed the smartphone revolution, they were punished by the market (like Microsoft or BlackBerry). If they missed the technology innovation moving towards the cloud (Cisco), they were punished by the market. The end result may be that, with AI, large-cap tech companies will view not going all-in as a greater risk than spending billions.
Nobody knows if the spending will have an ROI, but we do know the spending is happening now. And this kind of spending is great for markets and the economy. The following chart is the S&P 500 constituent company CapEx (corporate spending) and depreciation, plotted along overall S&P 500 earnings. We believe that CapEx line is going to keep rising faster, and given that depreciation is trailing, earnings will continue to enjoy an AI supercharge. This is even more amplified if just looking at earnings from Information Technology and Industrials.
CapEx spending is great for corporate earnings, as it carries a strong multiplier effect. Given what looks like limitless capital for AI-related spending, we believe this really bodes well for overall market earnings growth and for the economy, even if other areas like labour or trade soften.
Adoption of AI across corporations also continues to ramp up, as companies explore how to use the evolving tools to improve workflow and enhance productivity. Simply put, more and more companies and people are using the services. This certainly has us in the camp that, while the euphoric phase may be begun, it will likely have legs.
What Could Pop the Bubble?
Any number of things.
Recessions can quickly alter risk appetites and CapEx budgets. But we don’t see that as a near-term risk. Lower availability of capital would prove problematic, but again, there’s not much sign of that these days. Or if the CapEx doesn’t generate enough of a return, it would really crush valuations in these tech giants that carry very high weights in the market.
Does today’s cutting-edge data center become legacy technology in five years? Or if you charge to make an economic profit, will a competitor come in with ever-lower price points to take market share?
Final Thoughts
The euphoric phase is akin to a bucking bronco, just to bring back a rodeo reference. Given that there are just so many unknowns, the bucking will be driven by oscillating levels of enthusiasm.
Fortunately, we believe the potential bubble-ending scenarios or risks are far enough out, meaning this phase could have legs. In the meantime, this bubble can continue to inflate. But we would not be surprised to see an increasing frequency of market corrections.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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