Is the AI frenzy a replay of the Internet bubble? Will it be more devastating if it collapses?

According to the Zhitong Finance and Economics APP, the excitement over artificial intelligence has driven a significant rise in the US stock market, prompting comparisons to the internet bubble of 20 years ago and raising questions: whether the optimistic sentiment towards this revolutionary technology is once again causing a stock market bubble.

Similarities

The AI frenzy, coupled with economic resilience and stronger corporate profits, has propelled the S&P 500 index up by over 50% from its low point in October 2022, reaching new record highs this year. Since the end of 2022, the tech-heavy Nasdaq Composite Index has also risen by over 70%.

While various indicators show that stock valuations and investor enthusiasm have not yet reached the peak of the turn of the century, there seem to be many similarities between the two eras. The current leaders of the US stock market, such as AI chip maker NVIDIA (NVDA.US) and a few other large tech stocks, evoke memories of the late 1990s "Four Horsemen": Cisco (CSCO.US), Dell (DELL.US), Microsoft (MSFT.US), and Intel (INTC.US).

Among them, NVIDIA's stock price has surged by nearly 4300% in the past five years, while for comparison, network equipment manufacturer Cisco soared by about 4500% in the five years leading up to its peak in 2000.

Valuations have also increased, although the financial conditions of many tech giants seem to be much better than their internet peers from the late 1990s and early 2000s.

This has raised concerns that the AI-driven surge in the stock market may increase the risk of this rally ending in a manner similar to the internet boom - with an epic collapse. During the internet bubble period, the Nasdaq Composite Index surged nearly threefold in just over three years, before plummeting by nearly 80% from its peak in March 2000 to October 2002. During the same period, the S&P 500 index, which had doubled, also dropped by nearly 50%.

While a few internet stocks like Amazon (AMZN.US) survived and eventually thrived, many others never recovered.

Sameer Samana, Senior Global Market Strategist at Wells Fargo Investment Institute, said, "No one knows exactly what will happen with artificial intelligence." He pointed out that the same uncertainty exists for the ultimate long-term winners.

According to data from LSEG Datastream, echoing the internet bubble, the information technology sector's share of the total market value of the S&P 500 index has expanded to 32%, the highest percentage since 2000 when it reached nearly 35%. Only three companies - Microsoft, Apple (AAPL.US), and NVIDIA - account for over 20% in this index.

Significant Differences

However, Datastream's data shows that the current valuations of tech stocks are more moderate compared to the peak of the internet bubble, with a forward price-to-earnings ratio of 31 times, compared to 48 times in 2000 The valuation difference between NVIDIA and Cisco is also evident. Cisco is a key supplier of Internet infrastructure support products, and its stock price has not yet reached the peak of the Internet boom.

Datastream data shows that although both stocks are soaring, NVIDIA's forward P/E ratio is 40 times, while Cisco reached 131 times in March 2000.

Analysts at Capital Economics pointed out that the current rise is more driven by robust earnings prospects rather than continuously growing valuations, indicating that fundamental factors are the main driving force this time.

An analysis by Capital Economics shows that since early 2023, industries where today's market leaders are located, such as technology, communication services, and non-essential consumer goods, have seen faster expected EPS growth rates than other areas of the market. In contrast, in the late 1990s and early 21st century, the expected earnings growth rates of these industries were similar to other parts of the market, but their valuation growth rates were faster than other stocks.

Lei Qiu, a disruptive innovation stock portfolio manager at investment management company AllianceBernstein, pointed out in a blog post that as customers seek productivity improvements, many large companies building cloud infrastructure to support artificial intelligence are generating "substantial" revenue. She wrote, "Rather than waiting for the next big product - a strategy that failed during the Internet boom, today's profitable AI stalwarts are mainly investing in cloud infrastructure to improve efficiency."

Datastream data shows that from a broader perspective, the S&P 500 index's P/E ratio of 21 times is significantly higher than the historical average level, but lower than the level of about 25 times in 1999 and 2000.

Analysts at Capital Economics stated in a report, "Our fundamental forecast is that this tech bubble will not burst until valuations across the entire market reach the levels of 2000."

From certain indicators, investors' bullish sentiment during the Internet bubble period was much higher. In a widely watched survey by the American Association of Individual Investors, investor bullish sentiment reached 75% in January 2000, just a few months before the market peaked. Recently, this ratio is 44.5%, with a historical average level of 37.5%.

Potentially More Impactful

While an artificial intelligence bubble is not inevitable, many investors are concerned that if U.S. economic growth remains strong and tech stocks continue to rise, these indicators could become even more tense in the coming months, potentially causing greater impact when they collapse "There are many similarities," said Mike O'Rourke, Chief Market Strategist at JonesTrading, "When a bubble occurs, it usually stems from... some real, positive, fundamental developments behind it, which inspire people to pay any price for things."

Erik Gordon, a professor at the Ross School of Business at the University of Michigan, stated that the internet was revolutionary, and artificial intelligence will be as well.

"Both of these themes are correct. But that doesn't mean that companies valued based on these themes are good investments in the past or present," Gordon said, "Many internet companies that drove the internet revolution have gone bankrupt as a result. And many artificial intelligence companies that are driving such a huge transformation may also go bankrupt or lose half of their value."

In other words, even if artificial intelligence is the next big thing, the valuations of artificial intelligence companies may still be abnormal, and pioneers in the field may still collapse.

Gordon emphasized that most pioneers of the internet are small startups, while leaders in the field of artificial intelligence include old profit giants like Microsoft and Google (GOOGL.US).

"They can lose billions of dollars, but they won't go bankrupt," Gordon said.

However, on the other hand, internet newcomers do not have a large shareholder base, so when they collapse, "only brave or foolish investors are hurt." In contrast, large tech companies dominating artificial intelligence account for a significant portion of the market value of the U.S. stock market and are the backbone of pension funds and retirement portfolios.

"The giant pioneers of artificial intelligence will not go bankrupt," Gordon said, "but if losses in artificial intelligence cause their stock prices to fall, many investors will suffer losses."

Gordon warned, "This is not a false company bubble, but a magnitude of overvalued bubble."