Are We in an AI Stock Bubble?

Paul Winkler: All right. Back here on “The Investor Coaching Show,” Paul Winkler. Paulwinkler.com is the website.

What Drives Stock Markets

Okay, I’m going to talk a little bit about what people are concerned about: Is there a bubble with AI stocks? Okay, so let me put this in perspective. When we look at stock markets, there are different areas, and we don’t think about it this way, but there are different segments, very distinctly different, and very different types of companies.

You’ll have some companies that are energy companies, and that’s what they do. And there are going to be times that energy is going to be a hot sector because of whatever reason. Maybe there is some more profitability to be had because expenses come down or there’s more demand in that particular area. Maybe there’s a huge demand for energy.

We’re seeing it right now with running AI. We’re seeing it right now with running computers. There’s a huge need for energy for some of these computers and for some of these models out there.

Also, the other thing that you have to think about is that you might have healthcare. The profitability in that industry can change significantly based on demand, supply, different technologies, those types of things.

Regulations can actually affect it. If there are new regulations against certain types of drugs or things like that, that can have a huge impact. Or pricing of those types of things.

There’s, let’s say, financial services or banks, those types of things. The profitability of banks can change significantly with differences in interest rates. What they can loan money out for — what they charge to loan the money out, that you give them — versus what they have to pay you to use your money.

There may be technology. New technology and new demand for technology. Maybe the times when people want to change out technology and move up or actually start to buy new products based on the new technology.

Right now that’s a big thing. Back in the 1990s that was a big thing as well.

So different areas and different segments, it can change significantly, and fast. And trying to figure out when that’s going to happen, who on earth knows?

There are different sized companies. Mind that smaller companies, they borrow more money.

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When interest rates go up, those companies that borrow more money now have a higher cost of doing business and can be problematic. 

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If you’re dealing with companies outside the U.S., if the dollar weakens, those companies can benefit significantly from a pricing standpoint as far as what they do, as far as how much they go up in value. Now, if they export a lot of things to the United States, that can be harmful in that way, but it can be beneficial from a value of the company standpoint because it takes more dollars to buy those companies.

And because you’re investing and you’re using the dollar as the denomination when you invest … when you invest, you look at your account, it’s valued in dollars. And those dollars, the numbers can go way up if the dollar weakens, is basically how that works.

Sometimes you’ll have emerging markets in countries really, really do well. And sometimes they do really poorly based on things that happen, geopolitical risks and things like that. So there are all kinds of things that drive stock markets.

Frothy Sections of the Stock Market

One of the things that’s being talked about right now is there are certain sections of the stock market that are kind of frothy-looking. Pretty high.

And the reason it’s such a big deal is because they tend to be the very biggest companies out there. When you think about the stock market, and if you were just to name a company, pick a company, any company, chances are really good that a very huge technologically-driven company may be the first thing that comes to mind for you.

So this is a topic of conversation this week, and it was the case for and against a bubble in AI. And I’m just going to comment on a few of these things as we go.

Speaker 1: Here’s the case against the bubble that I hear actually from a lot of people that I trust. It’s not being driven by irrational speculation. Right? We don’t know exactly, and I guess it hasn’t been proven to be profitable growth ultimately.

PW: Right off the bat, she’s back and forth. “Is it irrational speculation?” Are people driving, is it irrational exuberance, as Alan Greenspan called it in 1996? And that’s when he was talking about tech stocks back at that point in time.

But is it irrational? “Well, we don’t know.” She started saying it wasn’t. Then she said, “Well, maybe it is.”

And that’s the media hedging their bets. They can basically say, “No, we didn’t say that.”

Well, you’re right. You did. You said both sides. You said it was speculation, then you said it’s not, or it might not be.

But the idea here is some of these companies don’t have any profits, or they have very little profitability. And that’s what happened in the late ’90s, if you remember.

There were technology companies that, on paper, they were worth a huge amount of money. Absolutely skyrocketing as far as stock performance went.

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But if you look at the actual profitability of the company and what money they were making, it was just pie in the sky. They weren’t making anything. 

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Their expenses exceeded their revenues by a lot. And they may have been even in the negative and nobody really knew what their future profitability was going to be. People were just trying to take a guess. But that’s what she’s talking about with AI right there, is saying right off the bat, “That’s sort of looking familiar, isn’t it?”

Well-Capitalized Companies

Clip: It is being driven by fundamental growth. And if you look, definitely OpenAI is at the heart of it.

But if you look in the public market at the companies that are at the heart of it, it’s dominated by a few incumbents that have very strong balance sheets and very strong growth, Jim. And to me, that’s the best case against it, the whole bubble mentality.

PW: So you have a few companies, a few very large companies, they’re well-capitalized. And that does help, when you’ve got a lot of money behind.

But recognize that the valuation of these companies is huge compared to earnings. Even the well-capitalized companies are selling for huge multiples.

In other words, historically, as we often talk about here, that large U.S. stocks, the S&P 500 sells for about 16 times earnings historically. But you’ve got some of these companies selling for 40, 50, 100 times earnings, these well-capitalized companies.

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So even if they’re well-capitalized doesn’t mean they can’t come crashing down. They certainly can.

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If a company’s selling for, let’s say 64 times earnings — let’s just use that because it’s a nice round number — well, that’s four times the historic number that they normally sell for. Unless those earnings go up fourfold, that thing, that could come crashing down.

You can’t look at it and say, “It’s well-capitalized. Therefore it’s going to be a good investment.” What’s it selling for? It’s selling for a high price.

Well, why? Is it justifiable? Well, yes, if those earnings come through. If the earnings don’t happen, if the companies don’t actually meet those earning estimates, it will come crashing down.

So you can’t look at that. But that’s basically what she said. So that’s the case against there being a bubble. And as far as that’s the case, it just really depends on, do they actually meet that?

S1: It is notable that OpenAI is at the center of a lot of these deals, and that’s not a public company. It’s a private company.

And they’re crafting these increasingly creative deals, as you mentioned, because they’re not profitable. They need to spend a ton of capital.

PW: So you’ve got a private company there. And what have we been talking about the last several weeks? Private equity. Owning companies that aren’t public.

And you look at them, some of these companies aren’t profitable. And we don’t necessarily know the whole picture because it’s private equity and they tend to be very secretive regarding the numbers on these companies.

Private Debt

There’s a whole thing, matter of fact, it was about private debt. It was super, super interesting. There was talk about the private debt this week. I wasn’t going to talk about it today, but it’s probably a good place to mention it.

So you’ve got the banking system, where you’re borrowing money from the banking system, you’re borrowing money from public markets, the bond markets and things like that. Well, you’ve got private markets. And some of these things came crumbling down.

And I thought it was an interesting comment somebody made about one of these stocks — private equity or private companies, they were lending companies — that came crashing down in value. And the reason was because there was a little bit of a spook.

And the spook was maybe things aren’t quite so rosy. Maybe things aren’t so good. And the public is basically saying, “Sell now and ask questions later.” And I thought that was interesting, because we’ve been talking about private equity, I hadn’t really thought about the private debt area, where you’ve got bonds and they’re borrowing money.

Speaker 2: Absolutely. I think that the bubble analysis has a lot to do with — if we really get into the nitty-gritty that David’s more familiar with than anybody — it was about fiber and about lighting fiber, and being able to connect to the internet. But there was far less demand than there was supply of fiber.

PW: So basically, before I go any further, right there they were just talking about, when you’re dealing with in the past, we might’ve had this very lackluster demand. But there was supply.

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When you have lackluster demand, there is lots of supply of something. 

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You look back and go, “Well, obviously it was overpriced.” Think about the tech bubble. It was obviously overpriced. Well, that was only something that people knew in hindsight.

And so therefore what ended up happening, a lot of people got all excited about that and started really investing in the mutual fund companies. It just reminds me so much of what I’ve been seeing recently. The mutual fund companies were really pushing yesterday’s winners like crazy.

And the reason they push yesterday’s winners so heavily is because people will buy it. It appeals to the sense of greed. It appeals to my desire to get rich quick.

Well, how do I get rich quick? Well, I’ll look at something that did really, really well, and I assume that it will do just as well in the future as it did in the past.

“And by the way, the story is still wonderful, and therefore there’s every reason to believe it will continue to go up.” And what people don’t recognize is that that rosy future is built into the price you are paying, because people that currently own the companies hear the same story that you’re hearing, that the future is looking bright, and they will not let go of a stock at a cheap price if the future seems to be rosy.

Buy Low, Sell High

So the big talk is just, are we in a bubble with AI stocks, markets in general? I think there are a lot of people that are sitting out there that are just complacent because things have been pretty good.

Now, I don’t predict when things are going to happen. I just look at undiversified portfolios as something that is just going against a rule of investing.

When I ask people, “Hey, what do you believe? What do you know to be true about investing? What are the rules that you know? What in effect are the things that you should be doing?”

They’re usually pretty smart about this. They’ll say, “Buy low, sell high.”

Okay, so don’t buy based on if something just had a hot streak. It’s probably not a great time to buy. Not necessarily time to load up. It would’ve been way better owning it before the hot streak happened, right?

Well, yeah, yeah. Of course. Obviously.

And what do we know about markets? They go up and they go down. Well, if you just had a hot streak, which one of those two just happened? Well, up.

Well, what followed up? And they’ll go, “Down.” And you go, “Okay, there you go. See, you’re kind of getting this.”

Now, the problem is what you run into is people think that the reason their investments went up was because of the skill of the investment manager. That they really knew that it was going to go up, and that’s why they had you where they had you.

And they don’t recognize that, no, markets just go up and down. And there’s a reason that we have cliches like we do, like, “Everybody’s a genius in a bull market.”

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The reason that cliche has been around for so long is there’s some truth to it. Everybody looks like they’re smart as anything in a bull market.

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And the thing that we run into is that bull markets do come to an end, and you just don’t know when. But that’s the first thing.

So we look at something that’s done well. What has done the best? And we would have to say that growth companies, large growth companies, U.S. in particular, have done really, really well.

Are You Really Diversified?

So what’s the second rule of investing? How do we protect ourselves against, you’re just all in one area that just had the best performance?

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Well, the way you protect yourself is diversifying. And it’s the most overused term in the history of finance. 

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I see investment managers, mutual fund managers, and investment advisors say, “Oh, I’m diversified.” And somebody said the other day, “I’m really diversified.” And I stopped. I looked at her, and it was so funny because I stopped and just looked, and she goes, “Well, I think I am, anyway.”

I think she just saw the look on my face and was going, Okay, I think I’m diversified, but you’re right. I really don’t know. 

It was just funny, looking at it. Watching her go from confident to going, “Well, maybe I don’t know everything I think I know.” That’s what I wanted her to get to, is because people get overconfident and they think they know more than they do, or they just repeat when they hear the investment person say that they’re diversified, then they think it’s true.

And I say, “Well, how do you know? Have you measured it?” “I don’t know. How do I measure it?”

Well, did you know that there are ways you can measure using correlations and things like that? And you can look at the number of holdings that you have and look at what areas of the market that you’re exposed to and what percentages you have in different areas of the market.

What percentage do you have in large U.S. growth? What percentage do you have in small U.S. blend? What percentages do you have in small U.S. value? What percentages do you have in emerging markets small?

What percentage of your portfolio is … and you can go through the different areas. And then when you start to see that the percentages in these different areas are a little close to each other, the numbers are close, then you could say, “Okay, yeah. I’m diversified.”

But if you see that 91% of your portfolio is in just large U.S. growth and that only leaves 9% to be in another 11 asset categories in stock markets, then you go, “Well, maybe I’m not diversified.” And that’s really what it gets down to. I’ve got to get people to the level where they’re just not so confident they really get what’s going on.

Where’s the Market Going Next?

So number three is, I look at it and I’d say, “Okay. Should I try to figure out where the market’s going next?”

And typically most people say, “Well, no. You don’t know. You can’t predict the future.”

And I’d say, “Right again. There you go.”

Or, “Which stock should I be in? Which stocks are better than others?”

Now, some people get this one wrong because these huge investment managers, by the way, say, “We align your interests with our interests. And by the way, when you do better, we do better.”

And they’re actually doing a lot of individual stock-picking. And I’ve seen commercials like this and I go, “Oh, gosh. If people only knew what was really going on underneath the hood.”

And you think it sounds good. It’s a good little marketing thing.

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But the reality of it is a lot of times you don’t have necessarily the most thoughtful investing process going on underneath the hood. 

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And why? Somebody asked me that. They said, “Why? Is it more profitable for the investment company to do that?”

And I said, “It’s interesting you ask that question because, in a way yes, but not in the way that you think.” And they said, “Well, what do you mean by that?”

And I said, “Well, think about it. If your investment portfolio moves with an area of the market that you are most familiar with, if it goes up when that area of the market goes up and it goes down when that area of the market goes down, you’re more likely to stick with it. And if you’re doing something that other big investment managers are doing, then you’re likely to stick with it because you have this feeling that there’s safety in numbers.”

It’s like when the tech stock bubble burst, 2000 through 2002. Everybody felt like they were in the same boat, that everything was coming down. Everything’s crashing.

And I’m sitting there going, “Well, no. No.” Value stocks actually did quite nicely in 2000, and small companies actually did quite nicely in 2001.

International small did quite nicely. Not a huge return, but it had a positive return in 2002. So the reality of it was a lot of people thought that everybody was suffering.

And the reality was, if you had diversified, you followed that rule of investing, you didn’t stock-pick and market time, it was kind of a non-event, really.

Does Demand Dignify the Price?

So back to the case for or against the bubble in AI.

S2: And you know David is a Hock Tan, hard businessman, not a guy who’s part of a bubble. It’s about demand. They cannot meet demand.

No matter how quickly they put up things, they cannot meet demand. Now, David, doesn’t real demand dignify it versus what happened in 2000?

S3: Without a doubt.

PW: So the demand. What’s he talking about there? Does it not dignify?

We look at demand, and you say, “What if we have companies that are putting out things that are huge as far as demand goes? That people really want this stuff? Well, doesn’t that dignify the price?”

“Doesn’t it make sense that if there’s a huge demand but they can’t even meet the output, then why is it that we would be in overpriced land? Why would we make the assumption that stocks are priced too highly if there is demand that needs to be met but they don’t have enough product to actually meet that demand?” That’s really what he’s saying there, right?

And my answer would be, “That’s already built into the stock prices.” You look at prices and the stock’s selling for 60 times, 70 times, 80 times, 100 times earnings.

Let’s go back to the 64 example because the math is easy. Let’s say the S&P, like I talked about earlier, normally sells for about 16 times earnings, and you have a company, one of these companies, selling for 64 times earnings, which is four times 16. Then what we’re thinking and what we’re looking at here is that the bottom number, the denominator, the earnings number, which, remember, it’s 16-to-1 is as 64 is to four, so that bottom number has to go from 1-to-4, or earnings have to go from 1-to-4.

Well, what will make it go to that level where we can say, “We can justify that price”? What makes it go to that level is growth in earnings.

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What is the biggest thing that grows earnings? It’s sales. 

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So that means that we have the product to sell that there is a demand for. Now, what you’re assuming and you’re not really thinking about or people aren’t thinking about is that these projections about whether the stocks are actually going to continue to go up is not whether there is not enough supply to meet demand, but rather whether the earnings in the future are going to meet what those projections are, or what those lofty projections are.

Walk Away From the Nonsense

Now, I’m not saying it’s wrong. I’m not saying we’re not going to go from $1 to $4 in my example. I don’t know. Nobody knows. My point is this whole discussion is kind of silly in a way.

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It’s really silly in that we do not have a crystal ball to know whether the price is too high or too low. This is why we diversify. 

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It’s why we make sure that we don’t have everything in that one basket. Because if you do, the numbers come out and say, “Oh, it’s not going to $4 at all, earnings aren’t. It’s going to only go to $2.”

Well, when that number is only likely to go to $2, what happens to the stock price? If it’s now selling for 64, it drops back to 32.

Now, I’m being oversimple in regards to that the number is always going to be a 16-to-1 ratio. Not the way it works. But I just want you to get the concept because if you get the concept, if you get this idea that the future, or future expectations, I should say, if they are already baked into the stock price, then changes in those numbers in the future will also affect the stock price, either in a positive way or a negative way.

If we think, Oh, gosh, it’s not going to be four, it’s going to be eight, then what will happen is the price will go from 64 to 128. I’m being oversimple that it’s going to be a 16-to-1 ratio, but it’s math. It’s all math.

This isn’t too bad, right? Hope I’m not losing you totally. But this is the idea. As an investor, we’ve got to be aware of how stock markets price things.

So when we hear projections like this and predictions as, “Is the AI of a bubble? Is it overpriced or is it underpriced?” And you hear all of this nonsense, you mark it as nonsense and you walk away from it. That’s the idea.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.