The dangers of falling for the AI market hype

Beware of excessive optimism leading investors to believe that factors driving the US stock market are different and will sustain the strong growth.

This was the warning from two leading fund managers speaking at the Investment Forum held in Cape Town and Johannesburg over the past two weeks.

Iain Power, the chief investment officer of boutique manager Truffle Asset Management, and Dan Brocklebank, UK head at Orbis, pointed out that the US market is currently highly concentrated in a few expensive shares.

The top 10 shares account for 36 percent of the S&P500, a leading US market index, while the S&P’s top 26 stocks make up 50 percent of it, Power said.

Brocklebank said the US is a phenomenal economy, with incredible strength and dynamism and AI is a real and powerful phenomenon, but the markets are pricing in utmost certainty about who will emerge as winners from these two phenomena.

Market cycles show predicting winners, especially when consensus is as extreme as it is now, is risky, he said.

History lessons from booms and busts

Power said there have been a number of times in the past when investors’ enthusiasm has driven high concentration in markets. However, subsequent market crashes caused significant investor losses, he said.

• The 1929 stock market crash: Before the crash, investors were overly optimistic about new technologies such as electrification, radio, aviation and automobiles. This pushed stock prices to unsustainable levels. The market ultimately collapsed, losing 85 percent of its value, and took 30 years to recover in real (after-inflation) terms, Power said.
  
  
• The 1960s "Nifty Fifty" bubble: In the lead up to this bubble, investors believed that the nine to ten percent growth that 50 large, high-quality companies were delivering would continue. Power said while these companies did continue to grow at these rates, investors bid their share prices up too high, leading to significant losses when valuations adjusted.
  
  
• The 2000 Dot-Com bubble: Widespread adoption of the internet led investors to believe certain early market leaders would continue to be the winners as the tech boom developed. Tech companies’ shares were driven to extreme valuations, Power said. At the peak of the bubble, 10 shares represented 27 percent of the US market. In 2000, many companies’ share prices collapsed, the US stock market dominated by tech stocks, the NASDAQ, fell by 85 percent and S&P500 lost 45 percent of its value, he said.

Power said in all three examples, there were developments that changed the way we live. But in all three cases investors looked at the profits companies benefiting from the change were making and assumed they would continue to be long-term beneficiaries of this income in the future, he said.

As a result, they then pushed these shares’ valuations to a point where they became unsustainable, he said.

Current market risks

There are similar warning signs in today’s market, particularly with AI and tech giants driving market concentration, Power said.

But new disruptors are likely to emerge, and today’s market leaders may not dominate in the future, he said.

History shows that market concentration typically leads to lower returns from the S&P500 in the decade after that concentration peaks, as investors buy into expensive shares that do not always dominate in future, Power said.

Use insight to choose shares

Brocklebank referred to a 1960’s television game show hosted by Monty Hall in which participants were asked to choose one of three doors with the potential to win a car if they chose the right door. After making their choice, they are shown that the car was not behind one of the two doors they had not selected. Participants were then given the option to switch their original choice before the outcome was revealed.

Brocklebank said the game teaches three things:

• The obvious is not always right. People found it hard to believe that the odds were higher that they would get the car if they switched their original choice of door after one was opened, as the odds of the car being behind that unchosen door were higher, he said. Similarly many investors struggle to see how the odds of earning good returns from high exposure to US shares have changed.
  
  
• If you have insight you can be successful, but you need to filter out signals from the rest of the noise, Brocklebank said. One of these signals shows unusually high average returns and high valuations from US shares – not only tech shares - over the past 15 years. The rise of passive investing has driven returns and valuations for an abnormally long period relative to US market cycles over the past 100 years, Brocklebank said. As a result, everyone is taking on more risk.
  
  
• Nothing is certain. The third lesson the TV-game show teaches is that even when participants act on information and switch their choice, it is still not certain they will win the car. In investing, you need proper diversification to reduce your risk if things do not turn out as you expect, Brocklebank said. Investing in an index like the S&P500 used to give you diversification, but it does not anymore since it is so concentrated, he said.

Avoid the herd mentality

Power says there are four things investors can do:

• Avoid following the herd: Following other investors into a concentrated expensive market is like being the last one at the party when all the food and drink is gone and the lights are about to come on.
  
  
• Limit exposure to overvalued areas of the market: It is not possible to predict the future, but it is possible to see which investments are expensive, Power said. Shares that are priced below their fair value have a margin of safety that minimises investors’ chances of losing money, he said.
  
  
• Diversification: Selecting independent and uncorrelated share positions across sectors, geographies and asset classes rather than blindly following indices – can reduce risk and give you the best chance to earn real returns over time, Power said.
  
  
• Focus on fundamentals: Invest in companies with strong balance sheets and sustainable competitive advantages.

The argument for tech

Presenting a contrary view on the big tech shares, Javier Panizo, a London-based portfolio manager of Nomura Asset Management’s Global High Conviction Fund, told the Investment Forum that big tech companies are not overvalued, are high quality companies and still have room to run.

The current market conditions differed in important ways from the Dot-Com bubble of the late 1990s – the S&P500 is 13 percent cheaper than it was in 2000 on a forward price-to-earnings (p:e) ratio and the S&P’s 10 biggest shares produce 37 percent of the profits that shares in the index earn, he said.

The business models of many of the companies have improved: semiconductor company Nvidia, software company Microsoft and hardware/software company Apple, for example, have all had leadership changes over the past 15 years that have improved these companies’ return on invested capital, Panizo said.

The big tech companies are generating significant free cash flow to reinvest in their businesses or return to shareholders, he said.

Nomura believes these big tech companies will benefit from the ongoing digital transformation of the economy and artificial intelligence. There are some risks, but there is also demand so for investors with a long-term investment horizon, the growth potential of these companies outweighs the risks, Panizo said.