Is AI a Bubble? It's Complicated

As we approach the 25th anniversary of the dot-com bubble's burst, seasoned Wall Street experts are feeling a sense of déjà vu — but this time, it’s not related to cryptocurrencies or meme stocks. Instead, it's the current rush towards artificial intelligence (AI) that is causing these professionals to relive those chaotic days. Unlike the dramatic fluctuations seen with Bitcoin and GameStop, it is generative AI that is reminiscent of the tech disaster in 2000.

The current scenario feels strikingly similar: enthusiastic pitches, sky-high valuations, and presentations where "generative AI" simply replaces "e-commerce" on slides that look almost the same. With major tech companies pouring billions into AI development, investors are faced with a huge question: Are we witnessing the dawn of a new internet, or is this just another bubble waiting to burst?

Goldman Sachs falls into the "this time it’s different" category. Peter Oppenheimer, their chief global equity strategist, brushes off bubble worries with data showing that tech sector earnings have skyrocketed by 400% since before the financial crisis, whereas other sectors grew just 25%. He attributes this success to the sector's ability to leverage software and cloud technology, noting remarkable demand growth.

However, Oppenheimer himself acknowledges some concerning signs. A few dominant tech companies, with Nvidia leading in AI hardware, are taking control of a large portion of the entire market.

"As the market becomes more reliant on a handful of players, the risk of significant losses from individual company missteps increases," he notes. Unlike the dot-com era, when companies could launch with minimal investment, today’s AI startups are burning cash at unprecedented levels. "The current AI boom is leading to massive capital expenditures, which may stunt the high returns we've seen in the tech sector for the past fifteen years," he adds, sounding increasingly concerned.

Those predicting a bubble aren't shy about expressing their views. Howard Marks, co-founder of Oaktree Capital and someone who accurately predicted the 2000 crash, described various "cautionary signs" in his recent investor memo titled "On Bubble Watch." He has highlighted alarming trends: investors chasing profits without considering risks, inflated company valuations based on questionable new ideas, and characteristics typical of "irrational exuberance."

Nobel Prize-winning economist Paul Krugman shares this cautious perspective. He points out that the S&P 500's price-to-earnings ratio is nearing 30, alarmingly close to the 93 level seen in 1999, which Krugman describes as "crazy." He also mentions a key difference this time: AI excitement is centered around a few dominant firms, referred to as the "Magnificent 7"—many of which already operate in quasi-monopolistic conditions.

Krugman urges investors to question the sustainability of growth in markets controlled by giants like Microsoft and Google. "How much more can the market for Microsoft Office or Google search expand?" he asks. While these companies may feel compelled to invest in AI to fend off rivals, this defensive strategy might actually reduce their profitability.

Among those calling attention to potential pitfalls, Gary Marcus, an AI researcher who has accurately predicted limitations in the field before, warns that while generative AI will not disappear, investment enthusiasm may wane, leading to significant financial losses for many investors.

For those caught between a fear of missing out (FOMO) and the need for careful investment strategies, Goldman Sachs suggests a balanced approach. While attempting to calm bubble fears, they also recommend diversifying investments to manage risk better—a typical Wall Street tactic that melds optimism with caution.

The real question is not if AI will revolutionize industries; it's a matter of timing and which businesses will endure this upheaval. A quarter-century ago, the internet indeed changed how business and society functioned, but not within the timeline or methods expected by dot-com investors. Amazon survived, but only after a crippling drop in stock value. Google thrived, while others like Excite and AltaVista faded into obscurity.

As Marcus observes, AI companies enjoying their current high valuations might face tough realities ahead: "Those that are valued in the billions today could either disappear or be broken apart. Many of last year's popular companies may ultimately not meet the high expectations set for them."

Change is coming with AI. But revolutions have a tendency to leave some of their eager advocates in the dust.

AI, bubble, investors