By Tim Courtney, Chief Investment Officer
In recent years, we've seen an unprecedented rise in the number of companies reaching trillion-dollar valuations. While it's expected that market growth leads to larger companies and the categories (i.e., small cap, mid cap, large cap, mega cap) we use to classify stocks are redefined every so often to account for larger markets, the pace at which companies are hitting these milestones is remarkable.
Take Nvidia, for example. It added $1 trillion to its market cap in just two months.1 This rapid growth is unprecedented and is largely driven by the current AI frenzy. There's an insatiable appetite for anything related to AI, and companies are capitalizing on this trend by highlighting and frequently mentioning their AI initiatives in quarterly reports. This is reminiscent of the blockchain frenzy of a few years ago when simply including the word “blockchain” in quarterly reports could boost a company's stock value. In the late 90s, adding ".com" to a company's name would make investors notice the stock. Today, it is AI’s turn.
It's important to acknowledge that AI does hold promise. With people working fewer hours and labor shortages driving up wages, companies are becoming desperate for AI to help automate processes and improve productivity.2 Many providers of AI solutions are leading investors and employers to believe that AI cash flows and productivity are just around the corner. We believe there will be benefits from the technology in time. However, this doesn't mean all AI-related investments are sound, especially if the real benefits are actually years away.
Historically, price and return are inversely correlated. The higher the price you pay for an asset, the lower your future return is likely to be. With today’s eye-popping prices of AI assets, history suggests that future returns will be much lower.3
During the late 90s, companies tied to the internet had sky-high valuations but underperformed over the next decade. Even successful companies like Microsoft had dismal returns from 2000 to 2008.4 We might see a similar scenario with AI. Just like ecommerce before it, AI could become integral to the economy and produce solid results all while AI-associated companies deliver underperformance due to starting prices that were too high.
To navigate this, it's crucial to maintain a diversified portfolio that includes both AI-related and broader economy related investments. Making disciplined decisions based on price and valuation is essential. We need to be price-aware of the assets we hold, especially when indexes buy what they are required to buy at any price.
There are historical exceptions to the rule that higher prices bring lower future returns, and maybe the current market for AI solutions will be one of those exceptions. But the headwinds for those assets are significant, and portfolios heavily weighted to these assets are making a big bet. If you have questions, please contact your Exencial advisor.
Sources:
- The Wall Street Journal (3/1/24) — Stock Market News, March 1, 2024: Nvidia Closes With a Market Cap Above $2 Trillion
- McKinsey Global Institute (7/26/23) —Generative AI and the future of work in America
- Investopedia (1/26/22) — What Investors Should Know About Interest Rates
- Reuters (7/2/24) — Echoes of dotcom bubble haunt AI-driven US stock market
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