Are AI stocks in a bubble?

In 2024, AI stocks skyrocketed, driven by the buzz around artificial intelligence’s potential. The S&P 500 hit new highs 31 times in the first half of the year till, with tech giants leading the charge. Yet, the surge in AI-related companies has raised concerns. Some skeptics fear this could be another bubble, much like the dot-com boom of the late 1990s.

AI’s transformative potential is undeniable, but much of its impact is still unfolding. Despite this, certain AI stocks have reached sky-high valuations, leading many to ask: is this enthusiasm justified, or are we headed for a crash?

The AI boom: déjà vu from the dot-com era?

The excitement around AI mirrors the dot-com bubble of the 1990s. OpenAI’s ChatGPT launch in 2022 sparked massive interest in AI, much like the early internet once did. Companies rushed to invest billions in AI hardware and data centers. Take Nvidia, the AI chipmaker, by mid-2024, it saw its market value surpass $3 trillion, making it the most valuable company in the world for a brief moment.

However, this rapid rise was followed by a steep decline in Nvidia’s stock, prompting broader concerns about whether the AI market is overinflated. 

 Due to these high expectations, Nvidia shares have fallen by 11% in the past month alone, signaling growing unease among investors. Apple, another tech giant that has been caught in the AI excitement, has seen its shares dip by 4% over the same period.

To understand if AI is in a bubble similar to the dot-com bust, it’s critical to explore the driving factors, the historical parallels, and the challenges AI faces in meeting these lofty expectations.

Lessons from the dot-com bubble: The pets.com cautionary tale

The dot-com bubble offers a sobering reminder of what happens when excitement and hype outpace reality. In the late 1990s, internet companies raised huge sums through IPOs, with investors betting that the internet would change everything. Pets.com became one of the most infamous examples of this phenomenon.

Launched in 1998, Pets.com seemed to have a solid business idea: it would be the “online leader in pet supplies.” The pet supply market was worth $35 billion annually in the U.S. alone, and Pets.com aimed to capitalize on that with the convenience of online shopping. The company quickly raised $300 million and invested heavily in marketing, including an expensive Super Bowl ad campaign featuring its sock puppet mascot, which became a viral sensation.

Despite the buzz, Pets.com had serious issues with its business model. It offered free shipping, which ate into its profits, especially when the average order size was only $55. The company was burning through cash, losing money on every sale. Unlike physical stores like Petsmart, which could rely on their existing infrastructure for pickup and delivery, Pets.com had to spend heavily on logistics, making it impossible to turn a profit.

In 2000, Pets.com went public, and within months, the stock price plummeted. Investors quickly realized that the company’s business model was unsustainable, and just 268 days after its IPO, Pets.com declared bankruptcy. The rise and fall of Pets.com became a symbol of the excesses of the dot-com bubble, where companies were valued based on future potential rather than present profitability.

The AI boom: How it compares to the dot-com era

Like Pets.com and other dot-com companies, AI stocks have been buoyed by high expectations. Companies such as Nvidia, Microsoft, Google, and Amazon have collectively invested trillions into AI technologies, driving their stock prices higher. Nvidia’s role as the key supplier of AI chips has made it the poster child of the AI boom, with its stock price increasing ninefold from 2022 to 2024. For a brief moment, it surpassed even tech titans like Microsoft and Apple.

However, just as the dot-com bubble burst, concerns about AI stock valuations have emerged. Nvidia’s market value plunged by $1 trillion shortly after its 2024 peak, a 30% drop in just a few days. This dramatic decline rippled across the tech sector, with companies like Microsoft, Tesla, Meta, and Alphabet also seeing significant losses.

Despite these sharp declines, Nvidia reported strong financial performance, with a 122% increase in revenue during its most recent quarter. Yet, even this wasn’t enough to satisfy investor expectations. The market anticipated even more growth, leading to concerns that AI stocks might be overvalued.

Are we in an AI bubble?

To determine whether AI is in a bubble, it’s essential to understand the difference between a bull market and a bubble. A bull market is characterized by rising stock prices due to genuine growth prospects, while a bubble is when prices are driven by speculative fervor, disconnected from underlying fundamentals. The dot-com bubble was a classic example of the latter, where many companies, like Pets.com, had no real profits or viable business models.

So, is AI heading down the same path?

According to Peter Oppenheimer, chief global equity strategist at Goldman Sachs Research, while the explosion of interest in AI has fueled a major rally in tech stocks, especially among a concentrated group of U.S. companies, the current valuations of AI stocks don’t indicate a bubble.

Through the first eight months of 2023, AI-related stocks—particularly semiconductor makers and cloud service providers—returned roughly 60%. Despite this surge, Oppenheimer argues that AI stocks aren’t in a bubble because their valuations, while high, are not as stretched as those seen during the dot-com bubble. The companies leading this rally have robust balance sheets and substantial returns on investment, distinguishing them from the speculative, profitless firms that inflated the internet bubble.

The price-to-earnings (P/E) ratios of the leading AI companies are significantly lower than those seen in past bubbles. For example, the biggest U.S. tech firms in the AI space have an average P/E ratio of 25, compared with a staggering P/E of 52 for companies during the peak of the dot-com bubble. Additionally, the market concentration—where a few companies account for a large percentage of the gains—isn’t as concerning as it might seem, given that these firms are already highly profitable and generate significant cash flow.

The Key Differences: AI vs. Dot-Com

Unlike the speculative environment of the dot-com bubble, today’s AI companies have more solid financial foundations. The AI leaders—Nvidia, Microsoft, Alphabet, and others—are already profitable and have significant cash reserves. According to Goldman Sachs, these companies hold cash that is double what was available to firms during the dot-com bubble, making them more resilient in the face of market volatility.

Additionally, AI companies have proven business models and are generating revenue from AI technologies that are already integrated into their services. For example, Google has long leveraged AI in its search algorithms, while Microsoft is incorporating AI into its productivity tools like Office and Azure cloud services.

The role of interest rates and market expectations

One of the key factors influencing the current AI stock market is the role of interest rates. As inflation has decreased from its 2022 peak, there’s growing speculation that the U.S. Federal Reserve will cut interest rates to stimulate growth. Lower interest rates make borrowing cheaper, allowing smaller companies to expand more quickly. As a result, some investors have shifted money away from large tech firms like Nvidia and Microsoft toward smaller firms, contributing to recent declines in AI stock prices.

However, the long-term potential of AI remains undeniable. AI technologies are still in their infancy, and while there may be bumps in the road, the industry is poised to have a lasting impact across sectors. From healthcare to finance to manufacturing, AI is expected to reshape how businesses operate.

What the future holds for AI stocks

While some AI stocks may be experiencing a temporary correction, that doesn’t necessarily mean we’re in a bubble. The lessons of Pets.com and the dot-com crash show us the dangers of speculative investing, but they also remind us that transformative technologies often survive and thrive once the hype dies down.

Just as Amazon emerged from the ashes of the dot-com crash to become one of the world’s most valuable companies, AI firms with strong fundamentals are more likely to weather any short-term volatility. The key is to focus on companies with sustainable business models, proven technology, and the ability to generate real revenue from AI applications.

In conclusion, while there are certainly risks associated with investing in AI, the long-term prospects remain bright. Investors should be cautious but not overly fearful of another dot-com-like collapse. 

This blog post is for general educational purposes only and does not constitute an offer to sell, a recommendation or solicitation to buy any security.  Information contained herein may include “forward-looking” statements.  Due to numerous factors, actual outcomes may differ.  Past performance of any security is no guarantee of future results.