AI bubble

It’s feeling like the late ’90s, with an impressive new technology pushing tech stocks and the broader US market to all-time highs. Retail investors are using new platforms to get in on the action, tech companies are doing more IPOs to take advantage of the higher stock prices, and other companies are trying to boost their stocks by saying they are pivoting to the new technology (though often they aren’t really changing).

The excitement drives valuations to record levels:

In the ’90s, the internet really was a transformational new technology that would enable lots of profitable new companies. But the market got ahead of itself, a bubble that led to a crash- the S&P fell by almost half, while the tech-heavy NASDAQ fell by over 3/4 and took 15 years to recover.

History rhymes, but it doesn’t repeat exactly. I don’t currently expect a big crash driven by AI stocks; it helps that unlike in the ’90s, many of the big players are currently profitable. But I also don’t expect the NASDAQ to keep posting 20+% returns every year.

If the AI bull market doesn’t end in a dramatic crash, how will it end? It’s already shrugged off a war. A US recession is unlikely this year, though plausible next year.

The end I see slowly approaching comes from crowding out. What Robert Solow said about computers in 1987 is true about AI today: you see the AI age everywhere except the productivity statistics. There’s only so much money to go around in markets when productivity growth is unexceptional and savings rates are falling.

We’re already seeing the war hit certain markets (if not US stocks). Iran’s gulf neighbors are now putting lots of money into missile defense, money they now won’t be spending on data centers or gold (down 16% from pre-war), and everyone else has to spend more on oil.

Interest rates have been rising- partly due to central bank attempts to fight inflation, partly due to ongoing high rates of government borrowing, and partly due to financing the AI buildout itself. Higher rates make it more expensive for companies to invest in the physical AI buildout, and make investors discount future AI revenues more while making bonds a more attractive substitute for stocks today. 10-year TIPS now yield 2% over the inflation rate, a sharp contrast to the 2021 stock boom when they yielded less than inflation. If I were older I’d be loading up on TIPS, and even at 38 I’m starting to get tempted.

Trying to call the top exactly is a fool’s errand, but if I were feeling foolish, I’d point to the big upcoming IPOs. SpaceX just filed for an IPO that would be the biggest ever both for the amount of money raised ($75 billion) and the total company valuation ($1.77 trillion). This shatters the previous records for the biggest overall raise ($29 billion raised by Saudi Aramco when it went public in 2019) and the biggest raise by an American company ($18 billion raised by Visa in 2008). OpenAI and Anthropic are likely to follow with IPOs that would also break the previous records- making 3 companies each trying to raise more than the $45 billion raised by the entire US IPO market in 2025. Even if the process of going public doesn’t reveal any flaws in the companies, that money has to come from somewhere- and it takes up a substantial proportion of all net inflows to US stocks in a typical year (IPOs plus new money into existing stocks).

In short- where will the money come from? What are investors going to sell in order to buy into these IPOs? Technically they could do it all with cash, but I think it’s at least plausible that they start selling other stocks. The selling pressure will continue after the IPOs as employees of the newly-public companies see their stocks vest and other early investors become able to sell off.

I’m not trying to time the market. Even if this is a ’90s re-run, we could easily still be in the 1998 buildup, not the 2000 peak and crash. But I am diversifying. US stocks are currently the world’s most expensive. Investors value US stocks that highly because there’s a real chance that US companies are profitably building the technologies that will drive the future. But there’s also a real chance they aren’t– and if that state of the world comes to pass, I’d prefer to own a significant chunk of bonds, foreign stocks, and real assets.

And I twisted it wrong just to make it right
Had to leave myself behind
And I’ve been flying high all night
So come pick me up, I’ve landed

-Fed Chair Ben Folds on the Covid inflation

The Fed has now almost landed the plane, bringing us down from 9% inflation during the Covid era to something approaching their 2% target today. But it is not yet clear how hard the landing will be. Back in March I thought recurrent inflation was still the big risk; now I see the risk of inflation and recession as balanced. This is because inflation risks are slightly down, while recession risk is up.

Inflation remains somewhat above target: over the last year it was 3.3% using CPI, 2.7% by PCE, and 2.8% by core PCE. It is predicted to stay slightly above target: Kalshi estimates CPI will finish the year up 2.9%; the TIPS spread implies 2.2% average inflation over the next 5 years; the Fed’s own projections say that PCE will finish the year up 2.6%, not falling to 2.0% until 2026. The labels on Kalshi imply that markets are starting to think the Fed’s real target isn’t 2.0%, but instead 2.0-2.9%:

The Fed’s own projections suggest this to be the somewhat the case- they plan to start cutting over a year before they expect inflation to hit 2.0%, though they still expect a long run rate of 2.0%. In short, I think there is a strong “risk” that inflation stays a bit elevated the next year or two, but the risk that it goes back over 4% is low and falling. M2 is basically flat over the last year, though still above the pre-Covid trend. PPI is also flat. The further we get from the big price hikes of ’21-’22 with no more signs of acceleration, the better.

But I would no longer say the labor market is “quite tight”. Payrolls remain strong but unemployment is up to 4.0%. This is still low in absolute terms, but it’s the highest since January 2022, and the increase is close to triggering the Sahm rule (which would predict a recession). Prime-age EPOP remains strong though. The yield curve remains inverted, which is supposed to predict recessions, but it has been inverted for so long now without one that the rule may no longer hold.

Looking through this data I think the Fed is close to on target, though if I had to pick I’d say the bigger risk is still that things are too hot/inflationary given the state of fiscal policy. But things are getting close enough to balanced that it will be easy for anyone to find data to argue for the side that they prefer based on their temperament or politics.

To me the big wild card is the stock market. The S&P500 is up 25% over the past year, driven by the AI boom, and to some extent it pulls the economy along with it. The Conference Board’s leading economic indicators are negative but improving overall this year; recently their financial indicators are flat while non-financial indicators are worsening.

Overall things remind me a lot of the late ’90s: the real economy running a bit hot with inflation around 3% and unemployment around 4%; the Fed Funds rate around 5%; and a booming stock market driven by new computing technologies. Naturally I wonder if things will end the same way: irrational exuberance in the stock market giving way to a tech-driven stock market crash, which in turn pushes the real economy into a mild recession.

Of course there is no reason this AI boom has to end the same way as the late-90’s internet boom/bubble. There are certainly differences: the Federal government is running a big deficit instead of a surplus; there are barely a tenth as many companies doing IPOs; many unprofitable tech stocks already got shaken out in 2022, while the big AI stocks are soaring on real profits today, not just expectations. Still, to the extent that there are any rules in predicting stock crashes, the signs are worrying. Today’s Shiller CAPE is below only the internet and Covid meme-stock bubble peaks:

Again, this doesn’t mean that stocks have to crash, or especially that they have to do it soon; the CAPE reached current levels in early 1998, but then stocks kept booming for almost two years. I’m not short the market. But the macro risk it poses is real.