Amid AI frenzy, concerns mount over sustainability of equity rally as valuations continue to soar
The bulls say the AI boom is unlike the dotcom boom in that the main players this time are extremely profitable giants such as Microsoft, Alphabet, Amazon and Meta
WITH growing concerns over a bubble surrounding the artificial intelligence (AI) frenzy of late, a debate is now raging on Wall Street: Is this time any different?
“This time, it’s different” is a phrase known in finance as the famous last words of an investor about to go bust in one of the speculative bubbles that periodically form.
As Ulrike Hoffmann-Burchardi, the chief investment officer for global equities at UBS, puts it: “The rapid pace of debt transactions has added to investor concerns over the sustainability of the AI-driven equity rally amid elevated valuations, raising questions over big tech’s ability to fund their AI expansion as monetisation continues to lag.”
She concluded that the current AI boom is different from the dotcom boom, coming down on the bulls’ side of the argument.
The bulls contend that the AI boom is unlike the dotcom boom because the main participants this time are extremely profitable companies such as Microsoft, Google owner Alphabet, Amazon and Meta Platforms.
As things stand, AI has already proven to be a profit-growth engine, showing up almost immediately in the massive income statements of these companies and other giants such as software maker Oracle.
On paper, these companies are nothing like the loss-making, smaller firms such as Pets.com, which the prime actors and stock-market darlings that drew such wild speculation on the first Internet boom.
On the contrary, the bears say this boom is almost an exact rerun of the dotcom bubble. No matter how much money they are making, the “Magnificent Seven” mega-cap stocks are still trading at absurd valuations – just like with the dotcom players.
Microsoft is currently trading at around 37 times its trailing 12 months’ earnings.
The rate of debt accumulation to fund AI developments, rather than valuations, may be the biggest parallel to the dotcom bubble, the bears warn.
Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund, recently started betting against the tech-heavy Nasdaq index because he thinks a tipping point for the debt frenzy is close.
“It will be important to watch how markets react to ever-increasing spending,” he said. “CEOs are eager to keep spending more for as long as they can, but if the market starts to punish their stocks, or worse, their bonds, it could finally impose some capital discipline.”
Remember how Worldcom, Lucent and others invested billions of dollars of borrowed money in Internet infrastructure, only to find that earth didn’t need to be wrapped four times over in fibre-optic cable?
That resulted in a string of bankruptcies and triggered the most epic burst of a speculative bubble in the last half-century.
Now, almost every other day, there is a multi-billion dollar data centre development deal. Like the dotcom days, these deals smack of rushed copycat behaviour. And, like the dotcom equivalents, when Lucent financed its own customers’ purchases of equipment, some of these deals had strange “circular” elements.
For example, Microsoft and Nvidia recently struck a deal to invest US$30 billion in AI model maker Anthropic – but only as long as Anthropic bought products from those two companies.
Sometimes, lenders to these deals even accept Nvidia chips as collateral. If there is a major AI bust, those chips would presumably lose almost as much value as the data centres they are collateralising.
The share price of one of the big lenders to AI deals, private-credit giant Blue Owl, has slumped this year.
Another disquieting development for AI bulls: the cost to insure Oracle’s bonds has doubled for the year to date. Oracle is attempting to be the principal provider of online data storage for OpenAI.
Oracle chairman Larry Ellison has become one of the wealthiest people who ever lived because of his iron stomach for risk.
In a clear example of this, he has backed his son David’s quest to remake the ultimate boom-and-bust town – Hollywood – by merging Skydance, the studio primarily known as Tom Cruise’s backer, with the sprawling conglomerate Paramount.
It is in the AI sphere, however, that investors seem to think the elder Ellison has finally taken on more risk than he can handle.
Recently, Oracle struck a mammoth US$500 billion deal with OpenAI to develop data centres. Dubbed Stargate, the project will start with a roughly 1,000-acre mega warehouse full of data-storing chips in Texas.
Oracle is betting that OpenAI will find applications for its ChatGPT orders of magnitude more profitable than current uses. That is a risky proposition, but Oracle has staked US$56 billion of debt on it in the last three months.
The behaviour of Oracle’s bonds is a microcosm of the whole bear case on AI. The bottom line is that there is no clear financial case for recouping the tens of billions of dollars spent on building better AI models. As in the dotcom boom and the 19th-century US railroad boom, the market may reach – or may have already reached – a collective conclusion that there is just too much capacity and too little profit potential.
Wall Street brokers are generally bullish on AI prospects, as they were about the Internet throughout the dotcom boom.
At least one brokerage has offered qualified optimism.
Analysts at Jefferies said in a note to clients: “The direction of travel points to continued adoption and capability growth, but with signs of friction that could temper the pace in the short term.”
Skeptics warn that behavioural factors come into play at this stage in a bubble. Fear of missing out is a powerful force, and can overpower financial reason.
The Magnificent Seven are already in correction territory, roughly 10 per cent below their all-time highs less than a month ago. If the bulls are right, this is a buying opportunity. If the bears are right, however, the carnage may only be beginning.
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