Are we in an AI bubble? "Not so fast my friend"

In reference to ESPN Gameday host Lee Corso, are we in an AI bubble? "Not so fast, my friend." Valuation is the key metric to determine the size and scope of the recent run-up in AI and AI-related companies. The comparison to 2000 is frequently discussed. Where do we stand on the 2000 valuation perspective, and what valuation metrics and criteria are we analyzing?

Preface to the note below: A Goldman Sachs analyst wrote the note, and we at SWCM agree with its context. Among the Magnificent 7 and several other major AI companies, most are either fully valued or overvalued. Google and Amazon are two that we are adding to client portfolios. While PLTR and TSLA remain overvalued, we are also not selling AAPL or MSFT, as they remain legacy holdings in SWCM accounts.

1. Criteria for Identifying a Bubble and the Current Situation • Historically, bubbles are characterized by excessive valuations, sharp price increases, over-leverage positions, and speculative participation.

• While today’s market shows some similarities (high valuations, capital intensity, vendor financing), the rise in tech stocks is grounded in real earnings growth, the financial structures of top firms remain solid, and competition in AI is still limited to a small group of large players. • On valuation metrics (P/E, PEG, P/B vs. ROE, DDM), the market is below historical bubble levels. See the chart below:

2. Diagnosing Tech Stock Valuations • The Magnificent 7’s average 24-month forward P/E is around 27x, about half the level seen during the dot-com bubble for large-cap names.

• Their PEG ratio is 1.7x, much lower than 3.7x in 1999, and P/B vs. ROE remains within reasonable bounds.

• However, to realize these valuations, an average dividend growth rate of 25% over the next decade would be required, introducing uncertainty in actual returns.

3. Differences in the Profit Structure of Tech Firms • Unlike the past bubble, which was driven by expectations, today’s rally is backed by actual EPS growth.

• The tech sector’s EPS has grown over 5x since 2009, widening the gap versus the overall market.

• Stock gains are therefore primarily earnings-driven, not valuation-driven — fundamentals, not speculation, are leading this cycle.

4. Market Concentration and Structural Risks • The top 10 U.S. companies now account for about 25% of global market capitalization. • Sector concentration has occurred repeatedly throughout history (finance → transportation → energy → IT). • High concentration itself poses risk, but it is not a defining feature of a bubble.

• Future risks could stem from over-investment and margin compression as competition intensifies.

5. CAPEX Expansion and Funding Structure • Since the emergence of ChatGPT, large IT firms’ CAPEX has surged — from $150 billion in 2023 to an estimated $370 billion by 2025.

• Unlike the telecom bubble, however, most investments are being financed by free cash flow rather than debt. • The Magnificent 7 maintain an average net cash ratio of –22%, ROE of 46%, and net profit margin of 29%, signaling a very strong balance sheet.

• That said, there are early signs of increased debt issuance in areas like data centers (about $141 billion in 2025 credit issuance).

While excessive optimism toward AI and tech stocks warrants caution, the market is not yet in bubble territory.

The following chart analyzes the valuation parameters of each bubble period.  

While valuations are higher than a year ago, I don't believe we are currently in bubble territory, considering the AI companies available publicly. More to follow:

_^Disclaimer:

_{^{The information in this material is for general information only and is that of the author, not a recommendation or solicitation to buy or sell investment products. This material was developed and produced by James Sullivan, who is not affiliated with the named broker-dealer. Always consult a tax or legal advisor to review your situation comprehensively.  Dollar-cost averaging will not guarantee a profit or protect you from loss, but may reduce your average cost per share in a fluctuating market. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment. It does not take into account the effects of inflation and the fees and expenses associated with investing.  A diversified portfolio does not assure a profit or protect against loss in a declining market.}}