One of the telltale signs of a bubble is when a stock price falls despite good news. Earlier this week, Nvidia released earnings that beat market expectations. Revenue was up 62% from a year ago. Sales hit new records. But despite a small bump at the time of the earnings release, their stock price was down 6% this week.
AI stocks have accounted for most of the gains in the US stock market this year. But in the last few weeks, large tech stocks have come back down. And without any bad news to explain the drop.
One of the fundamental tenets of long-term investing is the difference between a good company and good stock. A good company has a solid competitive advantage and strong growth prospects. A good stock is a good company that also trades at a fair price. AI stocks are good companies. At current prices, it’s less clear that they are also good stocks.
What do current valuations imply?
Consider that Nvidia’s PE ratio is around 50. This compares to the overall market PE ratio of around 30. A PE ratio of 50 means an earnings yield of 2%. Currently, a risk-free US 10-year government bond yields 4%. The only reason you buy a stock with a 2% earnings yield is if you think earnings will rise a lot.
How much do earnings have to rise? Well, if earnings double, the yield goes to 4%, the same as the risk-free bond. Which is still not worthwhile. So perhaps earnings must triple or more for this stock to make sense.
AI is a transformative technology. As its adoption and usage grows, we will likely witness rising productivity and GDP growth. But profiting from AI’s rise is easier said than done.
A Parallel Example
An instructive example here is the dotcom bubble of the late 1990s. This period coincided with the widespread adoption of the internet. As we know now, the internet has affected every aspect of our lives. It has changed the way we do business and led to huge increases in growth and productivity.
But what happened to investors during the 1990s? The technology heavy Nasdaq index in the US gained 600% between 1995 and March 2000. After that, it lost 78% of its value between March 2000 and October 2002. It took until December 2014, 12 years later, for the index to return to its high.
Most of the companies that tried to profit from the growth of the internet actually went bust. Most investors who entered the market at a late stage lost money. The dotcom bubble didn’t burst because the internet wasn’t transformative. It burst because valuations were too high.
Investors today face the same danger when it comes to AI stocks. The new technology may indeed live up to its hype. Even if it does, it does not mean every AI company is also a good stock. For investors, the same principle that has always applied still applies today. And that is to find good companies at fair prices.
Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Disclosure: The writer does not hold any of the securities discussed in this article.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
