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According to TS Lombard, the artificial intelligence boom could become “absolute madness” if a stock market bubble forms.
The investment firm outlined the three key ingredients needed to create a stock market bubble.
“The AI frenzy… over the past few weeks is showing the hallmarks of a potential bubble. But we’re not in one right now,” TS Lombard said.
Artificial intelligence has emerged as the new theme on Wall Street that’s driving stock prices higher, and it could turn into “absolute madness” if a bubble eventually forms, according to a note from TS Lombard this week .
The company said there are three key ingredients needed for a stock market bubble to form, but one of which is currently missing, leading to the conclusion that stocks are not yet in a bubble…yet.
These three ingredients are:
“A solid foundational story.”
“A compelling narrative for future growth.”
“Liquidity, leverage, or both.”
“The hype surrounding AI threatens to create the second technology bubble in just three years. However, at least for now, there is no sign of ‘absolute madness’ in equities,” said TS Lombard’s Andrew Cicione.
While the hype surrounding AI and its growth potential ticks the first two criteria of the stock market bubble checklist, the last ingredient appears to be missing, liquidity and leverage. For that, investors can thank the Federal Reserve’s ongoing balance sheet reduction plan.
“Unlike in 2020, central banks are shrinking their balance sheets. The narrow money supply is shrinking in most major economies and the broad money supply is decelerating rapidly,” Cicione said.
Meanwhile, investor leverage has fallen sharply over the past year as the stock market endured a painful bear market throughout 2022, with absolute FINRA margin debt falling more sharply today than during the Great Financial Crisis of 2008.
Another factor limiting the formation of a bubble is that fewer people are sitting at home speculating in the stock market today than they were during the COVID-19 pandemic in 2020 and 2021.
The story goes on
“Margin debt and open interest options data suggest it’s not speculation that’s propelled tech stocks to their recent highs. That’s good news: Leverage-driven rallies are very prone to panic and forced selling,” Cicione said.
On the valuation front, TS Lombard emphasized that while AI stocks have driven a large chunk of stock market performance over the past two months, as evidenced by the massive surge in Nvidia and other semiconductor stocks following the company’s upbeat sales forecast, some valuations have actually fallen .
For example, while Nvidia is up more than 160% year-to-date, analyst earnings estimates for the company have soared, ultimately causing the forward price-to-earnings ratio to drop to where it was at the start of the year.
“Nvidia’s quarterly results, which beat analysts’ expectations, led to massive EPS increases. As a result, despite rallying over 30% following the news, valuations have actually fallen,” explained Cicione. “Technology company valuations are cyclically high, but not at the outrageous levels they have reached in 2020-2021.”
Finally, Cicione warned that as promising as the prospect of AI sounds, investors should be aware of the fact that first movers don’t always emerge as long-term winners, as evidenced by the boom and bust of dot-com technology companies in 2000.
While the AI frenzy “shows the hallmarks of a potential bubble, we’re not in a bubble right now,” Cicione concluded.
Read the original article on Business Insider