Is AI a bubble?

Is this a bubble, or is AI the real deal? The answer is yes to both. AI’s economic promise is real. Investors and institutions are piling into this very real economic development, which raises the question: is AI a bubble destined to burst?

Bubbles 101

To start, mass market bubble psychology  begins with real, actual economic developments. Not fly-by-night flavor of the day mini-bubbles. Mini bubbles are meaningless to the big picture. Examples of minis are cannabis, meme stocks, small capped pops, crypto, and bitcoin mining stocks. Yes, these mini bubbles attract investors, then speculators, rise hard and crash harder. Today, I am talking about meaningful and real wide-scale economic developments like:

  • Internet
  • AI
  • Oil
  • Housing crisis

As a truly meaningful development takes root, stock prices increase surrounding its stocks. This increase in prices validate assumptions that the development is indeed “real”. And, it is real. So… Sell side analysts (brokerages, and etc.) make more aggressive growth and price projections. In the first leg of the bubble (where it is not actually a bubble yet – its “in the making”), these projections are fairly realistic. Possibly even understating the potential of the development!

As prices and development of the event continue to escalate, projections are pushed up as analysts fear being left behind. This pushes prices further, and draws in more investors. Index-ETFs are forced to rebalance into the sector.  Remember, they are not going into bitcoin mining stocks in the same way they are piling into a more meaningful economic sector like those mentioned above.

Speculators and unsophisticated retail investors alike, who missed the safer legs of the event, don’t want to miss out. They start to pile in. FOMO (fear of missing out) sets in.  Prices rise well past reality. Analysts projections soar. This overvaluation doesn’t change the viability of the actual event. The event is real. It’s the projected profits or impact of the event that has ramped up beyond reason. And so, the top eventually comes.

Parabolic moves typically signal a bubble that is coming to an end. I draw trendlines, and use uber-long moving averages to try and spot them. Below is the SPX chart, with a green trendline highlighting the uptrend that started after the last big bubble in 2008/2009. On the chart is a red line which is the 50-month SMA. This is a big MA!  I have found moves that are 20% =/- above that big long SMA, coinciding with an obvious sharp/parabolic move above the bull market trendline (green) can signal market peaks. Not necessarily bubble peaks, but peaks nonetheless.

We are in that situation now. Further, a high point on the long termed Rate of Change indicator (10-month) at the bottom of the chart – leading into it rolling over – tends to coincide with more meaningful pullbacks. This doesn’t mean a macro bubble top like 2001/2008. But it does mean at least a strong pullback.

To determine if we are in a bubble correction, like that seen in 2001, 2008 and further back, we can look at a weekly chart (not shown). Bigger bear markets can be identified by lower highs and lower lows on a weekly chart, plus a break in a 200-day (40-week) SMA–as taught in my Online Trading Course. Still, you can look at the monthly chart below and see the peak/trough successive declines in the big bear markets. My course teaches you the logical way to leg out during these periods.

S&P 500 Large Cap Index INDX (May 24, 2024)

Is AI a bubble?

Yes. Valuations are now entering into bubble territory for AI-related stocks. Like all bubbles, they can stretch a bit further. How much further is the question. Here’s an excerpt from an article from the economist:

The combined market value of Alphabet, Amazon, and Microsoft has jumped by $2.5trn during the AI boom. [This value creation] is 120 times the $20bn in revenue that generative AI is forecast to add to the cloud giants’ sales in 2024.

Read that again. It didn’t say 120 times the earnings. It said 120 times the revenue!!! Ponder on that for a second…

AI stocks will decline as smart money takes their money and runs. Smart money is ALWAYS ahead of the game. John Paulson’s hedge fund made $15 billion timing the housing bubble in 2007. Michael Burry made a few hundred million in 2008 and had a movie made about him, The Big Short. Retail investors were left in the dust yet again.

Poster boy NVDA is the quality name in the sector. Still, the bigger it gets, the more invested the market becomes in the name, the larger the sell-off when it happens. If Nvidia truly is the best stock on the market today, then it must generate sure-thing returns. Hard to say that can last forever. Technically, it would be healthy if it pulls back, given its overbought profile. See the chart below. Note the % over its 10-year trendline.  Note the % over its 200 day (40 week) SMA. Again, these are things I cover in my course.

For now, Nvidia’s winning quarterly report will likely keep inflating the stock, and the sector. Until it doesn’t.

Is AI a bubble? | NVIDIA Corp. Nasdaq GS (May 24, 2024)

Final Thoughts

When Smart Money sells, speculators will then start to sell.  This pressure will create a stampede for the exits by retail investors.  The leading stocks in a bubble (in this case, AI) influence the indices disproportionally. Index ETFs will rebalance. More pressure ensues. Some of you will time it well. Most won’t. You need a system.

My system, which I implore you to learn via my Online Trading Course, does not get you out at the exact top. But it does get you out before too much damage has been done. It’s the most pragmatic and effective investment strategy I know of. If you follow this blog, you know it works – most recently demonstrated in the 2022 bear market, where VT came out flat against a large market pullback.

You can’t predict, but you can prepare. Have a plan. If you don’t have a proven, structured trading plan, take my course. Follow it. Win by not losing!

Coming up…

I am thrilled to announce that I have secured an interview with Larry McDonald of BearTraps!!! I simply cannot tell you how excited I am on this one. We’re recording it late this week, and it will be posted next week. I will be all over making sure you watch this one! Its going to be a must-see!

The rapid ascent of AI stocks and their staggering valuations prompt a critical question: is AI a bubble? While the technology’s transformative potential is undeniable, the speculative fervor driving current market prices suggests caution. As smart money begins to pull out and retail investors face the fallout, it’s essential to stay informed and prepared. By understanding market dynamics and employing a robust investment strategy, you can navigate the inevitable corrections and capitalize on genuine opportunities in the AI sector.

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