If the AI boom turns out to be a bubble, what happens next? With huge datacentre build‑outs underway and equity markets at all‑time highs, could the bubble really burst? Premier Miton multi asset Fund Manager, David Jane, explores why bubbles can inflate and deflate quickly, and how the team navigate this type of environment.
It seems in financial markets there is always a bubble somewhere. Recently we have seen explosive growth in returns from areas as diverse as bitcoin, gold and silver, AI stocks and quantum computing.
It is part of human nature to be driven by fear and greed and, when this takes hold, prices can get into a classic bubble pattern.
This provides an interesting challenge for professional investors as naturally you want, even need, to capture some of the returns from these moves, yet you don’t want to be seen as participating in an activity that might be seen as irrational from the point of view of traditional market valuation theories.
Financial market bubbles tend to have a have a couple of features that drive them. There will be an original, undeniable and positive set of facts, such as transformational technology, leading to huge demand.
There needs to be an ample amount of financial market liquidity to enable speculation. When liquidity is ample, multiple bubbles can inflate and deflate in rapid succession as we have seen over recent years. When liquidity is withdrawn, they tend to deflate rapidly.
There has been much recent talk as to whether AI is in a bubble, particularly the semiconductor stocks which look set to benefit from the massive planned build out of data centres.
It certainly has many of those characteristics. AI appears to be a transformational technology and massive capital expenditure is taking place, benefiting semiconductors as well as other areas. There appears to be ample liquidity that can drive these price moves.
At the same time, we have several concerns which are worrying fundamental investors. Are the use cases for these technologies offering sufficient efficiency benefits to justify the scale of capex taking place?
There is insufficient energy and water supply to serve the planned datacentres. The semiconductor industry has a long history of booms and busts, leadership in semiconductors can change rapidly and so on. Throw in the obvious extreme valuations and it’s easy to see why people might worry.
Our approach is somewhat different; we don’t see any need to be either all in, or to avoid totally. When selecting ideas, we follow our process of data, narrative and affirmation – data being the fundamental case, narrative being the story and affirmation being the price momentum.
Data was clearly supportive at one time, less so now, narrative remains strongly supportive, while momentum is clearly strong. On this basis, we would not look to exit as we would require a deterioration in the momentum to sell out.
Things look very different once you take portfolio construction and risk into account. This is ultimately the key. Rather than seeing the world in terms of binary choices, as many do, – ‘are you in or out’, – instead we see it in terms of risk reward.
As the bubble inflates, we will rescale positions back to start weight, taking account of volatility and the ability to diversify risks elsewhere in the portfolios. In doing this, we don’t need to decide whether we think the bubble has further to inflate or not on fundamental grounds, the market will tell us what to do.
As they become more volatile, we can reduce, and as they rise, we can harvest the gains. Should momentum deteriorate, we will exit. Our decisions once we are in a theme are based on these factors, not some unknowable guess about future events.
This approach has served us well through recent events, such as the moves in gold and silver, where we continually harvested profits and once correlations to the rest of the portfolio became strongly positive and volatility became extreme, we exited.
We are following the same approach to the AI trade; reduce into strength, keep an eye on the ability to diversify the risk and the volatility, take profits and be thankful.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: bubbles, kind-and-curious-ZDUXvlyU_iI-unsplash
