Is a market crash looming? AI-fuelled rally in US stocks could unwind, impending bust could singe global markets

Now, nearly 40 ten years down, the Solow Paradox has some resonance in another new technological breakthrough: artificial intelligence (AI). While there is little debate over the overwhelming transformative impact of AI on society, there are question marks over when this will distill down to actual productivity gains in the short term.

Meanwhile, in Silicon Valley, the debate over whether AI companies are overvalued has taken on a new impetus. There are questions being raised on the rapid rise in the valuation of AI tech companies, the use of “financial engineering” and “circular deals”, and increasing comparison to the dot com crash.

Fears are being expressed of these tech companies being overvalued and that a bubble is building up. So, is there a stock market crash waiting to happen?

Valuations at record highs

On Thursday, the S&P 500 and the Nasdaq hit new records, while the Dow has surged about 10 per cent year-to-date. Almost all of this surge has been on account of the relentless surge in the valuation of the so-called ‘magnificent seven’, the leading US tech companies — Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta and Tesla.

Cumulatively, the combined market value of these seven tech majors, at nearly $21 trillion, now exceeds the entire output of the European Union. The S&P 500’s price-to-earnings ratio — P/E ratio that represents a company-s share price to its earnings per share over a period and is used to estimate whether they are overvalued or undervalued — was around 23 times in end-September, according to inputs from data aggregator LSEG Datastream. That is well above its 10-year average of 18.7, and just short of the P/E ratio of around the 25 level in the early 2000s, the data showed.

The relentless rally in AI-focused tech stocks, while stretching valuations and threatening concerns over potential market excess, comes alongside at least two genuine worries.

One, that the potential application of the AI tools is still some way off, and the monetisation potential looks further down the horizon. The surge is almost entirely driven by the relentless flow of capital into these company stocks, primarily in view of the future potential. The Solow Paradox is somehow not yet a factor at this point in time.

Two, the market seems to be ignoring multiple looming threats, including the US President’s assault on the global trading system, a massive drop in immigration into America, the attack on the US Federal Reserve’s independence, institutional backsliding, the inflationary impact of Trump’s actions, and worries over the US government’s ballooning debt burden after his new spending bill.

All that is being papered over for now, purely because of the AI optimism that has more than offset the serious structural problems looming in the horizon. Despite the fact that, like computers then, AI is not yet showing up in the productivity charts.

The market is pricing in a substantial boost to future productivity compared to what we have already seen in the last few years, but there could be a serious gap between the timeline of these expectations and when the productivity boost tangibly shows up on company books. It is precisely this gap that could be punctuated by a market crash, murmurs of which have already gained traction.

The growing bubble

International Monetary Fund chief Kristalina Georgieva warned Wednesday about the potential risks to the global economy from likely corrections in stock market valuations. JPMorgan Chase CEO Jamie Dimon too warned of a heightened risk of a significant correction in the US stock market within the next six months to two years, the BBC reported.

Author and statistician Nassim Nicholas Taleb has also warned investors against being taken in by the stock market’s record-breaking rally, because beneath the surface, a growing debt crisis could trigger a major reckoning, as per a Bloomberg report. Speaking at the Greenwich Economic Forum, Taleb, the author of The Black Swan (2007), urged investors to protect themselves from what he calls an obvious, looming threat, the Bloomberg report said.

All of this sounds prophetic, quite like then US Federal Reserve chairman Alan Greenspan’s December 1996 dinner speech, where he posed an ostensibly innocuous question: “How do we know when irrational exuberance has unduly escalated asset values?” Markets around the world, including in Asia, crashed in response.

Again, while there is no disputing the transformative potential of AI in the long term, there are question marks about when this will translate into monetisable figures that boost the balance sheets of companies. Meanwhile, there is a serious cash burn as AI companies shift to inference, or the ability of AI models to decipher patterns and draw conclusions from information that they were not trained before on or have not yet encountered.

In any case, generating an answer to an AI query is perhaps 10 times more energy intensive that a regular search query. So, there is a cash burn happening, especially on data centres to power the AI surge in the inference stage and the electricity used to power the backend.

On the front end though, there are financial reengineering deals that are now picking up in the AI ecosystem. One such measure, which is now partly fuelling this boom, is circular deals of the kind that Open AI and Nvidia entered into.

So, Open AI pledges billions of dollars to buy AMD’s chips. AMD, in return, offers Open AI a minority stake in the company. Despite the fact that both the companies are already overvalued, investors simply love this new deal and plow in more money into both stocks, boosting valuations further. It’s almost symbiotic, but with no real underlying reason for this exuberance.

“There is an element of FOMO gripping the markets. That is undeniable, given how fresh money is chasing the already high stock valuations. Also, this tends to ignore the fact that countries such as China or even India could be contenders to lead the application stage of AI, and not America,” a Mumbai-based market analyst said.

While the US appears to be shrugging off fundamental concerns that could upend this investment boom, countries such as France and Japan are showing some signs of trouble in their bond market. According to Ruchir Sharma, head of Rockefeller Capital Management’s international business, the deficit level in the US at this time is even higher than in France and Japan. But the reason why the US has lower yields than at the start of the year compared to those countries, is this implicit bet in the US bond market that America is going to see a big productivity miracle due to AI in the coming months.

If the markets, at some point in time, were to decide that this is not coming through, then that could trigger a potential crash. The renewed surge in investments in gold and silver are an indicator of sorts.

A crash in American stocks and bonds could potentially have a cascading impact on markets around the world, including India, where stock markets have been almost flat over the last 12 months. India’s reasonably healthy fiscal situation could be an insulating factor for the country’s bond markets and for long-term capital flows, but an impending global valuations crash could still devastate most global markets.

And there are increasing signs of an impending crash looming on the horizon.