Ruchir Sharma: The four ‘O’s that shape a bubble

The stadium is reflected in bubbles seen ahead of the English Premier League football match between West Ham United and Chelsea at The London Stadium, in east London on Dec. 9, 2017. Photo by IAN KINGTON/AFP/Getty Images

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The writer is chair of Rockefeller International. His latest book is ‘What Went Wrong With Capitalism’

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Amid the chatter about artificial intelligence mania, people have begun to joke about “a bubble in bubble talk.” Google searches for AI with the b-word have surged and the mood in the markets feels exuberant, but beyond these soft indicators there is no standard measure of a bubble. My test focuses on four Os: overvaluation, over-ownership, over-investment and over-leverage. Here’s how AI scores now:

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Overvaluation

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In major bubbles going back to gold in the 1970s and the internet boom of the late 1990s, inflation-adjusted prices rose 10-fold over 10 to 15 years. U.S. tech shares recently hit that threshold. Further, a study of bubbles over the past century shows that the probability of a crash rises to more than 50 per cent when the industry at the heart of a mania beats the market by more than 100 per cent over two years. AI-related stocks are near that tipping point, too.

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These dramatic price increases have pushed long-term valuations of U.S. stocks close to the highest levels in history. Some say this doesn’t matter, because AI will boost growth more dramatically than previous tech revolutions, and valuations were more extreme in 1999-2000. But if history is any guide, then valuation and prices are flashing a deep-red bubble warning.

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Over-ownership

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This measures how much money is flowing into the hot new thing. And Americans are furiously chasing stocks, particularly in tech. Households hold a record 52 per cent of their wealth in stocks, which is higher than the peak in 2000 and far above levels in the EU (30 per cent), Japan (20 per cent) and the U.K. (15 per cent).

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A closely related signal is overtrading. Over the past five years, the number of shares traded each day in the U.S. has risen by 60 per cent to around 18 billion. The retail share of short-dated stock options has grown from a third to more than half. Young people are succumbing to “financial nihilism” — indulging in speculation because they have given up on buying a home.

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If the stock market drops on a given day, retail investors impulsively buy the next day. Their favourites are clear: on the Robinhood platform, the five most heavily owned stocks are all in the Magnificent Seven. And with US$7.5 trillion still sitting in money market mutual funds, small U.S. investors may have buying power left.

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Because financial conditions remain so loose, liquidity keeps driving up stocks. That is almost forcing institutional investors to keep buying, including many who are sceptical of AI euphoria. The result is a strange new animal: the fully invested bear.

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AI enthusiasts say incessant bubble talk proves this is not a bubble, because peaks come when worry is gone and optimism is universal. Perhaps, but worry was in fact growing before the dotcom crash. One year earlier, the San Francisco Fed raised the spectre of 1929. Many columnists and economists echoed those fears, as did several institutional investors. Just like today.