From artificial intelligence to “absolute madness”, these are the 3 ingredients needed to fuel the next stock market bubble

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  • The artificial intelligence boom could turn into “absolute madness” if a stock market bubble forms, according to TS Lombard.

  • The investment firm outlined the three key ingredients needed to create a stock market bubble.

  • “The AI ​​frenzy…over the past few weeks has the hallmarks of a potential bubble. But we’re not in one right now,” TS Lombard said.

Artificial intelligence has emerged on Wall Street as the new theme driving stock prices higher, and it could turn into “absolute madness” if a bubble finally forms, according to a note this week from TS Lombard.

The company said there are three key ingredients needed to form a stock market bubble, but one of them is currently missing, leading them to conclude that stocks aren’t in a bubble yet…not yet. .

These three ingredients are:

  • “A solid foundational story.”

  • “A compelling narrative for future growth.”

  • “Liquidity, leverage, or both.”

“The hype around AI risks creating the second tech bubble in just three years. However, there are no signs of ‘absolute madness’ in stocks, at least for now,” said Andrew Cicione by TS Lombard.

While the hype surrounding AI and its growth potential meets the first two criteria of the stock market bubble checklist, the last ingredient of liquidity and leverage seems to be missing. Investors can thank the Federal Reserve’s ongoing balance sheet reduction plan for that.

“Unlike 2020, central banks are shrinking their balance sheets. Narrow money is contracting in most major economies, and broad money is slowing rapidly,” Cicione said.

Meanwhile, investor leverage has plummeted over the past year as the stock market suffered a painful bear market throughout 2022 as FINRA’s absolute margin debt saw a spike. bigger drop 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.

“Data on margin debt and open interest on options suggests that it wasn’t speculation that drove tech stocks to their recent highs. That’s good news: the rally fueled by the effect of leverage are very vulnerable to panic and hard selling,” Cicione said.

On the valuation front, TS Lombard pointed out that while artificial intelligence stocks have been driving much of the stock market’s performance over the past two months, as evidenced by the sharp rise of Nvidia and other semiconductor stocks following the company’s bullish earnings forecast, some valuations actually fell. .

For example, while Nvidia has jumped more than 160% since the start of the year, analysts’ earnings estimates for the company have soared, ultimately bringing its price-earnings ratio back to levels seen at the start of the year. ‘year.

“Nvidia’s quarterly results that beat analysts’ expectations led to massive EPS upgrades. As a result, valuations actually fell despite rallying more than 30% after the announcement,” Cicione explained. . “Tech company valuations are cyclically high but not at the outrageous levels they reached in 2020-21.”

Finally, Cicione cautioned that as promising as the prospect of AI may seem for investors, they should be aware that first movers do not always emerge as the long-term winner, as evidenced by the rise and the collapse of dot-com technology. businesses in 2000.

So while the AI ​​frenzy “has the characteristics of a potential bubble…we’re not in one right now,” Cicione concluded.

Read the original article on Business Insider

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