Are we in a stock market bubble?​

At a glance

• Parts of the market - particularly AI-linked technology shares – show signs associated with previous bubbles, including concentrated leadership, intense enthusiasm and heavy capital spending.
• However, many market leaders are profitable, overall valuations are not uniformly extreme and financial leverage is lower than before the global financial crisis.
• Rather than trying to predict the market peak, investors can focus on diversification, regular rebalancing and avoiding unintended concentration.

The trouble with stock market bubbles is they’re usually only obvious after they burst. Expensive share prices alone don’t make one. Bubbles form when compelling stories, investor enthusiasm, rising prices and easy finance reinforce one another, driving valuations beyond what company profits and cash flows can realistically support. Parts of today’s market show some of these warning signs - but the evidence is far from conclusive.
 

The case for a bubble

We can see several familiar bubble characteristics, particularly around artificial intelligence. Market returns and profit growth are increasingly concentrated in a relatively small group of large technology companies. At the same time, enthusiasm for AI has encouraged enormous capital spending on chips, data centres and power infrastructure. Expectations are high, leaving share prices vulnerable if revenue growth, margins or the commercial demand for AI disappoint.

There’s also a self-reinforcing effect. Strong performance attracts more investment, including through passive funds and strategies that favour recent winners. That additional demand can push leading companies higher still, strengthening expectations that they will continue to outperform. At the same time, companies are raising or borrowing more money to fund investment and expansion.

The question is whether that spending will ultimately generate strong enough returns to justify the investment and expectations surrounding it.  History shows that genuine innovations - from railways to the internet - can transform society while still producing poor outcomes for investors who pay too much or back the wrong businesses.

The case against a bubble

What we’re seeing, though, isn’t a simple repeat of the dot-com boom or the global financial crisis. Many of today’s market leaders are established, profitable businesses with strong cash flows. Overall valuations don’t appear uniformly extreme, although expensive pockets remain. 

Much of the initial AI investment was funded from operating cash flow, and borrowing by companies and households is lower than it was before the financial crisis, suggesting that any correction wouldn’t grow into a systemic issue. While the scale of investment is large, it’s not unprecedented. The technology itself may deliver substantial productivity gains, and company profits could eventually justify today’s share prices.

A less dramatic outcome is, therefore, possible. Markets could move sideways for a period, or investors could shift away from the largest AI-linked companies towards smaller companies, value shares, defensive sectors or markets outside the US. Even if share prices do fall sharply, that wouldn’t necessarily mean the wider market has been in a bubble.

How investors can build resilience

• Stay diversified. Avoid relying too heavily on one company, sector, investment theme or region. Diversifying across large, mid-sized and smaller companies, as well as value and defensive shares, can reduce accidental concentration.
• Use different sources of return. High-quality government bonds may provide balance if a sharp stock market fall leads to interest rate cuts. Depending on your objectives and risk tolerance, commodities or alternative strategies may also broaden diversification.
• Rebalance regularly. Taking some profits from areas that have risen strongly and redirecting them towards lagging assets can keep your portfolio aligned with its intended risk level.
• Look beneath the surface. Investors should look through funds and benchmarks to identify overlapping exposures, including whether supposedly different holdings are all tied to the same technology theme.
• Plan before volatility arrives. Deciding in advance how to respond to a correction can reduce the risk of panic selling. Trying to call the exact market peak is exceptionally difficult, and selling too early can mean missing a significant part of a rally.

So, are we in a bubble?

Parts of the market are showing some of the classic signs of a bubble: a small number of companies driving returns, intense excitement around AI, heavy investment and high expectations for future growth. But there are also reasons for caution before calling it a bubble, including strong company profits and less extreme valuations in other parts of the market. 

Rather than trying to predict what happens next, investors are likely to be better served by staying invested, maintaining a diversified portfolio and being prepared for a range of possible outcomes.