Markets continue to climb, led by capital investments in the Artificial Intelligence (AI) boom. However, cautionary signs are emerging, including decidedly negative headlines, lofty stock market valuations, talk of an AI bubble, and a deteriorating housing market.
Last Friday (October 10th), President Trump threatened again to impose even steeper tariffs on Chinese goods. This set off a steep market drop, but up until Friday, global financial markets had been enjoying solid gains for months. From stocks to bonds to commodities, nearly every major asset class has risen substantially since the start of the third quarter in July, both in the United States and in many regions of the world.
The remarkable part of this market rise has been the disconnect between its positive momentum and the challenging national climate.
Consider that President Trump has deployed National Guard units to certain cities amid ongoing political disagreements. At the same time, Congress has been divided over proposed changes to healthcare funding and subsidies, resulting in a government shutdown that began on October 1.
The tariff wars could be escalating, and U.S. relations with China, already tense, could easily deteriorate further. Deportations continue, the labor market has shown signs of slowing, and the Federal Reserve’s independence is under pressure from the Trump administration. Mounting civil strife is evident in the United States on many fronts.
Despite all that, the markets in recent weeks had largely shrugged off the turmoil, with longer-term upward momentum proving formidable.
A.I. Bubble?
In broad strokes, the S&P 500 is an index of the 500 largest companies in the U.S. It covers all sectors and industries from healthcare to construction, to retail, to technology. But never in its history has the index been so dominated by such a small group of companies.
The ten largest stocks in the S&P 500 make up over 40% of its value. In other words, of the 500 stocks in the S&P, ten stocks equal more than 40% and the remaining 490 stocks make up less than 60%. With the exception of JP Morgan, electric car-maker Tesla, and the conglomerate Berkshire Hathaway, these mega companies are big tech ─ the so-called “Magnificent Seven” ─ and they are investing heavily in AI.
Earnings for these companies have been strong. However, the current bull market rally has lifted valuations to lofty heights. At present, the S&P 500 trades at a price-to-earnings (P/E) ratio of over 30 versus its long-term average of only around 16. It’s unusual for the broad market to become this richly valued, prompting widespread chatter about the dangers of an A.I. bubble.
Investment in artificial intelligence has been huge. In this year alone, venture capitalists will invest nearly $200 billion in the sector. Additionally, data-center investment has tripled since 2022. Together, these investments are driving growth across the entire economy, pumping up the stock market and generating increasingly eye-popping valuations of the technology firms driving the A.I. revolution.
In financial markets, a bubble occurs when the level of investment in an asset becomes persistently detached from the amount of profit that asset could plausibly generate. A.I. investment might fit that pattern.
Consider this example: In rough numbers, OpenAI (the creator of ChatGPT) is valued at about $500 billion. The company has generated about $4.3 billion in sales in the first half of the year, and lost roughly $2.5 billion during that same time. Putting the lack of profits aside for a moment and just comparing OpenAI sales to its valuation, one gets a full-year price-to-sales ratio of about 50.
How does OpenAI’s valuation compare to the S&P 500? Not well. The price-to-sales ratio for the S&P 500 stands at about 3.3. In other words, OpenAI’s revenue would need to increase by roughly 15 times, or its sales would need to double each year for the next four years, to reach parity with the broader stock market. This seems unlikely. But even if OpenAI could grow its sales to this degree, an open question is whether OpenAI can be profitable at this size, given the enormous infrastructure investment that would be required to achieve this scale.
Since the debut of ChatGPT in late 2022, the S&P 500 has swelled by nearly two-thirds, with just seven firms — all of whom have invested heavily in A.I. — driving more than half of that growth. Indeed, hundreds of billions of dollars in capital expenditures on artificial intelligence infrastructure have lifted the entire A.I. industrial complex, with shareholders of companies like Nvidia, Arm, Broadcom, Intel, Taiwan Semiconductor, Microsoft, Oracle, and Meta all benefiting. Now the question becomes: how long will this investment continue before investors demand a return on, or a return of, their investment dollars?
As we experienced during the Dot Com boom and bust 25 years ago, things can unravel pretty badly when attitudes, expectations, and economics shift.
Housing. The “Real” Economy
The housing market has long been seen as an early warning sign for recessions, and one data point in particular has caught the attention of Moody’s Analytics chief economist Mark Zandi.
Zandi recently noted that Moody’s own leading economic indicator has estimated the odds of a recession in the next 12 months are now at 48%. And even though it’s less than 50%, Zandi pointed out that the probability has never been that high previously without the economy eventually slipping into a downturn.
A crucial component in the Moody’s indicator comes from the housing market.
“The algorithm has identified building permits as the most critical economic variable for predicting recessions. And while permits had been holding up reasonably well, as builders supported sales through interest rate buydowns and other incentives, inventories of unsold homes are now high and on the rise,” Zandi warned.
“In response, builders are pulling back, and permits have started to slump. They are now as low as they’ve been since the pandemic shutdowns.”
Last month, the Census Bureau reported that residential building permits in July were at a seasonally adjusted annual rate of 1.35 million, down 2.8% from the prior month and down 5.7% from a year ago.
In fact, the Federal Reserve has already started to worry about the housing market. Minutes from the central bank’s July meeting revealed concerns about weak housing demand, rising supply, and falling home prices.
And not only did housing show up on the Fed’s radar, officials flagged it as a potential risk to jobs, along with artificial intelligence technology.
“In addition to tariff-induced risks, potential downside risks to employment mentioned by participants included a possible tightening of financial conditions due to a rise in risk premiums, a more substantial deterioration in the housing market, and the risk that the increased use of AI in the workplace may lower employment,” the minutes said.
Permits aren’t the only housing market data point to follow. The economist Ed Leamer, who passed away in February, famously published a paper in 2007 that said residential investment is the best leading indicator of an oncoming recession.
On that score, the data doesn’t look good either. In the second quarter, residential investment tumbled 4.7%, accelerating from the first quarter’s 1.3% decline.
Conclusion
Despite the perceived risks, it is hardly a foregone conclusion that economic calamity awaits the U.S. markets. In fact, an optimistic take would be that the enormous A.I. infrastructure investments already underway will create a revolution in productivity. And strong earnings might make already-high stock prices go even higher.
Furthermore, the Fed has identified the stagnant housing market and its affordability problem as an economic risk. Lower mortgage rates, to which the Fed has considerable influence, would go a long way in helping this vital economic sector revive. Indeed, Fed rate cuts are expected in the near future.
A less sanguine view might be that vast sums of money are being wasted on a technology that won’t fulfill its backers’ dreams. Furthermore, stock prices were already so high they were bound to fall, and the current administration’s actions could damage the markets and the economy.
Obviously, our hope is that the recession will be avoided. The stock market is a leading indicator, and its strength is a good sign. That said, it would be foolish not to acknowledge the risks.
Portfolio Strategy
As we have just outlined in this article, the markets are facing risks. And when we look around and see economic problems like a declining housing market and slumping confidence, coupled with a stock market that continues to march higher — a market that is being fueled by an emerging and highly promising new technology, but one that is still unprofitable — our concern grows.
However, and we can not stress this enough, being able to predict when the market will tumble is nearly impossible. Knowing when to sell and also when to buy back in is not a realistic expectation. An investor will invariably sell out and miss gains, or fail to buy back in when stocks are low. Or, the worst of both… sell out expecting a drop, only to see the market climb higher and buy back in at even higher prices.
The best strategy is to have sober expectations about the stock market. That is, over long periods of time, the stock market has proven to be a great investment that beats inflation and creates wealth. However, there will be periods when the market drops — sometimes by a lot — and this is to be expected. The key is to have an allocation to stocks that makes sense through good times and bad, as patience will lead to profits.