The stock market’s AI-fueled upswing

The stock market has been on a remarkable upswing in recent years. The S&P 500 has increased by about 57% in the past two years and more than doubled over the past five years. This surge in value has led some to reconsider their retirement plans and others to indulge in more lavish expenditures. Many ask whether this growth is sustainable or represents a bubble fueled by temporary hype, particularly around emerging technologies like Artificial Intelligence (AI). A concerned reader inquired: “The market seems to be in a huge bubble right now due to all sorts of hype around Artificial Intelligence. Does this make it more vulnerable to a huge crash in the future, and will it affect my retirement?” To understand the current market dynamics, revisiting what a stock fundamentally represents is helpful. A stock is a convenient version of a rental house—both are investments that generate income. For rental properties, the income is rent, and for stocks, it’s corporate earnings. The price paid for these investments should ideally reflect the future income they generate. If you had invested $100,000 in the stock market in 2019 and reinvested the dividends, your investment would now be worth approximately $256,960—a 157% gain. However, the corresponding earnings have only grown by 42%, leading to an increase in the Price-to-Earnings (P/E) ratio from 20 in 2019 to 30 today. This suggests that future returns as a percentage of the portfolio value will likely be lower.

Market dynamics and AI-driven growth

The recent market euphoria can be primarily attributed to the impressive performance of the “Magnificent Seven” companies: Apple, Nvidia, Microsoft, Amazon, Google (now Alphabet), Meta (formerly Facebook), and Tesla. These companies have driven a significant portion of the market’s growth, constituting over 25% of the S&P 500’s total value. Their P/E ratios are much higher than the rest of the market, indicating high expectations for future growth. A major driver behind the rise of these tech giants is the advancement in AI technology, which has revolutionized multiple industries. Companies are investing billions in AI infrastructure, and this enthusiasm has spurred substantial market gains. AI’s potential to enhance productivity and profitability is enormous, affecting everything from automated legal reviews to medical diagnostics and even autonomous driving. Despite the optimism, the future is uncertain. Potential issues such as cost overruns, increased competition, or unforeseen technological challenges could dampen these high expectations. Additionally, the broader societal impact of AI, such as job displacement, raises questions about long-term economic stability. Ultimately, no one can predict the future with certainty. Historical trends show that the US economy grows at an average rate of about 3% annually after inflation. While past performance provides some guidance, the unique circumstances driving today’s market make it difficult to forecast precisely what lies ahead. Investors should remain cautious and consider the potential risks and rewards, balancing optimism with realistic expectations. Image Credits: Photo by Yorgos Ntrahas on Unsplash