Is the Stock Market in a Bubble?

“May You Live in Interesting Times.” -Source Unknown

The state of Artificial Intelligence (AI) and its impact on financial markets and the economy is an endlessly interesting debate. When a (relatively) new technology appears on the scene, it is a very human response to search for historical analogs to make sense of how the future may unfold. Of course, the most salient analog for today’s technology-driven market is the dotcom and telecom bubble of the late 1990s.  

I am not going to weigh in on whether the stock market is in a bubble or not (sorry for the head fake in the title of this blog). I have seen plenty of well-reasoned arguments that make the case both “for” and “against” the bubble thesis. I’m sympathetic to the view that there are stark differences between today’s market and the dotcom bubble as well as some interesting similarities. Either way, history will not be a perfect road map to the future.

Instead, I’d like to zoom out and discuss the nature of financial bubbles more broadly and our fascination with them as a society. 

To set the stage, I’ll quote from a recent article by the economist Tyler Cowen: 

“From the point of view of an investor, it matters whether or not we’re in an AI bubble. But if you are seeking to understand long-term social and economic trends, the bubble question is primarily a matter of short-term interest and timing. It will not decide where the economy is headed long-term.

Instead, what we are seeing is that America, at the drop of a hat, can turn on a dime and reallocate capital on an unparalleled scale, to our great and enduring benefit. Unless you were around to witness World War II, none of us have seen anything like this before. Do not expect the ride to be smooth or predictable, but feel free to sit back and enjoy: This is history in the making.”

There is a lot of handwringing about the amount and sustainability of capital investments being made by large tech companies (Microsoft, Google, Meta, etc.) into physical infrastructure. Yet not long ago, it seemed like society’s complaint with corporate America was that they were allocating too much capital to stock buybacks and not allocating enough capital to the “productive” economy! 

To reiterate Cowen’s point above: It is remarkable how quickly capital has been reallocated to new opportunities, largely tied to the thesis that AI will transform the world. Large investments will be needed to get there, and no single actor can omnisciently harness the capital that is necessary to make these investments. 

How, then, does the large-scale reallocation of capital take place? 

In 2024, Byrne Hobart and Tobias Huber wrote the book Boom: Bubbles and the End of Stagnation. The thesis of the book is that “technological breakthroughs and scientific megaprojects share an underlying dynamic with financial bubbles in one very specific sense: they coordinate behavior to build a complex future.” (My own emphasis added). 

The idea of social coordination is a fascinating aspect of bubbles. Our world is vast and complex. Particularly as societies become wealthier, we become risk-averse and prone to stagnation. To overcome that stagnation, Hobart and Huber argue that bubbles are on net a positive social good that align people and resources to build a unique vision of the future. 

To be sure, financial bubbles do result in excess, delusion, and wealth destruction. Some people blindly wade into the midst of a bubble out of a fear of missing out on life-changing financial returns, only to find that there is often a huge distinction between being right about where the world is heading and being able to make money off that knowledge. 

This is in part because during a bubble, capital often flows to opportunities that have a high potential payoff with a low probability of success. That is why a lot of investor behavior during a bubble may appear to be, or in fact is, quite irrational (particularly if one’s default position is to avoid or mitigate risk in life).

As an example of this phenomenon, the tech analyst Ben Thompson recently interviewed the founder of Substrate, a company that is trying to rebuild part of the semiconductor manufacturing process with x-ray lithography, a technique that could ultimately challenge the near monopoly that ASML and TSMC have on the use of extreme ultraviolet lithography. As Thompson wrote in a recent article, The Benefit of Bubbles:

“What is exciting about the last few weeks, however, is that there is attention being paid to other parts of the [AI technology] stack, beyond LLMs. For example, last week I interviewed Substrate founder James Proud about his attempt to build a new kind of lithography machine as the center of a new American foundry. I don’t know if Proud will succeed, but the likelihood of anyone even trying — and of getting funding — is dramatically higher in the middle of this bubble than it would have been a decade ago.” (My own emphasis added).

If a company like Substrate is successful in rearchitecting parts of the semiconductor supply chain, it may dramatically lower the cost of manufacturing advanced chips and alleviate the choke point that companies now face with their reliance on Tawain (TSMC). Furthermore, China now has a technical lead on vast parts of the semiconductor ecosystem. The chart below shows that over the last 15 years the U.S. has almost completely lost the leading edge in semiconductor wafer fabrication.

Source: Substrate Our Purpose

Substrate’s success in this endeavor with x-ray lithography is a low probability outcome. Semiconductor manufacturing is the hardest technical manufacturing feat that humans have ever achieved at scale. However, the potential payoff to investors in Substrate, and the long-term benefits to society writ large, may ultimately be priceless. 

I do not want to downplay the concerns that an AI-fueled bubble in financial markets, and its ultimate collapse, would be a scary and disruptive event. When the pendulum swings too far in one direction, it will eventually swing back even harder in the other direction. As we have noted in prior blogs, the stock market’s returns are not normally distributed, and to achieve “average” returns over a long period of time is an uncomfortable endeavor. 

Despite these challenges, it is worthwhile to reflect on the fact that with everything going on in the world of technology today, we are witnessing history in the making.