The observation that “history doesn’t repeat itself, but it often rhymes,” is often attributed to Mark Twain. Whether he said it or not, the financial markets are replete with examples of this phenomenon. One such rhyming episode may be playing out right in front of our eyes. The markets today feel similar to the second half of the 1990s, when enthusiasm in the stock market for technology stocks drove an upsurge in prices of such companies, which, in turn, led the market to new highs. During this period, now known as the dot-com bubble, then chair of the Federal Reserve (Fed), Alan Greenspan, was moved to use the phrase “irrational exuberance” to describe a market in which he thought investor enthusiasm for “dot-com” companies, both large and small, was too great relative to their fundamentals.

In the end, Greenspan’s cautionary words were on point. The dot-com bubble continued even after his warning and did not burst until the first quarter of 2000. The proximate cause of that bursting was (ironically) itself a technology issue. For about 18 months before the turn of the millennium, the Fed had been worried that many computer systems would not be able to cope with changing the first two digits of the year from 19- to 20-. The concern was that this would cause computer systems around the globe to crash, possibly crippling all financial systems.¹

As a result, the Fed provided substantial quantities of money to the banking system, if for no other reason than to assure that there was sufficient cash to function should any glitches materialize. As there was far more liquidity than the economy required, these surplus (precautionary) funds found their way into the stock market. (Who’d have thunk?) A strong bull market found another source of “fuel” to propel it to record levels. When the millennium turned, and nothing happened—everyone’s systems had fixes installed and there was no difference in the function between 23:59:59 31 December 1999 and 00:00:01 1 January 2000—the Fed’s first reaction was a sigh of relief. Its second reaction was to begin to drain those excess reserves, the same ones the stock market had industriously used to fire up the bubble in tech stocks.

Like the cartoon character Wile E. Coyote chasing the Road Runner over the cliff, nothing happened at first. It took the technology-heavy NASDAQ Composite Index until March 10, 2000, to peak at 5,048 while the S&P 500® Index peaked two weeks later (March 24, 2000) at 1,527.²

When that downturn was finally over on October 9, 2002, the NASDAQ was down 78% and the S&P 500 had fallen 49%. The S&P did not reach a new high until 2007, but the NASDAQ, heavily weighted towards tech, did not surpass its dot-com bubble peak for 15 years (April 23, 2015).³

There are two key points to be taken here. First, the market has a well-established history of letting its enthusiasm for the fad du jour, like the promise of the dot-coms and the Internet, run way too far ahead of what is realistic. This is something that investors, as opposed to speculators or day traders, have to keep in mind. When we buy the shares of any company for client portfolios, we are not buying that company. Rather, we are buying fractional interests in the profits (and dividends) that the company can generate at the price at which the market has decided to value those cash flows. Sometimes Mr. Market (a personification of investor sentiment) is deeply depressed about the prospects for those future earnings opportunities, and he will sell them at unduly pessimistic valuations. Sometimes, he is very excited by what a company can achieve, and the price he wants for his participation discounts not just growth into the foreseeable future, but growth as far out as the hereafter. Mr. Market can be nuanced, of course. While he was very excited about the outlook for just seven stocks in 2023, he was dismissive about the vast majority of other stocks.⁴

The second point to be made is a bit more serious. It is fun to talk about a mythical Mr. Market and his mood swings, but what these episodes reflect is not just “people gambling in the stock market.” It is the function of capital markets to allocate capital to its most productive uses. The best way to draw capital to work is to give people a reason or hope that extraordinary returns are available in a sector or industry. A large number of people independently reaching the same conclusions—even if they are being influenced by the same commentaries—will likely prove to be a more efficient way to allocate capital compared to authoritarian economies in which a central planning board makes such choices. See if you can guess what country I am referring to! (A hint: it is a country that has a five-letter name, beginning with “C”.)

So where is the rhyme to give us our pairing? What does the brief history lesson of the dot-com story have to do with the markets we encounter today? The comparison lines up this way. First, we have the raw ingredients for a bubble to form—the new technological breakthrough of artificial intelligence (AI) that appears to have transformative capabilities. It has been next to impossible in the past 12 months to read anything related to the financial markets without encountering story after story about how implementing AI will transform our economy. One cannot pick up newspapers without reading how AI will transform medicine, reduce many forms of drudgery paperwork, and facilitate new forms of visual entertainment. The list is endless. It is thought to be so transformative that serious debates go on as to whether AI requires special controls by governments over its implementation. Concerns are raised about how AI will transform warfare or disrupt elections, or even go far as to bring the premise of the “Terminator” movies to a reality. Without being facetious, a survey of Wall Street research at the moment is wall-to-wall about the promise of AI. Being only a tad cynical, the range of opportunity that AI promises grows only slightly more slowly than the rise of any stock that has even a tangential degree of attachment to AI in its business model.

For our part, we think the promise of AI is significant. At the same time, we think something as substantive as AI will take much longer to evolve and for the “killer app” or apps to be developed. The true ubiquity of the Internet in the lives of people around the globe really did not begin to take hold until the introduction of the first smartphone (one that combined a phone and web-browsing capabilities), Apple‘s iPhone in 2007. That said, there can be no denying the bullish commentary we hear from all the companies involved in this space, whether semi-conductor manufacturers, companies that sell equipment to the semi companies, companies that will sell products and services based on AI technology, or even utilities that provide power for AI-enhanced data centers.

At the same time, we have an abundance of fuel being injected into the system, thanks to government stimulus. We have written in many recent newsletters about the policy decision on the part of the central banks of the world, led by our own Federal Reserve, to drive interest rates to zero and hold them there for a prolonged period. We have suggested that history will see this as a major policy error that caused a rise in financial assets far larger than the underlying fundamentals warranted. Among the unintended consequences of this policy regime have been an increase in wealth inequality and an environment in which assessing risk and pricing it correctly has been significantly corrupted by market participants. To this dangerous stew, massive amounts of fiscal stimulus are being added. It would be hard to argue that the current pace of deficit spending is sustainable for a prolonged period. We note that neither candidate for president appears to be worried about it.

Other causes for concern that occur to us come from fundamental economics. Hints of a weakening consumer, particularly in lower income segments, are reflected in growing delinquency rates in credit card and auto loan data. In addition, there is a very serious problem looming in the form of commercial real estate loans that are likely to go into default this year as the result of remote work. Finally, an economic slowdown and deflation continue to plague the Chinese economy. Factors such as these are suggestive of cracks in the global economic foundation. While the outcome of these concerns remains an open question, current valuations in the stock market indicate that equity investors see nothing but clear skies ahead.

Valuation is a weak tool for market forecasting, but over the longer run, it can at least be a useful indicator. Refer to the following chart: forward price-earnings (P/E) multiples on stocks do not appear to have any predictive power in a 12-month period as the chart on the left suggests. The linkage between forward P/E ratios and returns over five years, however, suggests that there is something to Benjamin Graham’s dictum that in the short run, the stock market is a voting booth, but in the long run, it is a scale.

And while “let the good times roll” seems to be the current watchword, we can only add, “…but remember to leave the party a little early because it tends to get rowdy at the end.”

The research assistance of Tom Dzien and Michael Chilla of CI SBH Asset Management in the preparation of this essay is appreciated.