History demonstrates that investment booms have frequently preceded economic downturns, and several early warning signals can help identify such trends. One critical factor to monitor is the potential decline in the marginal return on investments. As capacity expands, the returns on new investments tend to diminish due to overcapacity. A concerning indicator is that business investment in Information processing equipment & Software as a percentage of GDP has already surpassed the peak observed in 2000. This development alone warrants attention.
Another key area to watch is how stock prices react when companies announce major investment projects. For instance, Oracle’s recent quarterly capital expenditure announcement provides an insightful case study. While the figures exceeded expectations, the company’s stock price declined following the announcement. It is worth noting that Oracle has faced pressure in recent months, partly due to its already high debt ratios. However, this situation does not necessarily apply to other major investors in the AI sector. It is essential to monitor whether less indebted companies also experience stock price declines following announcements of major investments.
Expected wave of initial public offerings
This could serve as an additional warning signal. On a positive note, the current investment boom is expanding beyond the technology sector, reflecting a broader trend.
Another notable parallel with the internet boom is the expected surge in initial public offerings (IPOs), particularly following last week’s IPO of SpaceX. Historically, the number of IPOs rose sharply in the months leading up to the internet bubble burst in 2000. A critical lesson from that period is to closely observe post-IPO price behaviour, specifically the difference between the IPO price and the Volume Weighted Average Price (VWAP) in the months that follow. If this difference turns negative, it could signal cause for concern. Since its IPO on Friday, SpaceX’s stock price has risen sharply. While this trend is still in its early stages, it is crucial to closely monitor upcoming IPOs, such as those of OpenAI, Anthropic, and others. We need to monitor whether several IPOs begin to exhibit negative price dynamics.
A valid critique when comparing the current market to the internet boom is that many companies during that era went public without being profitable. However, valuation criteria – particularly price ratios – remain essential. One key metric to watch is the price-to-sales ratio, which allows for the valuation of companies that are not yet profitable but are expected to become so.
For context, Apple and Google entered the market with a price-to-sales ratio of around 10, while Meta’s ratio was approximately 28 at its IPO. For SpaceX estimates are even above 90. Keeping an eye on this metric will provide valuable insights into market expectations and potential risks.
Means to invest in the AI theme
One way to invest in the AI theme while limiting risk is to focus on companies that supply the tools and services required by generative-AI providers. This “pick-and-shovel” approach borrowed from the Californian gold-rush era suggests that backing the manufacturers of equipment and infrastructure (the pick-and-shovels) can be less risky and more rewarding than financing the developers of the AI themselves (the miners). Indeed, it is likely that not all developers will survive in the long-term.
We see opportunities in two fast-growing areas of AI – related technology that are currently attracting significant and lucrative investment. First, the power generation, transmission and cooling systems needed to meet the soaring energy demands of AI data centres are witnessing rapid expansion. Second, “agentic AI”, the next generation of artificial intelligence capable of autonomous learning, flexible decision-making and adaptation to novel situations, offers transformative potential that could touch virtually every industry. While automation and robotics remain important, agentic AI is likely to enable a broad spectrum of innovative applications and use cases.
Investors need to be cautious, as traditional valuation tools are again reaching very high levels in some sectors. In addition to the price-to-earnings ratio, investors should follow some lessons from the internet bubble and also focus on the so-called PEG ratio. It was initially mentioned by Mario Farina (1) and later popularised by Peter Lynch (2). It is simply the price-to-earnings ratio divided by the expected growth rate of earnings (in real terms). Generally speaking, a company with a PEG ratio of 1 is broadly considered as fair valued. A higher PEG ratio suggests a higher valuation and vice versa. A PEG ratio is still a simplistic approach using important assumptions and should be used in combination with other valuation tools.
(1) Mario V. Farina, “A Beginner’s Guide to Successful Investing in the Stock Market”, Investors’ Press, 1969.
(2) Peter Lynch, “One up on Wall Street: How to Use What You Already Know to Make Money in the Market”, New York: Simon & Schuster, 1989.
