Should Investors Be Worried About an AI Bubble? Here’s What History Says.

Financial history is filled with bubbles, going all the way back to the Tulip Bulb mania in the 17th century. There are entire books written about how investors frequently take good investment ideas and push them way too far. To think that artificial intelligence (AI) will somehow avoid the same fate is shortsighted. And the best evidence comes from the last technology-related bubble.

The internet changed the world, but Wall Street still crashed

At the turn of the century, Wall Street was enamored of internet stocks. Companies would simply append “.com” to their names to gain investor attention. And far too often it worked! The technology has, in fact, changed the world. But that doesn’t mean investors who bought into the emerging bubble at the time made out.

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The S&P 500 index (SNPINDEX: ^GSPC) fell more than 45% after the bubble burst. The technology-heavy Nasdaq-100 lost more than 80% of its value. It was a brutal period for investors, and the downturn was clearly led by technology stocks. The very same stocks that inflated the bubble in the first place.

The poster child for the dot-com crash is Cisco (NASDAQ: CSCO). Its stock took roughly a quarter of a century to recover from its decline. The Nasdaq-100 “only” took around 15 years. But the problem wasn’t the technology. The problem, as it has always been, is investor emotions.

SPY data by YCharts

When Wall Street gets an idea in its teeth, it runs with it. Usually, it runs too far. Early investors make a lot of money, which leads more investors to jump into the space, fearing they are missing out on big gains. Eventually, emotionally driven investors push stock prices beyond what most would consider reasonable valuations. But people believe they can get out before the bubble bursts. Some do, but trees don’t grow to the sky.

At some point, it becomes clear that too much capital was wasted on projects that won’t produce the promised returns. Why? Because companies were indiscriminately throwing money at the technology because that’s what investors were demanding.

The signs of a bubble are here

Nvidia (NASDAQ: NVDA) is a well-run chipmaker with impressive technology. But it is subsidizing its customers in unique ways that are bolstering demand for its AI chips. Market watchers are already questioning these arrangements. History shows that spending on AI will likely be overdone, leading to supply outstripping demand and capital investment projects that don’t live up to expectations. When that happens, the bubble is likely to burst.