Shutdown, But Not Shut Out

The longest government closure in U.S. history was in Trump’s first administration, lasting 35 days in late 2018 into 2019. During that period, the stock market rose roughly 10%, but do not read too much into that. The fourth quarter of 2018, and especially December, was a painful period for the stock market, so that 10% return was calculated off of a low base. But the point remains valid. Economic fundamentals are far more important to the stock market than temporary government closures. The reason is that shutdowns are typically short-lived, as one political party eventually capitulates to avoid public backlash. As a result, the market’s attention remains focused on more impactful trends, which today is the development and adoption of AI.

The AI Boom vs. the Dot-Com Boom

A critical question facing investors is whether the current AI boom mirrors the dot-com bubble of the 1990s. In our view it shares both similarities and differences. To understand this dynamic, it is helpful to review the factors that fueled the dot-com boom and its subsequent bust.

The Boom

The dot-com boom was likely triggered by the 1994 introduction of Netscape Navigator, the first commercial web browser, which provided easy access to the internet to the masses for the first time. This period was also characterized by a flood of available venture capital, stable interest rates, and supportive government policies. This environment led to a proliferation of new companies promising to “change everything” via the internet. This created a high-stakes race for “first-mover advantage,” driving frenzied capital investment and rapid demand for new infrastructure like fiber optic networks. While the market correctly predicted the internet’s transformative power, it fundamentally misjudged the timeline and specific mechanics of its evolution.

The Bust

The dot-com bust began in March 2000, but in retrospect, warning signs were apparent long before. These included warnings of a highly concentrated S&P 500 Index which had the top ten largest stocks by market capitalization make up approximately 40% of the total value of the Index at the end of 1999, many of them leveraged to the internet boom; the widespread lack of profitability among internet companies; the Federal Reserve’s interest rate hikes beginning in mid-1999, and increasing insider selling. Despite all these classic red flags, investors largely ignored them, allowing valuations for both profitable and unprofitable “internet related” companies to soar. Wall Street employed increasingly creative metrics to justify these dizzying valuations, fueled by media coverage and speculative behavior. The easy flow of capital, which had driven the boom, was ultimately unsustainable without a clear path to generate returns from these investments. The eventual reckoning was, as with all bubbles, difficult to halt once it began.

Comparing the Dot-Com Era with the AI Era

The biggest difference this time around is that the large tech companies leading the charge are highly profitable. They are the survivors and/or outgrowths of the dot-com bust. Amazon and Microsoft were dot-com survivors. Microsoft had a lock on the PC world with Windows and Office to cushion the dot-com bust. Apple introduced the iPod in 2001, as a wildly successful product to utilize the internet. Google went public in 2004, successfully challenging the dominance of Yahoo! as the web portal of choice, another profitable outgrowth of the dot-com era. Meta (Facebook), another profitable utilization of the internet, was founded in 2004. Since then, all of these companies have grown rapidly and become highly profitable. Valuations today may be elevated, but they are certainly not outrageous. This profitability provides a crucial safety net.

Despite the difference in core profitability, there are several key similarities. Many smaller, less established AI firms have inflated valuations based on future growth projections, and many have little or no profits, and some have little or no current revenue. Some of these are likely to successfully transition from development to commercialization, but others are likely to fail that test. It is difficult to handicap winners and losers at this point, so we recommend taking a broad approach to investment in this area, as opposed to picking out one or two winning bets. If AI is indeed transformative, the winners in a broad portfolio should more than offset the losers.

Another similarity is the trend to overinvestment in core infrastructure. In the dot-com era, telecom companies (particularly Global Crossing) significantly overbuilt fiber optic networks based on unrealistic projections of internet traffic growth, resulting in large losses for many telecom companies (and the Global Crossing bankruptcy). The rapid expansion of data center construction by the “hyperscalers” (Amazon, Alphabet, Microsoft and Meta) – could be prone to similar problems. The AI race is largely considered a ‘winner takes most’ opportunity, driving ever increasing spending to stay in the race. The potential for over-investment in a race to beat the others is obvious. The fail safe is the highly profitable core businesses of each, however, the potential for a painful reset is a real possibility.

While no two financial bubbles are identical, they often share common traits. In the face of increasing speculation regarding the impact of AI and technology broadly, we continue to believe we are in the midst of several decade-long technology megatrends (AI, Genomic and Proteomic Engineering, Quantum Computing, Autonomous Vehicles, Robotics, and Blockchain among them) that are affecting many sectors of the economy and creating others.  We are cognizant that these trends are unlikely to go straight up, taking breathers or having corrections, and thus we expect downside volatility will occur along with this upside run. In the interim, we remain focused on seeking value in our investments while selectively participating in the wealth creation opportunity.

Have a great week!

 

What We’re Reading

  

Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance is no guarantee of future returns.

, , , , , , ,

General News

By: palumbo