Have we found ourselves in a stock market bubble?

History does not repeat, but it rhymes. I was reminded of this truism recently when I compared the recent stock market performance of Nvidia with that of Cisco Systems in the two years leading up to the bursting of the dot.com bubble in 2000. The similarity of the two charts is striking. 

In both cases, the share price trebled in a matter of a few months, then paused for breath for a few months more before turning left up the page as the fear of missing out sucked in the doubters. Nvidia had risen by more than 50 percent since the start of the year before this week’s wobble. Both companies’ shares increased seven-fold in less than two years. Nvidia remains close to its all-time high, and what happens next is one of the most important questions in investment right now.

In the case of Cisco, however, we have the benefit of hindsight. We now know that in the two years after its share price peaked it fell all the way back to where it started. Between March 2000 and September 2001, Cisco’s shares tumbled from US$78 to US$11, a loss of 86pc for anyone who had bought at the peak. It has taken a generation for enough of those who lived through the bursting of the last bubble to retire and make way for a new group of converts.

The echoes of 1999 are all around us, although there are some important differences too. The similarities include a narrow market leadership - the so-called Magnificent Seven group of leading tech shares that includes Nvidia accounts for around half of the S&P 500’s gains so far in 2024. Collectively, the companies represent a quarter of the value of the US stock market. The market 25 years ago was similarly dominated by a handful of internet-related stocks, including Cisco.

Then as now, investors fixated on the power of the new. In the late 1990s it was the internet that was going to change everything. Today it is artificial intelligence (AI). In both periods, valuations of companies expected to benefit from the perceived paradigm shift diverged from those of the also-rans operating in the ‘old economy’. It is very likely that in due course today’s AI bubble will go the same way as 1999’s technology, media and telecoms (TMT) boom. But waiting for that to happen will be hard. Watching from the side lines could be quite as painful as missing out on the final stages of the dot.com bubble.

A bubble is a speculative frenzy, usually driven by the promise of an economic and financial revolution, in which share prices massively exceed the underlying value of the companies that issued them. It is not just about overvaluation. It requires the abandonment of tried and tested fundamentals, a loss of reason. It is a mania that appears regularly but infrequently. A quarter of a century on, we are probably due one.

How does the current situation measure up on five key indicators of a nascent bubble? The first sign - the widespread adoption of a ‘new economy’ story - looks to be in place. The potential for AI to change the world is unproven but you would be hard pushed to find many people who don’t think it matters. Most of us are enthralled and scared by AI in equal measure. 

Related to this revolution narrative is a generational divide that drives a wedge between old guys like me who ‘don’t get it’ and young believers who do. Many of us have already had a taste of this via heated dinner-table debates over the merits of investing in bitcoin. The mantra that ‘it’s different this time’ famously links the four most dangerous words in investment.

In order to justify the ‘now is different’ argument, true believers need to invalidate the valuation framework into which old-style sceptics retreat. The easiest way to do this is to invent a new set of metrics that fit the bullish case better. In the dot.com bubble, we were told to dispense with outdated measures like price-to-earnings ratios and look instead at price-to-clicks or ‘eyeballs’. I recently came across a new expression: ‘price to innovation’. Alarm bells quickly rang.

A fourth indicator that trouble is brewing is when prices continue to rise even when news flow turns negative. When investors become selectively deaf, you can be sure a bubble is inflating. The recent fourth quarter results announcements from the Magnificent Seven were a mixed bag. Investors are choosing to see what they want to. Another potential red flag.

A final sign that we may be in a bubble is when investors, flush with their stock market gains, look for opportunities in other risky assets. Watch out for new asset classes to emerge, usually investments that offer no cash flows or asset backing but which rely on the ‘greater fool theory’ that someone else will pay an even higher price than you. The 1980s bubble in Japan was characterised by this contagion from stocks to property then impressionist art and golf club memberships.

Spotting a nascent bubble is one thing. Navigating it is another. The easiest, and most psychologically painful, approach is to stand back and let others enjoy the ride. Good luck with that. Resisting the temptation to join in the final stages of a bubble is near impossible.

I think that if we are in a bubble, it is still young. The valuation premium is well short of the level reached in 1999 or even in the early 1970s when the most popular shares were priced nearly twice as expensively as the rest of the pack. We are a long way off that today. Sentiment is not yet universally positive. When it becomes so, it will be time to worry. We’re not there yet.

Tom Stevenson is an investment director at Fidelity International. The views are his own.