This week in the markets: Is an AI bubble inflating?

The US market continues to push higher but beneath the surface some worrying divergences are showing up. The broadening out of the rally since last October looks to have run out of steam.

Bubble watch

The headline S&P 500 Index continues to look healthy. At nearly 5,500, it stands 25% higher than a year ago. Since the cyclical low in October 2023, the US benchmark is up 33%. But, as has been the case for much of the post-pandemic rally, the rise in share prices hangs on the performance of just a handful of companies.

Between October and March, it looked as if the dominance of the biggest companies - the Fab Five as they are starting to be called - might be coming to an end. The performance of the equal weighted S&P 500 Index (which gives equal importance to all 500 stocks rather than favouring the biggest companies) kept pace with the headline Index.

But over the past three months, there’s been a big divergence. Nvidia is up 45% and the Fab Five as a whole is up 11%. But the equal weighted Index is down by a couple of percentage points. The rally is looking increasingly narrow and fragile - and vulnerable to a change in sentiment.

Until recently, the performance of the big US tech stocks looked to be justified by superior sales and earnings growth - Nvidia has grown its revenues by 50% a year for five years now. That has kept a lid on valuations, an important distinction between the current market phase and previous periods of excess like the Nifty Fifty boom in the 1970s, the Japanese bubble in the 1980s and the period in the 1990s.

But over the past three months, the valuations of the leading stocks have risen by 20%. They are 50% higher than they were last October. The indications that we are entering an artificial intelligence (AI) stock bubble are growing stronger day by day.

Interest rate pivot

Meanwhile, the other big driver of the market - interest rate expectations - is in a holding pattern. Having started the year with forecasts of a string of rate cuts from the main central banks in the US, UK and Europe, the prospect of easier policy has been progressively kicked into the long grass as getting inflation back to target has proved more difficult than expected.

Now, the Fed thinks it might only cut rates by one quarter point increment before the end of the year and market expectations have fallen into line. Other central banks may want to cut rates, but they have to keep an eye on the exchange rate and so can’t get too out of kilter with the US. As ever the US Federal Reserve (Fed) has the whip hand.

This week could bring some good news on the inflation front and potentially cement expectations for the long-awaited interest rate pivot. The personal consumption expenditures index - the Fed’s preferred measure - is expected to fall marginally to 2.6% (from 2.7%) when it’s unveiled on Friday.

Slowly but surely, the US is heading back to the Fed’s 2% inflation target, just as the UK inflation also fell back to target last week. In both countries, however, the main preoccupation is not the headline rate but the underlying picture of wage and service sector inflation. That’s what determines the underlying rate of inflation and it’s what the central banks are watching most closely.