Morgan Stanley Warns of ‘Bubble-Like Euphoria’ Surrounding Artificial Intelligence

**The A.I. Hype: Investor Caution Amidst Bubble-Like Euphoria**

**The Short-Term Outlook: A Keynesian Beauty Contest**

In recent times, artificial intelligence (AI) has been surrounded by a great deal of hype. OpenAI’s ChatGPT chatbot, introduced in November, and the subsequent surge in generative AI startups have attracted significant venture capital investments. Correspondingly, stocks associated with AI technology, such as Nvidia, have seen a substantial increase in value. However, Edward Stanley, the head of thematic research in Europe at Morgan Stanley, urges investors to exercise caution amidst this “bubble-like euphoria.”

Stanley and his colleague, Matias Ovrum, have compared the enthusiasm surrounding AI to historical market bubbles, aiming to provide guidance on how investors should approach this theme. While they acknowledge the long-term potential of AI, believing it to be transformative across industries and one of the most prominent investment themes of the coming decade, they also recognize the elevated valuations and hype cycle debates surrounding AI-linked equities, particularly the remarkable performance of Nvidia, whose stock has surged by nearly 200% this year.

Drawing from research into past market bubbles, including the dot-com bubble and the post-COVID “everything bubble,” Stanley advises against hasty investments in high-flying AI-linked stocks in the current year. He emphasizes that history has shown multi-year themes, like AI, seldom require immediate action from investors.

**In the Short-Term, the A.I. Hype Resembles a Keynesian Beauty Contest**

Stanley cautions that while AI showcases long-term potential, short-term prospects may be less promising, as evidenced by historical data. For instance, the excitement surrounding search technology in the late 1990s warranted attention. However, investors could have waited until 2003 to gain a better understanding of the likely winners and still capture over 90% of the equity upside with greater downside protection.

Analyzing market bubbles across the last century, Stanley and Ovrum find that the recent surge in Nvidia and U.S. large-cap tech stocks due to AI has been even more dramatic than average. Utilizing Nvidia or U.S. Large Cap Tech as proxies, the analysts caution that tactically, this rally appears to be reaching its later innings.

In describing the recent market euphoria for AI, the Morgan Stanley analysts invoke the analogy of a Keynesian beauty contest described by economist John Maynard Keynes. Keynes proposed that in such a contest, participants select the most beautiful woman from a group of photographs. However, instead of picking the woman they personally consider the most beautiful, voters aim to predict the woman who the majority of voters will choose as the most beautiful, potentially to secure a cash reward. This behavior, termed “herding,” is frequently observed in markets and contributes to the formation of bubbles. Investors purchase stocks based on the perception that others will do the same, without conducting fundamental analysis. Stanley and Ovrum contend that this “annual beauty contest” phenomenon is fueling the current boom in the AI stock market.

With the euphoric rise in AI stocks and a recent slowdown in significant AI product releases, Stanley suggests that cautiousness on the theme is advisable in the second half of the year.

**The Long-Term Outlook: AI’s Potential Shines Through**

Despite the need for caution in the short term, the long-term narrative for AI remains promising. AI continues to be the dominant investment theme of the decade.

Stanley’s research highlights strong indicators of consumer and enterprise “stickiness” compared to previous hype cycles, citing impressive user adoption of open-source AI models. For example, the top 100 models at Hugging Face, the leading repository for open-source AI models, were downloaded 3.5 billion times since January 2021. Stanley describes the current phase of trial-and-error in leveraging these models to build killer apps as exponential.

To evaluate the long-term potential of AI-linked stocks in light of AI technology development, Stanley and Ovrum compare the modest year-to-date increase of AI indexes in 2023 to past bubble expansions. They indicate that bubbles tend to rally a median 154% in the three years prior to their peak, with an average increase of 217%. While the first derivative AI winners have experienced over a 200% rally year-to-date, broader AI indices have shown a more modest 50% gain, still below prior 2021 highs. Stanley and Ovrum argue that the “stickiness and breadth of diffusion set AI apart from prior hype cycles.”

Stanley concludes by asserting that the relative restraint in AI stock indexes, compared to past bubbles, confirms AI to be one of the most attractive secular themes in the market. However, careful consideration is essential for investors when deciding when and where to allocate their investments.

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