Are investors bullish on the bear?

A couple of years back, everyone seemed convinced that we were witnessing the bursting of a colossal bubble. Interest rates were climbing after years of staying low, shaking up the foundations of almost every asset class. Share prices were plummeting, government bonds were taking a beating, and even the crypto markets were in a freefall. The prophets of doom on Wall Street couldn't contain their excitement. The consensus that had prevailed over the past decade, suggesting that inflation was a thing of the past and that cheap money was here to stay, now seemed as ridiculous as any other groupthink during past financial frenzies. It appeared that the pendulum was swinging - from exuberance to skepticism, from risk-taking to cash-hoarding, and from greed to fear. It seemed like this shift would take a long time.

But guess what? The lowest point for American stocks came in October 2022. And less than 18 months later, stock markets around the globe are soaring to record highs. America, in particular, is on an incredible run, with the S&P 500 index of large firms rising in 16 out of the past 19 weeks. Companies like Nvidia, which make microprocessors essential for artificial intelligence (AI), have seen their value skyrocket by over $1 trillion in just a few months. And as if that wasn't enough, Bitcoin hit another record on March 14th. Surprisingly, this is happening despite central bankers' aggressive efforts to raise interest rates back to more normal levels. So, once again, every conversation about the markets inevitably circles back to the same question: Are we in a bubble?

For many, the comparisons that come to mind aren't with the most recent bull market, but with the late 1990s dotcom bubble. Back then, as now, new technology promised to revolutionize productivity and profits, with the internet being the innovation of the time instead of artificial intelligence. Bulls in the 1990s were right that advances in telecommunications would change the world and create new corporate behemoths. But many still ended up losing big—even those who bet on firms that eventually became wildly successful. One classic example is Cisco, which, like Nvidia, made hardware crucial for the new age. Despite its net profit reaching $12.8 billion in the most recent fiscal year, up from $4.4 billion in 2000 (adjusted for inflation), those who bought shares at their peak in March 2000 and held onto them have seen a real-terms loss of nearly 66%.

Cisco illustrates the defining feature of bubbles. They inflate when investors buy assets at prices completely disconnected from economic fundamentals like supply and demand or future cash flows. The question of what the asset is "worth" goes out the window; all that matters is whether it can be sold later for more. And that depends on how many people the speculative frenzy can draw in and how long it can last—essentially, how irrational the crowd becomes. Once buyers dry up, the frenzy fizzles out, and there's nothing left to support the inflated prices. Predicting the size of the subsequent crash is as futile as trying to time the top.

But here's the good news: we're not quite there yet. Researchers at Goldman Sachs have analyzed the valuations of America's ten largest stocks in the S&P 500 index, which have been the center of the AI hype. With prices averaging 25 times their expected earnings for the coming year, they're on the pricey side. But they're cheaper than they were last year and a bargain compared to the peak of the dotcom bubble, when prices were 43 times earnings.

There are other signs too that, despite soaring share prices, euphoria is nowhere to be found. Bank of America's latest monthly survey of fund managers finds them more bullish than they have been in around two years, but not particularly bullish by historical standards. Their average cash holdings are low, but not extremely so, meaning they haven't gone all-in on the market (nor are they hoarding cash, expecting a crash, as they were in the late 1990s). Among retail investors—the crowd that typically fuels the final, most dangerous stage of a bubble—there's been no repeat of the rush into tech funds and meme stocks seen in 2021.

So, what would it look like if things were to take a euphoric turn? One strong signal would be for gains that have so far been concentrated in a few mega-cap stocks to spread more broadly through the market. The winning streak of the past few months has been dominated not by America's "magnificent seven" tech giants but by just four of them. Amazon, Meta, Microsoft, and Nvidia have left the other 496 stocks in the S&P 500 far behind. And those other stocks, in turn, have recovered from the beating they took in 2022 far better than the smaller firms represented in the Russell 2000 index. If investors really start throwing caution to the winds, expect them to start betting on riskier corporate minnows as well as on giants—especially those that manage to shoehorn the letters "AI" into their annual reports.

A corollary is that the pipeline of initial public offerings (IPOs) ought at last to start gushing. In both 1999 and 2021, rising share prices and ebullient investors proved irresistible to bosses in search of capital. A puzzling feature of the current bull market is that it's taken place amid an IPO drought. EY, a consultancy, estimates that firms going public in America raised just $23 billion in 2023, compared with $156 billion in 2021. It might be that bosses are simply more worried about economic headwinds than investors are. But in a euphoric market, such level-headedness becomes impossible to maintain.

Similar dangers haunt professional money managers, whose job is to beat the market whether or not they think it's behaving rationally. When certain pockets look dangerously overvalued, it makes sense to avoid them. But in a bubble, avoiding overvalued stocks—which, after all, are the ones rising the most—starts to look suspiciously like routine mediocrity.