AI has been driving huge gains in the stock market, but its impact is just scratching the surface.
The artificial intelligence (AI) boom has driven the stock market to record heights in recent years, pushing AI stocks like NVIDIA (NASDAQ:NVDA), Broadcom (NASDAQ:AVG), and Palantir (NASDAQ:PLTR) to outsized returns.
But the impact of AI on the markets and economy is just scratching the surface of its potential, wrote Vanguard Global Chief Economist Joe Davis in a new report.
“I am optimistic about the future of AI,” Davis wrote. “There’s a meaningful chance for it to drive significant gains in productivity and economic growth over the coming decade or so. But we are not yet in the AI boom.”
In fact, Davis said Vanguard does not expect to see the “peak effects” of AI on productivity and economic growth until the 2030s.
Impact beyond Silicon Valley
Currently, the transformative nature of AI has occurred mostly within the technology sector. But when AI truly transforms the economy, said Davis, it will be when it most benefits companies outside the technology sector.
“In my estimation, the productivity unlocked across industries would be as if the 17 million baby boomers expected to retire between now and 2034 never do so,” Davis said. “Indeed, if AI proves transformative, every company on the planet will benefit—not just those in Silicon Valley.”
Davis drew parallels to the late 1990s, early 2000s dotcom boom. The innovative small cap tech stocks of the day grew into the mega cap leaders that dominate the markets today, as the Internet transformed the economy.
Yet, in March 2000, the bubble burst and the broad U.S. stock market suffered a near-50% decline over the next two-plus years, with technology stocks taking the biggest hits.
The major culprit was an overvalued stock market, based on what former Fed Chair Alan Greenspan famously called the “irrational exuberance” of investors in the latter half of the 1990s.
As Davis pointed out, transformative technological changes tend to lead to outsized overvaluations and corrections.
“Investors grow euphoric early on, then suffer disappointment when the new technology’s vast potential is not more quickly realized,” Davis wrote.
Ultimately, tech stocks thrived over the next two decades as this technology transformed the entire economy. But the late 1990s boom is not dissimilar to what we have seen over the last few years with another transformative technology, AI.
Stocks haven’t been this overvalued since 2001
It is impossible to predict exactly what is going to happen and whether the AI boom will follow the same pattern, but there are similarities.
The enthusiasm around AI stocks has created the most overvalued market since 2001, said Davis.
“In aggregate, U.S. stock prices are roughly 45% above the top of what I consider to be their fair-value trading range,” Davis wrote. “I would view stocks as overvalued even if we knew with certainty that artificial intelligence—the probable cause of investors’ recent enthusiasm—will ultimately transform every facet of human life, delivering economic benefits on par with the advent of electricity.”
This is particularly true within the technology and communication services sectors, where stock prices are high relative to expected earnings.
Moreover, large cap tech companies in the S&P 500 are, on average, 80% more expensive than the rest of the market by measure of their trailing price-to-earnings (P/E) ratios. Also, they are more than four times as expensive when measured by price-to-sales.
“Tremendously expensive AI-related shares combine with optimistic pricing in most other market segments to leave the overall U.S. stock market more overvalued than at any point since early 2001,” Davis said.
The Vanguard chief economist said some of the share price premium is justified for the potential of technology to drive productivity and profits. But at the same time, Davis called earnings growth expectations for the next three to five years “wildly optimistic.”
