The stock market is overvalued by historical standards, but not to same degree as it was during the dot-com bubble.
The S&P 500 (^GSPC -0.16%) is commonly regarded as the best barometer for the entire U.S. stock market. The index has advanced 45% since January 2023, due in large part to enthusiasm about artificial intelligence (AI) stocks. Indeed, the five largest AI stocks delivered incredible returns during that period, as detailed below:
- Microsoft: 85%
- Nvidia: 745%
- Alphabet: 106%
- Amazon: 117%
- Meta Platforms: 305%
The gains in AI stocks have been so substantial that some analysts have drawn comparisons to the dot-com bubble, a period in the late 1990s when rapid price appreciation in internet-based stocks let to absurd valuations across the technology sector. The dot-com bubble collapsed in March 2000, and the S&P 500 declined 49% by October 2002.
Could the AI boom cause a similar stock market crash?
New technologies tend to follow the Gartner Hype Cycle
Consultancy Gartner developed the Hype Cycle to educate clients about a common pattern arising from technological innovations. The framework breaks the lifecycle of new technologies into five distinct phases, as described below.
- Innovation Trigger: A breakthrough technology like generative artificial intelligence (AI) captures public attention through widespread media coverage.
- Peak of Inflated Expectations: Enthusiasm leads to overly optimistic forecasts and adoption timelines, and the market develops unrealistic expectations regarding the new technology.
- Trough of Disillusionment: A backlash ensues when the technology fails to meet unrealistic expectations. Media coverage wanes and the market becomes overly pessimistic.
- Slope of Enlightenment: The market develops a deeper understanding for the technology, and companies find practical use cases that boost revenue and/or reduce costs.
- Plateau of Productivity: The benefits of the technology are supported by an abundance of data, and it moves toward mainstream adoption.
The dot-com bubble followed the Gartner Hype Cycle. The internet was the innovation trigger that led to inflated expectations, which itself led to absurd valuations across the technology sector. When the dot-com bubble burst, the market crashed and many analysts predicted the internet would fail.
However, practical use cases like e-commerce and cloud computing began to emerge shortly thereafter, and the internet has since become indispensable to the global economy. Artificial intelligence may follow a similar pattern, but the key word is similar. There is no guarantee the generative AI boom will trigger a stock market collapse that rivals the dot-com crash.
In 2023, Gartner estimated generative AI was nearing the peak of inflated expectations, and would reach the plateau of productivity within two to five years. If that timeline is accurate, AI stocks will probably lose momentum and suffer a drawdown during the next few years. But current valuations suggest the drawdown will be less severe than the dot-com crash.
Stock market valuations were more alarming prior to the dot-com crash
Many stocks are historically expensive today. The S&P 500 currently trades at 21.2 times forward earnings, a premium to the five-year average of 19.3 times forward earnings and the 10-year average of 17.9 times forward earnings, according to FactSet Research. But the S&P 500 commanded an even higher valuation of 25 times forward earnings around 2000.
Some investors are concerned about technology stocks in particular, but the discrepancy is even more pronounced within that sector. Specifically, technology stocks in the S&P 500 collectively trade at 29.7 times forward earnings today, but they traded above 55 times forward earnings in 2000, according to Yardeni Research.
Some investors are also concerned about market concentration, but the discrepancy persists among the megacap companies. In 2000, the five largest dot-com stocks — Microsoft, Cisco, Intel, Lucent, and IBM — traded at an average of 59 times forward earnings, adjusted for their relative sizes. Today, the five largest AI stocks — Microsoft, Nvidia, Alphabet, Amazon, and Meta Platforms — trade at an average of 49 times forward earnings.
Stephanie Aliaga, strategist at JPMorgan Chase, highlighted another key difference in a recent blog post. “During the dot-com bubble, rampant speculation surrounded young companies flaunting internet excitement before profitability. In contrast, today’s AI beneficiaries are already very profitable companies that make their money selling key infrastructure and resources to the rapidly growing market of AI adopters.”
A stock market downturn is coming, but it will probably be less severe than the dot-com crash
Investors should prepare themselves for a stock market downturn, and AI stocks will probably be the flash point. That downturn may start next week, next year, or several years from now. But history makes it clear that market corrections and bear markets are unavoidable.
However, there is good news. First, valuations are more reasonable today than they were during the dot-com bubble, so the next downturn will probably be less severe than the dot-com crash. Second, investors that buy AI stocks today could still make plenty of money even if those stocks decline sharply in the future.
Amazon shares peaked in December 1999, then declined 90% when the dot-com bubble burst. However, the stock has still returned 3,310% since reaching a record high in December 1999, while the S&P 500 has returned just 523%. Put differently, investors that bought Amazon stock on the worst possible day during the dot-com bubble have still crushed the market over the last quarter-century.
Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Trevor Jennewine has positions in Amazon and Nvidia. The Motley Fool has positions in and recommends Alphabet, Amazon, Cisco Systems, JPMorgan Chase, Meta Platforms, Microsoft, and Nvidia. The Motley Fool recommends Gartner, Intel, and International Business Machines and recommends the following options: long January 2025 $45 calls on Intel, long January 2026 $395 calls on Microsoft, short August 2024 $35 calls on Intel, and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.