How AI investors could lose everything and still win
While most currently consider bubbles a dangerous precondition for a stock market crash, they can also be better navigated by appreciating they’re a necessary step on the road to humanity’s advancement.
As I have noted previously, there’s a myriad of definitions for asset bubbles, but most fall into two camps: those that measure overvaluation and those that observe the behaviours and conditions that typically give rise to it.
But in their book published a year ago, Boom: Bubbles and the End of Stagnation, authors Byrne Hobart and Tobias Huber propose two further variations.
The first, known as a “mean-reversion bubble”, is when purely financial fads rise on empty promises and subsequently collapse. This example might be best illustrated by the subprime mortgage crisis, which, of course, revolutionised absolutely nothing.
The second is the “inflection bubble”. Inflection bubbles are centred on technological breakthroughs, in particular. Historical examples I have previously cited include railroads, electricity, the internet and, today, artificial intelligence (AI). These bubbles move money, but they also ultimately move the world.
The low cost of progress
Inflection bubbles’ benefit to society stems from the associated hype’s ability to radically lower the cost of capital. When fear of missing out (FOMO) takes hold, investors stop demanding immediate, safe returns. Instead, they pour billions into speculative ventures that would usually be laughed at. Even governments succumb to the exuberance, granting easy conditions and even easier funding.
Those companies at the centre of the hysteria then take advantage of the cheap capital to scale the technology in a winner-takes-all race for market share.
Renowned British-Venezuelan scholar and economist Carlota Perez calls it the Installation Phase, and it allows for massive infrastructure, such as the fibre-optic cables of the 90s and the railway tracks of the 1800s. Early investors lost fortunes, but the remnant infrastructure became the backbone of the next century’s economic expansion.
The hype means that cautious testing over 10 years by a single entity is replaced with 50 companies testing 100 versions simultaneously. Consider personal vertical take off and landing (VTOL) aircraft as a current niche example.
Finally, the hype permits hyper-scaling. Technology that would naturally take decades to reach the public is forced into existence in just a few years.
Throwing caution to the wind
A collective delusion that the path from invention to worldwide adoption will be an uninterrupted 45-degree “north-easterly” line attracts human talent as well as capital. Meanwhile, the hype that inflates bubbles creates a rare environment in which the usual rules of risk are suspended, and prudence is shunned. While much of this money is eventually lost when the bubble pops, the physical and intellectual assets (the “learnings” about the technology – but not the bubble!) remain.
Broad adoption can only occur when the technology is affordable. Cheap funding fuels inevitable oversupply, which produces losses for investors, but brings down the price of the technology, allowing its broader uptake. In other words, a period of creative destruction is necessary for the technology to change the course of human history.
Think of it this way. The prosperity derived from the technology is only made possible by the money-losing investments of the mania that preceded it.
Be right but go broke
Investors must understand that correctly predicting AI technology will change the course of humanity, even if for the better, doesn’t automatically translate to great investment returns.
History is littered with general purpose technologies (GPTs) such as the automobile, electricity, commercial flight, steam locomotion and TV which have all changed the course of human history.
Yet, historically, the financial road is paved with ruin. More than 1000 car makers and 1000 TV manufacturers have disappeared from the U.S. since the respective technologies were invented.
Creative destruction
Investors are often confused during the fallout because they correctly predicted the technology’s life-altering nature, yet their portfolios suggest they were wrong. These investors fail to realise that the “this-technology-is-going-to-change-history” theme is perceived as structural and uninterrupted. The reality is that suppliers must meet cyclical rather than structural customer demand.
The creative destruction is the final, painful mechanism required for the technology to truly succeed. After the massive losses, buyers of distressed assets secure the technology from distraught early investors and having acquired the infrastructure for cents in the dollar, they ensure the technology is widely and affordably distributed. It is only then that the course of human history truly changes.
A necessary waste
Mean-reversion bubbles destroy wealth and leave nothing behind. Inflection bubbles destroy wealth but leave behind the foundation of a more prosperous future. The waste is a feature, not a bug – it is the price paid for surfing the wave of the future.
Invention, hype, cheap capital, overcapacity, creative destruction and distressed buying are the processes that ensure new and innovative technologies change the course of human history, placing it in every person’s hands.
Looking at the valuations and the scaling in AI today, you surely recognise the pattern. We’re living through the costly birth of a new paradigm, whose construction must be financed by capital that is typically destroyed.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Who would have thought that asset bubbles are a necessary part of humanity’s advancement through technology?