This Sky-High Metric Says We're Probably in an AI Bubble

Is the stock market in an AI-fueled bubble that's destined to pop? That's the trillion-dollar question as the major indices switch daily between euphoria and angst. Tech giants are making massive investments in AI data centers, loading up on debt and increasingly using complex strategies, such as special purpose vehicles (SPVs), to keep that debt off their balance sheets. SPVs don't have the cleanest history, playing a central role in the Enron scandal at the turn of the century.

Meanwhile, cash-burning OpenAI is signing long-term deals for enormous amounts of AI infrastructure despite not having the resources to pay for those deals. Analysts at HSBC Global Investment Research estimate that OpenAI will need to secure $207 billion in new financing by 2030, based on its commitments https://seekingalpha.com/news/4525336-openai-could-need-207b-in-financing-by-2030-amid-compute-capacity-pledges-hsbc. The company will also need to increase its revenue dramatically.

While these developments point to a likely AI bubble, there's one metric that's flashing a major warning sign.

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The Shiller CAPE Ratio is nearing dot-com bubble levels

Measuring how expensive or cheap the S&P 500 (SNPINDEX: ^GSPC) index is based on earnings for a single year can be misleading. Some industries are cyclical, with earnings fluctuating over several years. The overall economy also undergoes cycles, which can inflate corporate earnings during good times and depress them during bad times.

The Shiller CAPE ratio, named after economist Robert Shiller, attempts to account for these cycles. Often applied to the S&P 500 index, the Shiller CAPE ratio is defined as the price divided by the moving 10-year average of earnings, adjusted for inflation. By factoring in earnings over the prior decade rather than just a single year, the Shiller CAPE ratio smooths out the impact of business cycles and other distortions in companies' results.

The Shiller CAPE ratio isn't perfect, just like any financial metric. However, it can be useful to gauge the overall exuberance in the stock market. Right now, smack in the middle of the AI boom, exuberance is running hot.

The current Shiller CAPE ratio for the S&P 500 is just under 40, compared to an average of roughly 17. The only time this metric was higher was at the peak of the dot-com bubble, more than two decades ago, when the Shiller CAPE ratio topped out around 44.

What should investors do?

An elevated Shiller CAPE ratio doesn't mean that the stock market is going to crash tomorrow. Rather, it's an indicator that something may be amiss. The incredible sums of money being hurled into the AI fire, and the lack of visibility into how, when, or if those AI infrastructure investments will generate acceptable returns on investment, is another indicator.

Meta CEO Mark Zuckerberg recently defended the company's mammoth AI infrastructure spending plans during Meta's third-quarter earnings call by saying that if they overbuild, "we feel pretty good that we're going to be able to absorb a very large amount of that to just convert into more intelligence and better recommendations in our family of apps and ads in a profitable way." That's quite a leap of faith with hundreds of billions of dollars in planned investments on the line.

One thing investors can do now is focus on companies that are leveraging AI in ways that are unlikely to be heavily impacted by an AI bust. International Business Machines (NYSE: IBM) is a good example. IBM isn't playing the AI infrastructure game. Instead, the company focuses on AI consulting services and deploying small, efficient, and fine-tuned AI models for its enterprise customers with well-defined returns on investment.

IBM has booked $9.5 billion in AI business so far, primarily through consulting services with some software offerings mixed in. AI is a transformative technology that is genuinely useful for businesses, but finding the right use cases can be challenging. A recent MIT report found that 95% of generative AI pilots at companies fail to produce results. IBM is playing a critical role by helping its clients deploy the technology in a productive way.

If AI is truly a bubble, there's no telling how long it will take for the wheels to come off. Maintaining some exposure to AI through safer stocks like IBM, and avoiding more speculative investments, seems like the right approach to prepare for whatever comes next.

HSBC Holdings is an advertising partner of Motley Fool Money. Timothy Green has positions in International Business Machines. The Motley Fool has positions in and recommends International Business Machines and Meta Platforms. The Motley Fool recommends HSBC Holdings. The Motley Fool has a disclosure policy.