The AI bubble and interest rates: which one will become the "culprit" that brings an end to this round of the U.S. stock market bull run?

The valuation of US stocks has entered an extreme range. However, analysts believe that high valuation alone is not enough to end this bull market. The real "culprit" requires a significant jump in interest rates or a fundamental collapse of the AI profit logic, neither of which has been met at present.

On Wednesday, Ian Harnett, co-founder and chief investment strategist of investment strategy research firm Absolute Strategy Research, wrote in an article that since October 2022, the cumulative increase of US stocks has exceeded 100%. If calculated from the end of the 2009 financial crisis, the overall increase has reached 10 times.

The core driving forces of the current bull market come from two directions: the strong corporate profits driven by AI technology and the relatively loose monetary policy environment. He warned, although the market may still be in the "endgame stage", the "endgame" has not arrived yet.

For investors, this judgment means that systemic risks are still controllable in the short term, but they need to closely monitor unexpected changes in the interest rate path and potential deterioration in the profitability of clients in AI-related industries. The latter may become an early signal of the next market reversal.

Valuation Has Entered an Extreme Range, but High Valuation Does Not Equal an Inflection Point

The current valuation of US stocks far exceeds the historical average. Based on the actual earnings in the past 12 months, the price-to-earnings ratio is 28.4 times, about 40% higher than the average of the past 40 years. Based on the cyclically adjusted 10-year average earnings, the price-to-earnings ratio is as high as 41 times, with a premium of about 60% over the average. Even based on future earnings forecasts, the current market valuation is 20.3 times, still about 25% higher than the historical average. In addition, multiple valuation indicators such as the price-to-book ratio and price-to-cash flow ratio are also at historical highs.

Ian Harnett pointed out that such an extreme valuation level has only appeared near the top of major bull markets in history. However, high valuation is a necessary but not sufficient condition for a market reversal. To break the current strong upward momentum, a major change is needed in interest rate expectations, corporate profit prospects, or the fundamentals of the AI sector, and none of the three can be missing.

Interest Rates Need to Jump Significantly to "Kill" the Bull Market

The discussion about the interest rate trigger point in the market has a long history. However, Ian Harnett believes that there is no "critical interest rate level" that can be fatal with one blow. What really causes market turmoil is always the speed and magnitude of interest rate changes.

Looking back at the tops of major bull markets in the past 125 years, each was accompanied by a sharp rise in policy interest rates. The market reversals in 1907, 1929, 1973, and 2000 all occurred after policy interest rates were raised by 2 to 4 percentage points. In contrast, the current futures market has only priced in an expected interest rate hike of about 0.5 percentage points, far from the magnitude that has been sufficient to end a bull market in history.

He also pointed out that if the Federal Reserve continues to "fall behind the curve" under the leadership of the new chairman, Kevin Warsh, that is, maintains a relatively loose policy stance, it will provide room for the short-term continuation of the bull market. Even though the expected growth rate of corporate earnings in the United States in the next year is as high as 21%, historical rules should prompt the Federal Reserve to raise interest rates more significantly, but the current market pricing does not reflect this pressure.

The Burst of the AI Bubble Is a Deeper Risk, but It Has Not Been Triggered

Ian Harnett believes that if this bull market comes to an end, the burst of the AI "bubble" will be the core trigger factor. Currently, the profits of AI-related companies remain strong, and sales growth remains healthy. However, investors' concerns about the scale of AI capital expenditure, financing pressure in the capital market, and the cash flow of ultra-large cloud computing companies are rising.

From the perspective of capital supply, the risk of short-term market pressure is limited. Even if companies such as Anthropic, OpenAI, and SpaceX raise a total of $200 billion through IPOs, according to Federal Reserve data, US retail investors still hold about $2.3 trillion in investable cash, and institutional investors hold another about $6 trillion. The capital supply is abundant and will not cause a major market shock.

However, Ian Harnett cited the historical lessons of the bursting of the Internet bubble and pointed out that the real risk often does not come from AI companies themselves, but from the deterioration of the profitability of their potential customer groups. He suggested that investors focus on the profit and cash flow trends of industries with heavy AI applications such as finance, manufacturing, media, transportation, education, and healthcare. Once there is a significant slowdown in these industries, it will be a more reliable early warning signal for the end of the bull market.

Geopolitical Shocks Failed to Shake the Market, and External Risks Are Still Controllable

The escalation of the situation in Iran has not become the "black swan" to end this bull market. Ian Harnett analyzed that the magnitude and persistence of the recent oil price increase are not sufficient to substantially damage the prospects of economic activities, nor have they significantly pushed up the market's expectations for interest rates.

From a historical comparison, the recent increase in oil prices is about 63%, far lower than the about 100% increase in 1990, and even more incomparable with the about 300% increase from 1973 to 1974. This means that the current geopolitical shocks have a rather limited transmission effect on the macroeconomy and monetary policy and do not pose a systemic threat.

Overall, Ian Harnett's conclusion is that this AI-driven bull market will probably continue. The market may have entered the endgame stage, but the endgame has not ended yet.

This article does not constitute personal investment advice and does not represent the views of the platform. The market is risky, and investment requires caution. Please make independent judgments and decisions.

This article is from the WeChat official account "Wall Street Insights", author: Zhao Ying. It is published by 36Kr with authorization.