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If an AI Bubble Triggers a Bear Market, History Says This Is the Best Move Investors Can Make
Key Points
AI-related businesses comprise nearly 50% of the S&P 500.
Investors should understand their current diversification, as well as levers to benefit during a crash.
Several major AI stocks have now entered correction territory. Nvidia shares, for example, are down more than 25% over the past month, shedding more than $1 trillion in market value.
A bear market, however, has hardly arrived. Many AI stocks have continued to gain value during the rout, including BigBear.ai, Amazon, and C3.ai.
Missed AI’s "Act 1"? Act 2 Could Be 15x Bigger. Most investors think they missed the AI boat because they didn't buy Nvidia in 2005. But according to our analysts, we’re only at the end of "Act 1"—the R&D phase. "Act 2" is the global rollout. Continue »
From a demand perspective, there's very little to worry about regarding the long-term promise of artificial intelligence.
"AI demand remains strong," stresses new research from Barclays. "What the market is questioning is funding, as hyperscalers keep lifting capex while free cash flow evaporates."
The issue, therefore, is a matter of logistics and timing, not a matter of demand prospects. "AI fundamentals remain very strong in absolute terms," Barclays' research affirms.
Image source: Getty Images.
Still, the potential impact of a bear market in the AI sector is difficult to ignore. After all, overly optimistic valuations may shrink even as demand remains strong. It won't be difficult for a downturn in AI stocks to impact the rest of the market. Nearly half of the S&P 500's value is now tied to AI companies, whether that is AI developers themselves or suppliers to the industry.
How should investors respond to the popping of the AI bubble? The history of the dot-com crash offers clear advice.
Investors should accept that AI adoption growth isn't going anywhere
From a market-value perspective, technology companies suffered significantly during the dot-com bubble. The Nasdaq Composite (NASDAQINDEX: ^IXIC) fell nearly 80% over a 31-month bear market.
But here's the thing: Internet adoption continued to grow unabated. According to data from the U.S. Federal Reserve, 36% of Americans were active internet users in 1999. In 2000, that figure grew to 43%, reaching 49% by 2001. By 2002, nearly 60% of all Americans were regular internet users.
So while market valuations plummeted, the actual underlying technology -- the internet -- continued to experience sustained success. Nearly every business on Earth, not just technology companies, ultimately benefited from the internet's rise. So, to truly bet on the internet, it wasn't necessary to buy only dot-com companies. In fact, in the long term, the wisest decision may have been the simplest: maintain exposure to broad market indexes, ensuring your portfolio will benefit no matter how the internet's success is distributed.
The same should prove true for the current AI craze. AI companies are soaring in valuation, accounting for massive chunks of broader market indexes. But it's still far too early to know who the ultimate winners will be. Will it be GPU producers selling to AI software developers, or will it be the end users of that software development? As the dot-com bubble proved, predicting the future of a game-changing technology is more difficult than many suppose.
What's the main takeaway? There are two potential paths.
First, don't overthink the current environment. Throughout history, there has never been a bad time to buy an index fund tracking the S&P 500 (SNPINDEX: ^GSPC). Bought in at the height of the dot-com bubble, then doubled down just before the financial crisis hit? No problem. If you maintained a long enough time horizon, your portfolio would still be in the black.
The second takeaway is to understand just how exposed you are to an AI bear market. Historically, owning a diversified index fund exposed you to a wide variety of industries. But due to rapidly rising valuations in the AI sector, nearly half of the components in many popular indexes are businesses tied to the AI economy. If that segment of the market struggles, it could disproportionately impact your entire portfolio.
If you're concerned about AI valuations, you don't necessarily have to sell your existing positions for something else. But it may be wise to look at small-cap or international index funds, as these segments of the market are far less dominated by U.S. mega-cap AI companies. Many international and small-cap funds also trade at lower valuations, given their relatively lower exposure to pricey AI stocks.
Ryan Vanzo has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Nvidia. The Motley Fool recommends C3.ai. The Motley Fool has a disclosure policy.