Is market heading towards a big AI crash like the dot-com crisis? Here's what European Central Bank predicts

Amid the rising exuberance around artificial intelligence, European Central Bank feels that a market correction on Wall Street is likely and could have far-reaching consequences due to limits in fiscal and monetary policy buffers to blunt the potential economic hit.

In a blog post titled 'The AI boom: rational enthusiasm or the next dot-com bubble?', ECB highlighted that the rise of artificial intelligence has driven a blistering rally in the tech sector, bringing valuations in the stock market to levels last seen during the dot-com bubble.

"The extremely optimistic valuations raise questions: do today’s stock market prices reflect a rational bet on the transformative technology? Or are we seeing a remake of the dot-com bubble? We argue that economic research on past technological revolutions points to a worrisome conclusion: a correction of current stock market valuations is likely," European Central Bank said.


It added that a sharp stock market correction would have severe consequences for Europe through two channels - investors' direct exposure to the Magnificent Seven stocks and the degree of overexuberance in euro area stock markets themselves.

Similar frenzies in history

ECB noted that the ongoing frenzy around AI has many historical precedents - the railway boom of the 19th century, the expansion of electricity and radio in the 1920s and the surge of the internet, or the "dot-com era", in the 1990s. "In each case, a genuinely transformative technology attracted investment, and the stock market valuations of firms that adopted it rose strongly before falling sharply," it highlighted.

Even if artificial intelligence succeeds and meets investor expectations, the stock prices still may eventually fall, according to the ECB, which believes that this will be driven by the nature of uncertainty shifting from a "single sector" to the "entire" economy.

Even if the technology succeeds and profits rise, stocks may still fall because it is hard to fulfil markets' excessively optimistic profit growth bets, the blog post added, noting that overly optimistic investors tend to bid up prices beyond fundamentals. Then when optimism fades, prices tend to fall even more sharply than in the rational scenario.

Also read | Peter Lynch does not like the AI trade; here's why he says 'Know what you own


AI warnings

Since last year, stock markets around the world saw an increasing frenzy around AI, with hyperscalers increasing their investments in the technology. The increased optimism sparked a sharp rally in the AI stocks, before things began to go down. Analysts soon began sounding the alarm over the massive AI spending and rising debt of the tech giants, questioning if they will actually bear fruit in the future. The worries sparked a sharp selloff in the tech stocks, although they have begun to rebound.

Earlier this year, Michael Burry, famous for correctly predicting the 2008 financial crisis, wrote on a Substack post that he sees many indicators, both technical and fundamental, lining up for the same conclusion as the dot-com crash. "1999 went where no market had gone before, and I would say so can this one...It is already there on a number of indicators," he said, arguing that massive venture capital flows, rising AI debt issuance, and extreme market optimism are creating conditions where valuations may detach from economic reality.

Also read | Michael Burry revives AI warnings, Big Short investor says 'You could have heard it first'

(With inputs from agencies)

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