Should contrarian investors join the AI hype?

There are early signs that a bubble is forming but experts say it may not be too late for investors to make a profit

Artificial intelligence-related stocks have surged in the past year. Getty Images

Anyone who knows anything about investing knows the dangers of following the crowd, and buying something simply because everybody else is buying it, too.

Known as the “bandwagon effect”, investors can be prone to lose their minds en masse. Think the South Sea Bubble, tulip mania, the dot-com boom, meme stocks and Dogecoin.

Investors may be jumping on the artificial intelligence bandwagon today, including US chip maker Nvidia and the rest of the Magnificent Seven mega-caps (Amazon, Apple, Google-owner Alphabet, Meta, Microsoft and Tesla).

Yet, shunning the crowd isn't easy. We hate to admit it, but human beings are herd creatures at heart.

And sometimes, the herd is right. While crowds succumb to moments of madness, they can also bring their own wisdom.

Targeting stocks that are doing well is called momentum investing and it has paid off for more than a year now as Wall Street breaks one record high after another. Investors who scorned the frenzy over US tech companies surging higher have been trampled in the stampede.

Last August, the mob went crazy for Nvidia after it posted 101 per cent year-on-year quarterly sales growth to $13.5 billion.

With its shares up 230 per cent in a year and the valuation surging past $1 trillion, other investors – this one included – decided that AI mania had got out of hand. That has been a losing bet. The stock is up another 87 per cent since then, after fourth-quarter revenue hit $22.4 billion.

Market-beating stocks have a momentum of their own, says Nick Saunders, chief executive of stock trading platform Webull UK.

“As they outperform, exchange traded funds [ETFs] tracking the index buy them to maintain their exposure, driving their share prices even higher.”

While ETF issuers downplay their impact, saying they account for only 5 per cent of US stock transactions, Mr Saunders is not convinced. “Of that 5 per cent, though, much will be concentrated in the big names.”

While there have always been bubbles, one thing is different now. The whole world wants a piece of the US action and Mr Saunders says this is distorting the market. “Stocks trading on Wall Street are more expensive as capital flows into the US from all over the world.”

When bubbles form, investors are on their own, he adds. “Traditional valuation models do not account for irrational sentiment.”

AI-led buying euphoria is not entirely irrational, says Vijay Valecha, chief investment officer at Century Financial.

“The US economy is proving surprisingly resilient. Tech stocks' fourth-quarter earnings grew more than 8 per cent on average, beating the rest of the US and Europe, where earnings have largely been flat.”

Despite its euphoric rise, Nvidia isn’t hugely overpriced compared with earlier bubbles. “Its current valuation of 76 times earnings is high but still notably lower than peak dot-com valuations. In March 2000, Cisco traded at 200 times earnings.”

Nvidia’s valuation looks justified by its underlying business growth and near monopoly in its AI GPU chip design, Mr Valecha adds.

Broader fundamentals are also in its favour. “Expectations of lower interest rates and falling inflation are underpinning today’s bullish market momentum,” Mr Valecha says.

Yet, investors may be racing ahead of themselves as they ignore warnings by the US Federal Reserve that it is in no rush to cut interest rates, says Fawad Razaqzada, market analyst at City Index and Forex.com. “As Magnificent Seven valuations climb, so does the danger of a correction.”

Some argue that it has already started, with Elon Musk’s electric car maker Tesla down 30 per cent this year. Apple and Alphabet are also down in 2024.

Many investors pride themselves on being contrarian investors, buying cheap, out-of-favour stocks rather than chasing momentum.

Contrarians deliberately bet against the crowd, making informed decisions based on research and analysis, says Yusuf Mansawala, chief market analyst at CPT Markets. “Independent thinking helps avoid being caught up in market bubbles fuelled by mass psychology.”

Yet, it can also be lonely. It requires conviction. The fear of missing out (FOMO) is strong. And sometimes, the crowd is right, and you'll be wrong. For months. Maybe years.

Mr Mansawala says a study by the London Business School found that buying the 20 best-performing stocks from the previous 12 months was more rewarding than buying the worst performers. “If investors are excited by a particular trend, it is signals there's an opportunity there.”

The danger comes where herd mentality sets in, with decisions driven by “social influence rather than rational analysis”, Mr Mansawala says.

But how do you spot it?

Jason Hollands, managing director at investment platform Bestinvest by Evelyn Partners, says investors shouldn't be mesmerised by a rising share price. “Make sure the business is delivering actual sales and profit growth to justify that.”

On these terms, Nvidia justifies the hype, he says. “This is in marked contrast to the meme stock craze, where private investors poured into shares of companies like AMC Entertainment and GameStop, whose rocketing share prices were not justified by the fundamentals.”

There are early signs of an AI bubble forming, Mr Hollands says, but it may continue to balloon for some time before busting.

“It can be very uncomfortable sitting on the sidelines refusing to take part while watching others get paper rich. FOMO is a powerful force. Often the last stage of a bubble is rapid melt-up in prices as those who have stood on the sidelines capitulate, throw their caution to the wind and buy at the top.”

Mr Hollands doesn’t think we’re there yet. “My feeling is that this has further to run.”

If you are going to ride the momentum train, adopt a disciplined approach to profit taking, he says. “As a stock or sector rises, take some of your gains. If you’re lucky, you may find that you can withdraw the amount you originally invested and have effectively de-risked your position.”

This is not easy, though. We are hard-wired to follow the crowd. What makes it harder is that this is often the right thing to do.

US billionaire Warren Buffett is the world's most successful value investor, renowned for his advice to be “fearful when others are greedy”.

Mr Buffett shunned tech stocks for years but even he had to bow to the crowd’s wisdom in the end, and that’s the problem.

Following the crowd works. Until it doesn’t.