In an era where artificial intelligence (AI) is not just a buzzword but a pivotal force driving innovation, investments in companies like Microsoft, Nvidia, Google, Amazon, and Meta are surging.

Investors, lured by the promise of groundbreaking technologies and unprecedented growth, are flocking to these AI giants, hoping to be part of the next big wave.

However, the above Seth Klarman quote should serve as a crucial reminder of the importance of risk awareness in the face of overwhelming optimism.

Drawing on my background as a growth manager during the late '90s, I've witnessed first-hand the dazzling allure of tech investments and the harsh realities that can follow.

The late 1990s were marked by a similar exuberance for companies like Cisco, Sun Microsystems, EMC, Yahoo, and AOL, which, alongside others, grew at an astonishing pace. This period of rapid growth and investment fervor, however, culminated in the burst of the Technology, Media, and Telecom (TMT) bubble.

The parallels between the late '90s tech boom and today's AI investment craze are striking and offer valuable lessons on the dangers of market concentration and the need for a balanced view of opportunity and risk.

The Late '90s Tech Boom: A Historical Parallel

The late 1990s marked an era of unprecedented growth in the technology sector, a period that would later be characterized as the dot-com bubble. Companies like Cisco, emblematic of this tech boom, became the darlings of Wall Street, with their stock prices soaring to dizzying heights.

Investors, driven by a fear of missing out (FOMO) on the digital revolution, poured money into technology stocks, driving valuations to levels detached from traditional financial metrics. This investment frenzy was fueled by optimism about the internet's potential to transform business and society, a sentiment not unlike what we see today with AI.

However, this golden era was not to last. 

By the early 2000s, the TMT bubble burst, erasing trillions in market value and leaving many investors with significant losses. The aftermath was a sobering reminder of the risks of market concentration and the volatility inherent in high-growth sectors.

Several factors contributed to the bubble's burst, including overvaluation, excessive speculation, and a rush to invest in companies with unproven business models.

Many of these highflyer companies of the 1990s, despite their rapid growth and prominence in the market, were not very profitable and lacked a clear path to sustainable growth. When the market's sentiment shifted, the lack of fundamental value became painfully apparent, leading to a swift and brutal correction.

The parallels between the late 1990s tech boom and today's AI investment surge are clear. In both cases, technological advancements promised to revolutionize industries and create new economic paradigms. In both instances, the excitement about these possibilities led to an overheated market, where the growth potential often overshadows the historical bumpiness of technological innovation.

The Current AI Investment Landscape

Today, the focus has shifted to AI, with companies at the forefront of this technology becoming the new titans of the tech world. Microsoft, Nvidia, Google, Amazon, and Meta are not just household names; they are the driving forces behind the AI revolution, commanding significant investment interest.

The allure of AI, with its potential to automate complex tasks, enhance decision-making, and unlock new forms of innovation, has captured the imagination of investors worldwide.

Like the late 1990s, today's market is characterized by a high degree of optimism about the transformative potential of technology. AI is seen as a key driver of the next wave of economic growth, with applications ranging from autonomous vehicles and healthcare diagnostics to personalized marketing and smart cities.

However, the excitement about AI's potential also brings with it the risk of overlooking fundamental investment principles. The concentration of investment in a small number of AI giants raises concerns similar to those of the late 1990s tech boom.

While these companies are more established and profitable than many of the dot-com era startups, the principles of market concentration and the importance of risk management remain relevant.

Risks of Concentration

The quote by Seth Klarman serves as a timely reminder of the dangers of focusing too narrowly on the upside of investments.

Concentrating investments in a handful of AI companies carries significant risks.

• First, it exposes investors to sector-specific shocks, such as regulatory changes or technological disruptions. The tech sector, and AI in particular, is subject to rapid changes and innovations that can quickly alter the competitive landscape.

• Second, the heavy investment in AI giants can lead to overvaluation, where stock prices may not fully reflect the companies' underlying risks or potential challenges. While AI offers significant growth opportunities, the path to realizing this potential is fraught with uncertainties, including ethical considerations, data privacy concerns, and the potential for backlash against automation's impact on employment.

• Third, the history of technological innovation shows that today's leaders are not guaranteed to maintain their position indefinitely. New entrants, armed with innovative technologies or business models, can disrupt established players. Investors who concentrate their holdings in a few large companies may miss out on these emerging opportunities.

Strategies for Mitigating Risk

Wherever there is opportunity there is also risk. The emergence of at-scale AI has boosted the fortunes of a small number of mega-cap companies, but investors can’t lose sight that the path of innovation is often bumpy.

Investing is not a free lunch and proper risk management should always be front and center of any successful approach. Spreading your risk is never a bad idea.

Diversification remains a cornerstone of sound investment strategy, allowing investors to spread their risk across different sectors and companies, including those outside the AI domain. This approach helps protect against sector-specific downturns and capitalizes on growth opportunities in other areas.

Look beyond the obvious. The biggest AI beneficiaries may lie outside of Big Tech. This applies particularly to small-cap equities. The AI discussion has focused entirely on the developers of the technology, but in the end, the users of AI may be the biggest winners of all.

Think about what happened in the 90s when the internet first came to the attention of investors. The initial winners were companies such as AOL, Netscape, and the telecom providers. Then the focus shifted to companies developing the picks and shovels of the digital transformation such as Cisco and EMC. Only much later did the benefits of having a robust internet infrastructure and toolset accrue to companies incorporating digital strategies into their business models.

The real winners of the AI revolution will ultimately be companies using the technology to improve the productivity and scalability of their business. I contend that many of today’s small capitalization companies represented by the Russell 2000 will end up as huge winners. By diversifying your holdings you get to play today’s winners as well as tomorrow’s.

Finally, a long-term perspective is crucial. The technology sector is known for its volatility, with rapid innovations and market shifts. By focusing on long-term trends rather than short-term fluctuations, investors can better position themselves to benefit from the transformative potential of AI while managing the associated risks.

The Big Picture:

• Equities keep outperforming bonds. This past week US Small Cap and Emerging Market Equities led the way.

• The S&P 500 reached new record highs, breaching 5,000 for the first time, but the advance remained narrow with gains concentrated in mega-cap tech stocks.

• The big winners last week were Commodities (up 3.4% for the week) in particular those with heavy oil exposure. This was a reversal from the prior week. Year to date Commodities remain neck and neck with the S&P 500 albeit with significantly higher volatility.

• Shorter maturity bonds are outperforming longer maturities. Until there is more clarity as to the direction of Fed policy this situation is likely to persist. Stay short.

• The investment environment remains risk-on. Our proprietary risk aversion index (RAI) is near all-time lows indicating very bullish investor sentiment.

Economy:

• In China, consumer price inflation fell 0.8% in January, the fastest pace since 2009. The second-largest global economy remains in the doldrums due to a stagnant consumer sector and a deteriorating property sector.

• Fed speakers this past week reiterated not seeing a need to cut rates immediately despite market expectations of cuts in early 2024.

• New York Community Bankcorp (NYCB) remained in the news as fears of contagion spread. We may be in the early innings of a commercial real estate crisis precipitated by higher costs of refinancing and lower office occupancy rates.

• The US Dollar remains strong. Against a basket of major currencies, the USD is up 2.9% year-to-date.

• Most market prognosticators at the end of last year had expected a depreciation of the USD primarily driven by lower interest rates in the US.

• Monetary policy in the US as well as in Japan and Europe remains highly uncertain given changing economic conditions. If I had to guess the first move will come from the US (rate cut in June) followed by the European Central Bank (also a rate cut). The Bank of Japan (BOJ) policy seems to be vacillating between staying the course (ultra-accommodative) and the need for a more normal (read higher interest rates) monetary stance.

Equities:

• US Growth equities dominated last week with the S&P 500 Growth up 2.5% while the Value index was flat for the week.

• Small Caps did better than Large Caps but still trail year-to-date by a wide margin with the S&P 500 up 5.5% and the Russell 2000 down 0.8%.

• Dividend-oriented strategies continue to lag. Dividend growth as well as high-yield strategies are being negatively affected by the timing of interest rate cuts.

• Over the last 5 years, the Morningstar Dividend Yield Focus Index (HDV) has had an annual return of 7.05% while the more growth-oriented Dow Jones U.S. Select Dividend Index (DVY) returned 7.97%. Contrast that to the S&P 500 with a 15.10% annualized return. As always, investors are trading the safety of dividends for the potential of higher total returns in lower-yielding securities.

• On the international front, Chinese stocks popped last week with the Shanghai Composite Index gaining 4.97%. Markets in mainland China resume trading on Monday, February 19. Investors are eagerly awaiting further clarity on the various stimulus packages proposed.

Bonds:

• Fed Chairman Powell spooked the US bond market last week when he stated that there was little urgency in cutting rates given the current strength of the US economy.

• Long-maturity bonds performed poorly last week. The ICE U.S. Treasury 20+ Year Bond Index (TLT) was down 2.3% last week while the U.S. Long Credit Index (IGLB) was down 1.8%.

• Cash continues being king. The ICE U.S. Treasury Short Bond Index (SHV) is up 0.5% for the year.

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