This Is Nothing Like 1995 – The AI Bubble Appears Near Its Peak (SP500)

The 1995-like bullish thesis

The stock market bulls argue that the current environment is similar to the environment in 1995, which is when the dot.com bubble started to form, and continued to inflate until March 2000.

The bullish thesis is that the current AI-bubble is similarly in a very early stage, with possibly years to go until the burst.

The parallel with 1995 is based on the Fed’s policy path. The Fed was removing easy monetary conditions after the 1991 recession, and hiking interest rates in 1994. However, the Fed was able to pause the hikes and cut interest rates in 1995 – without causing a recession. The “soft-landing” or no-landing” outcome of the Fed’s tightening cycle triggered a major uptrend in the stock market.

The chart below shows the Fed’s policy path (red line) and Nasdaq 100 (QQQ) (blue line).

Similarly to 1995, the market is currently predicting a soft-landing or no-landing outcome of the Fed’s recent hiking cycle, and consequently, the AI-fueled longer-term rally in stocks.

But, let’s look at the macro environment during the 1990s.

The goldilocks of 1990s

• The geopolitical context.

The U.S. entered the 1990s as the ultimate geopolitical winner with the collapse of the Soviet Union. The 1990s started the trend of privatization in the emerging markets, and accelerated globalization – all under full control of the U.S.

• The real economic growth.

After a shallow 1991 recession, the U.S. real GDP spiked to over 4%, which is what triggered the Fed’s monetary policy tightening. After a brief slowdown to 2.5%, GDP roared back to 4-5% annual growth rate for the rest of the 1990s. The point is – the U.S. real GDP growth was very strong during the 1990s.

The unemployment rate was over 7% after the 1991 recession, but it kept gradually falling throughout the 1990s, down to 3.8% by the year 2000.

Inflation, as measured by core PCE (Fed’s preferred measure), was above 4% entering the 1990s. However, it reached the 2% level in 1994/1995 and kept gradually falling throughout the 1990s, dipping to 1% in 1998, and then gradually rising to 2%. The point is, rising inflation was low and never a problem after 1995.

What was the Fed concerned about during the 1990s?

The 1990s had a perfect macro environment.

• The geopolitical situation was perfect and supportive of high-growth and low inflation.
• The GDP growth was booming, with increased exports, production, and consumptions.
• The employment situation was perfect, with falling unemployment, but not too low to trigger inflationary pressures – until the end in 2000 (when things changed).
• Thus, the inflationary situation was perfect – low and stable inflation, supported by globalization.

So, what was the Fed concerned about during the 1990s? Here are the key FOMC statements during the period.

• The last hike in 1995 – The “moderation in growth” statement signaled the pause. The Fed had been concerned about the strong growth and rising resources utilization (falling unemployment rate and rising capacity utilization). But inflation never really spiked. This triggered the beginning of the dot.com bubble.

• The first cut in 1995 – the beginning of normalization: “inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions.” Inflation was never a problem, despite very strong growth.

• The Fed increased interest rates in 1997, quoting “persistent strength in demand” meaning strong economic growth, but still inflation remained low.
• The Fed cut interest rates in 1998 due to the emerging markets financial crisis, which boosted the speculative dot.com mania as US growth remained strong with very low inflation.
• The first hawkish hike in 1999 and the beginning of the end – reference to the “tight labor market”(unemployment rate was already below 4%), and “ongoing strength in economy in excess of productivity gains.”

• Several dovish flip-flops – The Fed stated over several meetings in 1999 that “productivity gains could contain inflation, and even paused due to the Y2K issues.
• The February 2000 hawkish pivot and the burst of the dot.com bubble – the Fed finally decided to burst the bubble and stated, “the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.”

• The last hike in May 2000 – 50bpt hike – still concerned about the “increases in demand in excess of even the rapid pace of productivity-driven gains in potential supply.” The unemployment rate was 3.8% but core PCE inflation was still below 2%!

• The End – The December 2020 recessionary warning and the signal of monetary easing – “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” References to “eroding consumer confidence” and “shortfall in sales and profits.”

The Fed was primarily proactive during the 1990s, viewing strong economic growth as an inflationary risk, but it became seriously concerned about inflation only when the unemployment rate dropped to 3.8% in 1999/2000.

The main thing to consider is that the Fed never inverted the yield curve in 1994-1995, as the graph below shows. Thus, the Fed did not see the need to induce a recession to control inflation.

The Fed inverted the yield curve in 2000, and that induced the recession and the burst of the dot.com bubble.

How is this similar to the current situation?

Let’s start with the geopolitical context. The world is in process of deglobalization with the emergence of bipolar governance. This is the return to the Cold War setting of the 1970s, and a complete reversal of the 1990s situation.

Thus, the current macro environment favors higher inflation and lower growth – due to deglobalization. Again, this is a complete reversal of the 1990s.

Currently the U.S. growth is strong, still due to post-pandemic spending, and also government spending. Yet, nobody expects 4-5% annual growth over the next 5 years. Other major global economies are currently in a recession or borderline recession.

More importantly, during the 1990s, the U.S. government reached a budget surplus, now it’s facing an unsustainable increase in debt and deficit – and this is putting more pressure on inflation as well.

Specifically, with respect to the 1995-bubllish thesis – the yield curve is now deeply inverted, and it was not inverted in 1995 – but it was inverted in 2000. Thus, the current situation more resembles 2000, especially given that the unemployment rate is at a similar level of 3.7/3/8%.

Implications

The AI bubble is currently in a full upswing, mostly led by Nvidia (NVDA) However, based on the macroenvironment, the current situation more resembles 2000 than 1995, which suggests that the AI bubble is near its peak.

The bubble will likely burst with the Fed’s hawkish turn, like in March of 2000. The Fed had several dovish flip-flops in 1999, and similarly it’s currently in a dovish mode. But given the rising inflationary pressures, it’s likely that the hawkish pivot is near – and with it the bust of the AI bubble.

The broad market index S&P500 (SP500) is now heavily concentrated in the big tech, and Nvidia is the third largest stock in the Index. Thus, the index investors are vulnerable to a deep selloff comparable to the 2000-2003 bear market. Given that the bubble is still on the upswing, my recommendation is still Hold, with the focus on the March FOMC meeting for a potential hawkish pivot.