Sean Neethling, Head of Investments, Morningstar Investment Management South Africa

The staggering scale of AI spending - super charged by OpenAI - has prompted a lot of discussion about whether there is a “bubble” and what investors should do about it. Our definition of a bubble is extreme conditions that lead to a large loss in short order. Over history, these have been rare, with few being correctly predicted, but they are spectacular and so garner a lot of attention.

So how do you know if conditions really are extreme? You need a clear process that counters the natural human tendency to be overconfident and overemphasise recent conditions when forecasting what may happen next. Ours uses the full breadth of Morningstar data, research, analysis and investment experience to create three signals.

The first is valuation. Just looking at moves in asset prices is not enough because big economic or structural forces can dramatically change companies’ earnings power. Fundamental research is key, as the plight of Nvidia has shown this year, with skyrocketing earnings far outpacing investor expectations. We do this across markets, asset classes and across time, using forecasts as well as historical comparisons. We also consider company-level data to reflect today’s more concentrated markets.

Our latest reading (end November data) shows that markets have become more expensive, but there are enough opportunities to generate the risk-adjusted returns that investors need. Our portfolios remain biased to UK equities, EM equities, Healthcare and high-quality bonds, all of which offer good risk- adjusted returns.

The second signal is sentiment - we consider whether investors are too greedy or fearful. Classic examples of “bubble behaviour” include a lack of scepticism and ignoring risk, leading investors to fully commit to fantasy scenarios that are very unlikely to occur. We track flows, expectations and positioning to gauge investor behaviour. Today does not compare to prior periods of full-blown, rip-roaring risk-taking. Talk of bubbles is not typical of extreme behaviour, as it signals that there is still caution.

The third signal is capital supply. In a nutshell, is it too hard or too easy for companies to raise funds? Dangerous extremes include investors accepting terrible terms like higher fees, fewer rights, less protection and sketchy details. It also shows up in surges in equity funding and loans for speculative activities and loss-making companies with no comparative advantages. Today, the picture is mixed. We are seeing more signs of capital being raised for speculative endeavours such as Crypto, but bank lending standards have not been relaxed, and IPO markets are not at fever pitch.

The punchline is that we are not in a bubble, but we are seeing more signs of speculation that justifies a greater focus on diversification by asset class, sector and country, as well as avoidance of overvalued market segments such as AIand Crypto.