Public AI Markets Stable, Private Markets Show Bubble Risk

Key Quotes

"The most frequently asked question from investors all over the world has been are we in an AI bubble and that is, I think, important to answer that in two ways. The first is, it's not a single market. There's a market for price and there's a market for capital availability. Those are two markets. They exist both in the public and the private space."

David Kostin explains that the question of an AI bubble requires a nuanced approach, distinguishing between the price of assets and the availability of capital. Kostin highlights that these two factors operate independently in both public and private markets, suggesting that a blanket answer to the "AI bubble" question is insufficient.

"In the public market, Nvidia, which is the company that people most associate with AI, its share price has increased by 12-fold in the last three years, and earnings have increased by 12-fold as well. So pretty much the price and the earnings have matched each other. That would be one exhibit, one example of where the price in the public markets, if you will, AI is not a bubble; it's sort of matched the earnings growth and the price."

David Kostin uses Nvidia as an example to argue against the notion of a public market AI bubble. Kostin points out that the company's share price growth has been commensurate with its earnings growth over the past three years. This alignment, according to Kostin, suggests that the valuation is supported by fundamental performance rather than speculative excess.

"George Soros argued in The Alchemy of Finance that that is not the right way to think about it. That actually, the valuation of the shares today, the price change is an integral part of the valuation of the shares. That is a differentiating view. It's thinking about momentum."

David Kostin introduces George Soros's theory of reflexivity from "The Alchemy of Finance" to explain market dynamics beyond traditional discounted cash flow models. Kostin explains that Soros's view posits that price movements themselves are not just a reflection of future value but actively influence and become part of that valuation. This concept, Kostin notes, is particularly relevant for understanding momentum in markets.

"The experience in 1999 was that at a point in time when the growth cannot be sustained or may not be sustained, you have a recursive or reflexivity coming lower. It's so-called circular financing."

David Kostin draws a parallel between current market conditions and the dot-com bubble of 1999 to illustrate the potential downside of reflexivity. Kostin explains that when growth projections become unsustainable, the self-reinforcing cycle of rising valuations and increased capital can reverse sharply. This "circular financing" can lead to a rapid decline, as experienced in 1999.

"If you look at the mutual funds, around 29% of the mutual funds are beating their style benchmarks. That would be the relative performance of core managers versus the S&P 500 index, growth managers versus the Russell 1000 Growth Index, and value managers versus the Russell 1000 Value Index. So those are the sort of measures that you think about, and that's typically around 37%."

David Kostin presents data on mutual fund performance to illustrate the difficulty many investors have faced in the current market environment. Kostin notes that only 29% of mutual funds are outperforming their respective benchmarks, which is significantly lower than the historical average of around 37%. This underperformance, Kostin suggests, indicates a challenging market for active managers.

"The framework that we use is actually quite similar. I think about in terms of the economy, earnings, valuation, and money flow. And I think about those as almost four legs of a table, and trying to understand where the opportunities may exist."

David Kostin describes the consistent analytical framework he has employed throughout his career as an equity strategist. Kostin outlines four key pillars: the economy, earnings, valuation, and money flow. He likens these to the legs of a table, emphasizing their foundational importance in identifying investment opportunities. This framework, Kostin notes, has remained largely unchanged despite market evolution.