'This bull market in equities has a serious problem': Strategist warns a crucial AI-stock index is sending a potential bubble signal

It’s one of the biggest mysteries in markets right now: Is the AI trade driving a stock-market bubble?

While earnings remain impressively strong, the potential warning signs of a bubble are there. The S&P 500 is sitting near all-time highs after a 28% rally since early April and 57% gains since ChatGPT was announced in November 2022.

Meme stocks are ripping, suggesting investor sentiment is abnormally elevated. Excitement around AI has also driven up market valuations to levels consistent with prior major bubbles, like those seen in 1929 and 2000.

Tom Essaye, the founder of Sevens Report whose clients include advisors at some of Wall Street’s biggest firms, recently addressed the topic in a couple of client notes.

“Every bubble in modern market history has been based on a narrative, whether it be the internet or real estate. Critically, that given narrative is widely perceived by the investment world to be a source of unlimited earnings growth across most market sectors,” he wrote in an August 1 note. “Today, that potentially bubble-inflating theme is unquestionably AI technology.”

As Essaye sees it, the best way to measure the health of the AI trade is to look at how semiconductor stocks overall are behaving, as chips are the lifeblood of AI technology. One can do this using the PHLX Semiconductor Index (SOX), a group of 30 stocks, he said.

Comparing the index’s performance to the S&P 500 over the last couple of years shows “this bull market in equities has a serious problem,” he said.

The concern for Essaye is that SOX still sits below its July 2024 highs while the S&P 500 has risen by almost 14% over that time. This suggests the market’s rally, which is largely being fueled by the AI narrative, could be in an unhealthy place if many AI stocks themselves are failing to keep up their momentum.

“The takeaway here is that if AI remains the primary source of bullish optimism for a continued rally in the broader stock market in the months and quarters ahead, this market is in trouble and at risk of rolling over sooner than later as the SOX should still be leading the market higher like it was in 2024, not lagging considerably over the last 12 months,” he wrote. “That divergence in index performance is meaningful, and if we see the SOX roll over in the weeks or months ahead and start selling off materially, the S&P 500 will almost certainly not be far behind.”

Here’s the performance of an ETF that tracks the SOX index over the last three years:

And the S&P 500’s performance:

Another sign of a potential bubble, and perhaps of trouble ahead for stocks, is that the US economic outlook appears to be weakening, Essaye said.

Bubbles usually form late in an economic cycle, Essaye said, and a recession usually causes them to burst.

Job gains over the last few months have been poor, as payrolls data released on August 1 showed, raising recession fears. Plus, continuing jobless claims are creeping up, he said.

Essaye wrote in an August 8 note that “it is critical to keep close tabs on economic data right now,” adding that “stretched valuations in the wake of the S&P 500’s rapid ~85% trough-to-peak rally since the October 2022 lows were established leaves the broader equity market vulnerable to considerable downside in the quarters ahead, pending economic resilience.”