All the Money Flooding Into AI Is a Giant Warning Sign
When companies as a group turn into sellers, it’s a reasonable sign that stocks are very overpriced
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What should you do if investors bid up your stock on the basis that you will be a winner in artificial intelligence, but your product isn’t popular? Elon Musk has the answer: Use your expensive stock to buy another AI business.
SpaceX’s $60 billion all-stock purchase of Cursor, a programming assistant that popularized “vibe-coding,” makes Musk a player in corporate AI in a way that his Grok chatbot hasn’t.
It is also part of a rush of stock issuance that should raise serious red flags even among those who dismiss elevated valuations.
Companies always have a choice of how to finance capital spending and takeovers. They can raise debt or issue stock (or a mix). If interest rates are low, debt is cheap for companies. Equally, if stock valuations are high, it is “cheap” for a company to issue more. Only firms in desperate need of cash sell more shares when their valuations are low, because it dilutes existing shareholders and trashes the share price.
Legendary investor Benjamin Graham thought of “Mr. Market” as a manic-depressive, offering daily prices to investors—sometimes far too high (you should sell) and sometimes far too low (you should buy). Mr. Market also offers companies the opportunity to buy from or sell to us investors—and when they issue stock, they are choosing to sell.
In any individual case selling stock can be perfectly reasonable. Balancing the amount of debt and equity a company uses helps offset the perceived riskiness of an investment or acquisition. Equity is good for risky endeavors because it doesn’t have to be paid back like debt. The mix of debt and equity feeds into the company’s weighted average cost of capital, a measure that helps determine whether a particular investment is worth it.
But step back, and when companies as a group turn into sellers, it’s a reasonable sign that stocks are very overpriced. Indiscriminate demand from investors incentivizes companies to step up to supply them, both with secondary offerings, like Alphabet’s recent record-breaking issue, or IPOs.
Examples from recent history stand out.
In the dot-com bubble and postpandemic SPAC mania there were waves of IPOs and secondary issues as stock valuations rose. There was also a boom in U.S. mergers and acquisitions, only just surpassed in the past four quarters in dollar value. Companies financed those deals with equity—two-thirds with new stock in the dot-com M&A and 45% in 2020-21, the two highest over a rolling four-quarter period in LSEG data dating back to 1990.
Big deals are flourishing again: giant IPOs blasted off with SpaceX, and companies are choosing to issue stock—using shares to finance almost half the cost in the current quarter, according to LSEG. (Over the rolling four-quarter period, it is still only a third.) Investor demand for stock is, in part, being satisfied by the creation of new stock.
The flip side is, when debt is cheap, it can cause even more serious problems. Pre-financial crisis deal value peaked at $910 billion over the year to the end of September 2007, just before shareholders realized the economy was built on sand. Only 19% of that was financed with stock, because debt—helped by endless structured products—was far too cheap. The bubble was in the debt markets, not equities, although the implosion of the banks and deep recession still hit stocks exceptionally hard.
Corporate financing decisions are in some ways better at measuring how expensive the market is than standard valuation gauges, which compare price to some measure of corporate fundamentals such as past or forecast profits (soaring), book value, free cash flow (plunging) or sales.
These can be misleading, often disagree, and mostly have fairly short histories. Worse, the baseline for what counts as expensive can change over time as the structure of companies or accounting standards shift. In the case of book value, it now needs so many adjustments as to be virtually useless.
One example: The S&P 500’s ratio of price to forecast earnings currently stands just below 20, well down from the 23 times reached both in 2020 and last year, and the record 24.5 times in the dot-com bubble. It’s still very high, but it has fallen because Wall Street expects earnings to boom—particularly in highly cyclical chip stocks where record near-term profit margins are unlikely to be a good guide to the distant future.
There are drawbacks to looking at how much companies choose to issue debt or equity too. The decision on whether to raise money through stock or bond issuance tells us about how companies see the relative valuation of stocks vs. bonds more than the absolute valuation.
When it becomes concerning, at least in my view, is when there’s a flood of fundraising, debt or equity or both. If lots of companies are raising cash to chase the same opportunity—in this case AI—there are three possibilities.
The bull case is that the opportunity is so huge it can absorb all the cash and still deliver fat profits. The bear case is that the opportunity is real but spending so much will destroy value as competition erodes margins. The deeply depressing third possibility is that companies are raising and spending so much merely because shareholders are cheering them on, and the AI claims are just wildly overhyped.
The danger is it turns out like the dot-coms. Then, like now, companies competed to spend as much as they could as quickly as possible and the “burn rate” was seen as a positive—until it turned out all the shareholder money had gone up in smoke.
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