Small investors with money in index funds could be left holding the bag when the AI investment frenzy – slated to kick off next week with the giant SpaceX IPO – eventually comes crashing down.
That’s the warning from savvy investors including former Wall Street trader Lawrence McDonald, founder of the Bear Traps Report. Among other things, he cites the traditional market trajectory of any nascent technology.
McDonald’s research platform has done some interesting analysis of the reported mega-cap valuations slated for IPOs on the upcoming artificial intelligence darlings, namely SpaceX, Anthropic and OpenAI, and why they won’t last.
All will be coming public this year starting with SpaceX, which slated to price next Thursday and start trading as early as Friday. The Wall Street hype machine is working overtime to pitch these stocks as the next Apple or Google. But McDonald has seen his fair share of market crashes and they all have similar attributes. They begin with irrationally high valuations of IPOs, and company insiders selling their stakes before the market fully digests the froth.
Retail usually gets slammed with losses when hot stocks begin to correct or crash.
McDonald says the AI correction could be worse than previous routs since the hype is bigger than anything we have seen in years. That combined with the new dynamic of the markets – so many small investors play stocks through passive or index investing that are already heavily tilted toward tech – means even people who don’t want to roll the dice on AI will find themselves in the middle of the correction.
McDonald tells me that the peeps who run the indices have compounded the problem by watering down standards of entry. Companies used to have to trade publicly for a year and show profit before index entry, and for all their hoopla, neither SpaceX, OpenAI nor Anthropic are turning a profit. Wall Street is mixed on when that might happen.
Yet the S&P is weighing a rule that allows immediate entry to the index. The people who run Nasdaq and the Russell indices already have a fast-track rule in place.
“Facebook was profitable when it went public in 2012 with a $100 billion valuation,” McDonald tells me. “it was the hottest valuation, much like SpaceX today. But SpaceX is being valued at $2 trillion, which is 20 times the price and it doesn’t make money. This is all based on believing in very pollyannaish assumptions of SpaceX’s future including possible data centers in space.”
A rep for S&P said in a statement that “methodology changes and other aspects of index maintenance and administration are made through the lens of indices continuing to meet their stated objective.” A spokeswoman for Nasdaq said: “Public markets look fundamentally different than they did a decade ago — companies are staying private longer, listing at larger scale, and arriving with more complex share structures. The updates to the Nasdaq-100 methodology reflect those shifts.”
A rep for Russell said its “indices are constructed using transparent, rules-based methodologies. The Fast Entry enhancements followed a market consultation and reflected feedback from a range of market participants, ensuring the Russell US Indexes continues to represent the US equity market accurately and consistently.”
It should be noted that Elon Musk has been good to investors in his EV maker Tesla. SpaceX which will combine rocketry with the Starlink global satellite business, all powered by AI tools, seems like a no-lose situation. Ditto for AI darlings OpenAI, run by AI pioneer Sam Altman, and Anthropic, which is the company behind Dario Amodei’s “Claude,” maybe the most advanced AI chatbot.
This new technology has also been fueling a productivity boom as businesses use it to perform tasks more efficiently. It’s the reason the stock markets hit new records every other day. The US economy has weathered the Iran conflict, inflation inspired by President Trump’s tariffs and other headwinds because the AI revolution is real, not a redux of Pets.com during the internet bubble.
Yes, prices of all things AI related – from chips, to buildout of AI data centers to the costs associated with various AI tools – remain elevated, which seems to support the valuation euphoria. These models can demand huge premiums from their sophisticated users. But as my old pal Andy Kessler, a tech analyst and now columnist, has written in the Wall Street Journal, his long experience in this space suggests price compression follows competition and that such disruption can be most pronounced in emerging technologies like tech.
In other words, SpaceX might be worth $1.8 trillion or more when it goes public next week, but there will be a correction at some point, and with insiders bailing on the stock as they normally do, the passive investors in index funds will be holding the proverbial bag.
Recall the Nasdaq after the dot-com crash of 2000 fell to a low of around 1,100 in 2002. It also took a decade to double from those relatively modest levels before a yearslong surge brought it to the levels around 27,000 we see today.
In other words, caveat emptor.
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