US tech stock correction likely, warn ECB economists

A correction in US technology stocks is likely and could threaten Eurozone financial stability, even if AI eventually lives up to investors’ hopes, a team of European Central Bank economists has warned.

In a post published on the ECB’s blog on Monday, the researchers wrote that a pullback in the tech sector did not necessarily need to be driven by irrational exuberance and “should be expected even if current valuations are rational”.

The warning matters for Europe despite most of the tech stock gains of recent years happening in US markets. Euro area households have about €440bn of exposure to US tech equities, according to the economists, largely through investment funds, while insurers and pension funds also have significant exposure to the so-called Magnificent Seven megacap tech stocks.

US and euro area stock markets have historically been highly correlated, leaving European investors vulnerable to a Wall Street crash, the economists added.

A “US AI fallout would not remain a US problem” but could become “a question of financial stability for the euro area”, they wrote, adding that a stock market crash combined with “broader market instability” would be particularly dangerous.

The tech-heavy Nasdaq 100 index sold off last month but has since rebounded to near its record high.

The economists compared the AI investment boom to previous innovation-driven investment frenzies such as the 19th-century railway boom, the expansion of electricity and radio in the 1920s, and the dotcom era at the turn of this century.

“In each case, a genuinely transformative technology attracted investment, and the stock market valuations of firms that adopted it rose strongly before falling sharply,” the economists wrote.

They argued that such technological breakthroughs created “extreme uncertainty” because the overall impact on the economy was initially unclear. At an early stage of a breakthrough innovation, pioneering stocks such as Nvidia present major opportunities for early investors, who in the best case can make huge gains but in the worst case may lose all their investment.

“This ‘option value’ increases the stock valuations of early adopters, causing their price-to-earnings ratios to rise sharply,” the economists wrote.

However, this changes if the technology succeeds and spreads through the wider economy. The uncertainty surrounding the breakthrough technology then shifts from individual companies to the economy as a whole.

“If something then goes wrong with that technology, the whole economy suffers,” they argued.

Unlike the risks linked to individual companies, the economy-wide uncertainty “cannot be diversified”, prompting investors to demand higher returns to compensate for the risks they are taking, the researchers wrote.

Although successful adoption of AI can boost profits, the increase in this risk premium pushes stock market valuations in the opposite direction, meaning share prices can eventually fall even if the technology itself succeeds.

The economists also wrote that tech boom-and-bust cycles could be driven by “overconfident, over-optimistic investors” who “bid up prices beyond fundamentals”.

“When overconfidence fades, prices can fall even more sharply than in the rational scenario,” they wrote, although they added that this did not mean that prices could not rise further from here, even after a correction.

“If AI proves to be transformative enough, valuations could still be much higher in the future, even after a correction.” However, such “boom-bust patterns” were “only identifiable with hindsight” and it was “impossible” to judge in advance “where we stand on this path”, they added.