Diversifying Equity Exposure: AI Psychosis and the Frenzy of Crowds
Samuel Ziff
Partner | Portfolio ManagerSam Ziff joined OP in April 2013. He was previously employed by J.P. Morgan Cazenove working in the UK Industrials Corporate Finance team for a total of 4 years. He graduated from Oxford University. He is CIO, manages the global equity portfolios, and contributes to the overall investment selection.
Microsoft’s head of AI, Mustafa Suleyman, recently warned of the growing risk of “AI psychosis” a condition where individuals, over-relying on chatbots, come to believe that something imaginary is real. Equity markets are showing similar symptoms, with overdependence on the promise of AI. This is creating the near-term risk that valuations are increasingly detached from reality.
With valuations high, asset allocators increasingly call for a reallocation from equities to bonds. There is logic to this, as a short-term antidote to high valuations. However, over the long run equities consistently outperform bonds. Therefore, diversification within equities, presents an opportunity and an effective antidote for high valuations.
Equities today are heavily dominated by large cap, US growth companies. Yet, there are many opportunities beyond this. Value stocks, small cap and markets outside the US remain fertile hunting grounds for long-term investors, areas often overlooked or underappreciated. They offer more attractive entry points, greater diversification, and the potential for meaningful re-rating as market leadership broadens.
Our preferred valuation metric is the Shiller price to earnings ratio (PE). This replaces the current earnings with the average inflation-adjusted earnings of the last decade, a useful modification for earnings cyclicality. For the S&P 500 the Shiller PE is at 38x, a level exceeded only in the bubble years of 1999 and 2000 which peaked at 44x. Over a ten-year horizon the Shiller PE has proved remarkably predictive, and from today’s elevated starting point, it implies poor prospective returns for the S&P 500.
Shiller’s work focuses on the US; however, Bloomberg has compiled an equivalent valuation metric across other markets. The picture is striking. While the S&P 500 is nearing its all-time high, both value and small-cap segments are trading below their historical norms. With equities outside the US priced in line with their long-term averages and well below historic peaks.
With every bubble, there is often an “anti-bubble” — corners of the market left behind, overlooked, and under-owned. It is here, rather than in the crowded heart of US large-cap growth, that we believe the best long-term opportunities lie today. These bubbles, for one reason or another, always deflate. It is not always clear why before the fact but either a tumultuous political event or doubts over the promise of AI could easily rebalance the scorecard.
Vanguard’s latest asset allocation projects that US equities will deliver 3 to 5% annualised returns over the next decade, whilst returns from US bonds are expected to be 4–5%. On that basis, they encourage investors to diversify away from equities into bonds. We echo the view that there is significant risk in many equity portfolios today. We agree that diversification is sensible, and we also believe there is another way.
History shows that low valuations provide a margin of safety for investors and a strong starting point for attractive future returns. Vanguard themselves note that developed equities outside of the US and US value stocks are expected to return 6–8% per year, an outperformance of roughly 3% annually compared to core US equities. For investors willing to look beyond the crowded US large-cap growth trade, diversification within the asset class represents a significant long-term opportunity.
Markets may currently be gripped by an “AI psychosis” that has propelled US large-cap growth stocks to historically extreme valuations. However, to diversify away from this, there are good opportunities elsewhere in small caps, in ex-US markets, and above all in value. Our disciplined, contrarian approach seeks to capitalise on opportunities overlooked by the crowd and to preserve a margin of safety against valuations that are increasingly detached from reality.
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