Economists warn AI-driven market rally is due a sharp correction

U.S. and European stocks are scaling record highs as investors pile into the AI boom, but economists at the European Central Bank warn that history points to a sharp downturn ahead.

“Economic research on past technological revolutions points to a worrisome conclusion: a correction of current stock market valuations is likely,” the economists wrote in a Monday blog, citing two potential scenarios.

A correction could occur because “overconfident, overoptimistic investors” push prices up beyond their fundamental worth, leading to a crash when that exuberance fades, they said.

But a fall in prices should be expected, even if current valuations are an accurate reflection of AI’s capacity to reshape the global economy and boost corporate profits, they add.

The economists cite parallels with the 19th century railway boom, the expansion of electricity and radio in the 1920s, and the rise of the internet in the 1990s — not the first time the current AI wave has been compared to the dotcom bubble of the early 2000s.

In each case, investor nerves about the success of a technology-linked transition spilled over into the wider economy.

“As adoption spreads…uncertainty becomes economy-wide. If something then goes wrong with that technology, the whole economy suffers,” the economists wrote.

This drives investors to demand a higher risk premium, which their analysis found is likely to eventually drive stock prices down, even if profit growth remains robust.

“Both views imply a boom followed by a correction, or a pullback from wherever valuations have risen, at some point in the future,” they said, noting that this could in turn be followed by a recovery and further climb in stocks.

“The exact timing is unknowable in advance. These boom-bust patterns are only identifiable with hindsight.”

The blog goes on to warn of the fallout of such a pullback and urged investors to prepare for it.

European retail investors are highly exposed, potentially without knowing it, because of the prevalence of “Magnificent 7” stocks in global index funds and pension funds, the economists said.

There is a further risk that a sharp correction triggers knock-on effects through fund-based structures that eventually threatens euro area stability, they continued.

“Unlike in the dot-com episode, today’s starting point leaves markedly less room to cut interest rates or use fiscal policy to cushion the fallout.”