• Tech shares recently declined as investors questioned the value of the industry’s more established players.

• There’s always potential for new entrants to disrupt the status quo in areas of great innovation, particularly when valuations are stretched.

• Investors should be aware of the risks and opportunities; balance and diversification—across, and beyond, equities—remain key for investors.

News of an open-source artificial-intelligence (AI) model that could potentially rival current models at significantly lower cost caused tech shares to tumble recently, as investors began to question the value of the industry’s more established players. Here, Vanguard Global Chief Economist Joe Davis gives his perspective on current market valuations and what the future might hold, especially given his team’s ongoing research on “megatrends” and its views of AI’s potential to fundamentally change the economy.

What’s driving the dynamics in the tech sector?

Recent events are not entirely surprising. In areas of great innovation, there’s always potential for a start-up or new entrant to disrupt the status quo, particularly in today’s environment, where US tech stocks have already been priced for near perfection. Despite impressive earnings, stretched valuations provide little margin for error. This has been reflected in the historically stretched valuation of US equities, particularly large-cap growth stocks.

Much of this lofty valuation has rested on a key assumption that the leading tech firms will be able to continue to grow earnings based on their “competitive moat”. Whether or not the new open-source AI proves to disrupt the existing AI ecosystem, it is a timely reminder of an enduring investment lesson: Markets can underestimate the chance that dominant incumbents’ business models get disrupted by upstarts or economic changes.

There’s certainly plenty of precedent for this, especially in times of transformational technological change. We cover several examples in an upcoming book on megatrends. For instance, between 1900 and 1908, nearly 500 automobile companies came into existence, but more than half also disappeared. Today, only two of them are still around. That’s typical of the creative destruction you see as new entrants wipe away the value of older companies.

According to Stanford University’s annual AI Report, there have been 5,500 AI-related companies launched in the past 10 years in the US alone, both public and private - greater than the total number of publicly listed US companies¹. They can’t all be winners. And, if history is any guide, a few of them will surely be disruptors to today’s AI ecosystem as we know it.

Investors need to be aware of both the risks and opportunities, though the latter may not always be self-evident.

What are the hidden opportunities?

Sticking with equities for now, if AI is truly transformative, the biggest winners will likely be the beneficiaries of this technology, not necessarily the builders of the technology and its infrastructure, whose prices already reflect that optimism. Our secular outlook is that value stocks might benefit the most from AI over time. And I stress over time.

That said, I’m not suggesting that investors should abandon tech stocks entirely and instead go all in on value equities. For most investors, it’s better to diversify by owning the full haystack, instead of searching for those few needles. But diversification goes beyond equities.

Some investors questioned the value of bonds and balanced portfolios after 2022, when both equities and bonds plunged. But 2022 was more of a historical anomaly. In the most recent period, while tech stocks fell, bond prices rose. Bonds fulfilled their traditional role as ballast for equities in a balanced portfolio. As we’ve said in our economic and market outlook for 2025, fixed income looks especially attractive currently, providing generally higher yields than inflation, and a return to what’s known as “sound money”.

Last but not least, whether in bonds or equities, for those comfortable with active-management risk—and perhaps uncomfortable with current valuations in some pockets of the market—using active managers might give bargain-hunting investors an edge.

But the bottom line is balance and diversification.

¹ See Artificial Intelligence Index Report 2024.