ELLEVEST INSIGHTS

Imagine a small town where the florist buys cookies from the bakery, the bakery buys shirts from the tailor, and the tailor buys flowers from the florist. The money just loops endlessly, and everyone's sales look fantastic. Until you realize no actual customers ever showed up.

This isn't just a thought experiment. It's what investors are increasingly questioning as they examine recent investment patterns among tech giants. You may have read about "circular investment" or "vendor finance” within tech and the timing of these concerns isn't coincidental.

While the S&P 500 closed up 2.3% for October and 16% for the year, the tech-heavy Nasdaq has posted gains of 4.7% for the month and 23% year to date. With tech valuations climbing higher over the past year, questions around the sustainability of this growth are natural.

Historical context

That small town analogy is actually a nod to the tech bubble of the late 1990s/early 2000s, when investments in digital advertising helped fuel revenues and propped up inflated valuations before the eventual collapse.

Here's how it worked: Venture capital-funded internet companies used investment dollars from their investors to buy banner ads on websites. Unfortunately, those websites were just more venture backed online companies doing the exact same thing. Revenues looked impressive on paper until everyone realized those advertising dollars weren't generating anywhere near the user growth needed to justify valuations.

Today's circular investments

Fast forward to today, and we're seeing a new version of this dynamic emerge in the AI ecosystem. Recent transactions have created an intricate web of investments among tech giants that raises important questions about underlying demand. 

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Consider these recent notable examples:

• OpenAI received a $100 billion infusion from Nvidia, with a large portion of this investment likely earmarked for leasing Nvidia's GPUs. In other words: Nvidia invests in OpenAI, which then uses those funds to buy or lease Nvidia products.
• OpenAI then announced a deal with AMD where OpenAI agreed to purchase AMD chips. In return, OpenAI is set to receive up to a 10% stake in AMD over time.

The pattern is clear … money flowing in circles among companies that are simultaneously customers, investors, and suppliers to one another.

Understanding the risks

The immediate concern is artificial revenue growth. Circular flows such as purchases of cloud credits, hardware, or AI compute capacity can distort growth metrics, hide real underlying demand, or mask structural weaknesses. That then can lead to more systemic risk in the system. Market concentration combined with deep interdependence amplifies systemic risk. If these companies are all financially intertwined, a slowdown in one area could trigger sharper, more synchronized declines across the entire ecosystem.

However, on the flip side, it's critical to note that the companies making these investments have strong, profitable core businesses that existed long before the AI boom. Unlike the dot-com era's unprofitable start-ups, today's tech giants generate substantial cash flow from established operations. And reported demand for AI products and underlying usage remain robust and continue growing. 

The bubble question

The question that will undoubtedly resurface throughout this AI wave is, “are we in a bubble?”

History suggests we should expect overinvestment ahead of demand. That's a consistent feature of transformative technology cycles. Railroads, electricity, and the internet itself all followed similar patterns of initial exuberance, correction, and eventual widespread adoption. The challenge? We won't know the cycle until after the fact. There may even be multiple ebbs and flows through this cycle, with periods of correction followed by renewed optimism as real applications gain adoption.

Keeping an eye on underlying demand for products and services is key. Watch for signs that actual end users, not just other tech companies, are adopting and deriving value from AI applications. That's the signal that will separate sustainable growth from circular momentum.

Practical implications

If you're looking to add AI exposure, recognize that major indices and ETFs have become increasingly concentrated in a handful of tech names. You may already own more exposure than you realize. The Magnificent 7 (Mag 7) stocks alone now represent 37% of the S&P 500's market capitalization.

If you're concerned about stretched valuations in mega cap tech, remember there's a broader investment universe beyond the Mag 7. International equity markets, for instance, have outperformed the S&P 500 this year while trading at more reasonable valuations. 

AI technology is real and it will likely transform industries in ways we're only beginning to understand. But transformative technology and good investment timing don't always align. Successful investing isn't about predicting the exact timing of market turns or chasing the hottest trends. It's about understanding fundamental value, maintaining disciplined risk management, and staying focused on your long-term objectives.