Investor enthusiasm for artificial intelligence stocks has propelled markets to new all-time highs in 2024. Unfortunately, the spectacular surge in a handful of leading AI technology stocks has also raised concerns among skeptics that the market could be overheating.
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AI technology could be one of the most transformative advances in economic history. While its true impact is only beginning to make a mark on corporate financial statements, the long-term effect will likely be large. Skyrocketing prices of AI stocks reflect market expectations that may simply be unrealistically high, however.
Whether you’re already invested or are considering buying AI stocks, here are some things to keep in mind:
— Bull market vs. bubble.
— How will AI create value?
— Dot-com era, version 2.0?
— Should you buy AI stocks?
Bull Market vs. Bubble
The first step in diagnosing AI stocks is to understand the differences between a bull market and a bubble. In hindsight, it seems obvious which periods in the market were bubbles and which periods represented healthy economic expansion. In real time, it can be extremely difficult.
Market bubbles typically begin as bull markets. Investors recognize a trend in the market — such as the proliferation of the internet, a rising housing market or the emergence of electric power grids — that will certainly create value for corporations. Investors are initially enthusiastic about the developing trends and respond by buying stocks and driving stock prices higher.
In a bubble, however, the exuberance for stocks can transition from rational to irrational. The market loses sight of the fundamental reasons stocks were rising to begin with, and investors start buying simply because stock prices are rising. Further gains are driven by FOMO, or fear of missing out, rather than realistic expectations of future earnings growth.
When looking at industries such as tech, it can be very difficult to tell the difference between irrational exuberance and a rational, long-term mindset. AI technology could potentially create trillions of dollars in value over the next 20 years, so it’s easy to rationalize buying leading AI technology stocks today at virtually any price or valuation.
How Will AI Create Value?
One of the most important questions is how companies involved in the AI space will monetize their services to create profitable revenue streams.
AI technology experts tout its potential to streamline business operations, reduce or eliminate labor costs and analyze data to come up with novel products and services.
When it comes to leading AI chipmakers such as Nvidia Corp. (ticker: NVDA), it’s easy to see why investors are so excited. Not only will Nvidia benefit from the initial AI investment boom, but its customers will likely need to continually upgrade their chips and servers or risk losing their edge to competitors and becoming obsolete. These constant upgrades should continue to feed Nvidia’s profit growth for as long as the company maintains its position as the leading AI semiconductor company.
AI services providers, such as Microsoft Corp. (MSFT), Alphabet Inc. (GOOG, GOOGL) and Meta Platforms Inc. (META), are investing tremendous amounts of money in building their AI models and upgrading their infrastructure. AI bulls say these heavy investments are analogous to the massive investments cloud services providers made in the early 2000s. Those investments are now paying off in a major way for companies like Amazon.com Inc. (AMZN) and Microsoft. In 2023, Amazon Web Services generated $24.6 billion in operating income. Microsoft’s Intelligent Cloud segment generated $87.9 billion in operating income in its most recent fiscal year. Not only is that cloud services profitability contributing significantly to these companies’ overall earnings, it’s also helping to fund investments in future cloud infrastructure and development. Microsoft and Amazon are likely hoping they can reach a similar point with their AI technology in the future.
AI service providers and AI hardware makers will certainly be at the epicenter of the AI technology boom, but the AI revolution could ultimately lift the entire global economy.
Michal Oglodek, chief technical officer and co-founder of Ivy.ai, says AI technology has the potential to unlock tremendous value for companies in all sectors of the economy.
“AI technology is poised to create substantial economic value by automating routine tasks across industries, freeing up human workers to focus on higher-value activities and sparking new innovations,” Oglodek says.
“Additionally, AI’s ability to analyze vast amounts of data and make predictive insights is expected to drive efficiency gains, enhance decision-making, and enable the development of entirely new products and services across sectors like health care, finance and transportation.”
One challenge that AI technology may face that other tech industries have also navigated is potential disruptions from regulators and lawmakers. As AI companies become more influential, they will likely face scrutiny and regulations related to factors such as safety, ethics, privacy, data collection and accessibility.
Dot-Com Era, Version 2.0?
For value investors, there is certainly cause for concern. From the beginning of 2023 through July 12 this year, the S&P 500 is up about 46%. The Nasdaq Composite is up 75% in that stretch. AI technology stock Arista Networks Inc. (ANET) has rocketed 198% in that period. AI chipmaker Nvidia is up 784% since the beginning of 2023, while shares of AI hardware maker Super Micro Computer Inc. (SMCI) have soared 1,008%.
Meanwhile, the S&P 500’s current forward price-to-earnings (P/E) ratio of 21.4 is 19.6% above its 10-year average of 17.9, according to FactSet. The S&P 500’s cyclically adjusted P/E (CAPE) ratio, which is a long-term valuation metric based on average inflation-adjusted earnings from the previous 10 years, is 36.4. That CAPE ratio is more than double the S&P 500’s long-term mean ratio of 17.1 and is approaching the highest level of all time outside of the dot-com bubble.
David Bahnsen, chief investment officer at the Bahnsen Group, says there are many great companies leading the AI boom, but the dot-com bubble demonstrated that even great companies can have unrealistic valuations.
“The euphoria in Big Tech stocks in recent weeks and months is absurd, and investors seem to be forgetting what took place in the years leading up to the 2000 tech stock collapse,” Bahnsen says. “The combination of technology and communication services stocks now make up almost half of the S&P 500’s market cap, which is frightening and certainly unsustainable.”
At this point at least, it seems mega-cap AI technology stocks have not yet returned to the extreme valuations of the dot-com bubble.
JPMorgan recently compared the valuations and growth expectations of today’s AI technology leaders to the tech sector giants of the dot-com bubble. To represent the dot-com bubble, JPMorgan used Microsoft, Cisco Systems Inc. (CSCO), Intel Corp. (INTC), Lucent Technologies Inc. and International Business Machines Corp. (IBM). To represent today’s AI services leaders, the analysts used Microsoft, Nvidia, Amazon, Meta Platforms and Alphabet (class A shares).
JPMorgan found today’s group of AI giants have an average 2024 P/E ratio of around 34. Value investors know a 34 P/E ratio isn’t particularly cheap, but it’s certainly no red flag for a growth stock. It’s also significantly lower than the average 59 P/E ratio of the dot-com group in 2000. At the same time, today’s AI technology stocks have an average 2024 earnings growth rate estimate of 42%, exceeding the 30% average growth rate expectations of the dot-com bubble tech stocks in 2000.
Should You Buy AI Stocks?
Much like during the dot-com bubble, the question of whether long-term investors should buy leading AI tech stocks like Microsoft, Nvidia and Alphabet is not really about “if” but instead is about “when.” If the market is not in an AI technology bubble, now is as good a time as any to add to your AI technology portfolio. If we are in an AI bubble, it might be more prudent to wait a year or two for a more attractive entry point.
Robert Persichitte is an adjunct professor at Metropolitan State University of Denver and a financial planner at Delagify Financial. Persichitte says AI stock prices are high at the moment, but we are not experiencing a bubble. However, he says investors still need to take precautions and avoid chasing empty AI promises.
“There are … isolated instances where companies without a clear plan or path to profitability are getting funded because they claim to incorporate AI. Make sure you don’t just buy based on hype but also the substance of the investment and the long-term plan,” Persichitte says.
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Are We in an AI Bubble? originally appeared on usnews.com
