The rise of AI is frightening

Good morning. The big event this week is the first presidential debate of 2024. It's going to be awful, like all presidential debates. But we at Unhedged feel obligated to keep an eye on whether either candidate is serious about reducing the huge budget deficits that have been such a big driver of stock prices. What will you be watching? Email me: robert.armstrong@ft.com.

Inside the AI ​​Rally

Last week, Unhedged investigated how AI and AI-related stocks have driven most of the gains in the S&P 500 since the end of March. Below is a chart showing the dollar and percentage gains of Nvidia, the Fab Five tech giants (Alphabet, Amazon, Apple, Microsoft, Meta), and a set of semiconductor stocks, all of which have soared on hopes of an AI-driven digital investment boom.

This is a bit worrying. It seems to me that a rising, historically expensive market would decline slowly in the absence of a single investment theme, but could turn into a bear market if sentiment around that theme worsens. Imagine, for example, Nvidia lowering its earnings outlook, or one of the Fab Five cutting its investment budget.

Expectations are obviously high for AI stocks, but it's worth being a bit more precise. Consensus forecasts for revenue growth next year and 2026 actually don't seem all that aggressive. Analysts expect 23% annual growth for Nvidia over that period, which suggests growth will moderate somewhat. Over the past five years, Nvidia's revenue has grown 50% annually. Similarly, the Fab Five's two-year revenue growth rate is on par with or lower than its recent growth rate. Only a handful of chip stocks — Micron, Texas Instruments, Analog, and Lam — are expected to see significant revenue acceleration.

Is the AI ​​group's recent rise due to higher revenue estimates? Not when we look at forecasts for 2025. Revenue estimates across the group have increased by low single digits percentage-wise since the end of March. Only Apple, Amazon, and Micron have received significant increases.

One thing that has changed dramatically as AI stocks have rallied, perhaps unsurprisingly, is valuation. Over the past three months, the price-to-earnings multiples of Nvidia, Apple, Broadcom, and Qualcomm have all risen by more than 20%. Looking back to last October, when the rally began, the average (harmonic mean) P/E ratio for the AI ​​group has risen by almost 50%.

That's a lot of money. How should we interpret it? Perhaps it simply reflects momentum and animal spirits. More generously, it may reflect an expectation that the AI ​​business will bring incremental profits for years to come. So, this is a bet on the competitive dynamics within the AI ​​industry: that it won't be too competitive, and that in the long run the winners will be the same ones we have today: the Fab Five and today's semiconductor industry leaders.

To me, the second half of the bet, that the incumbents will continue to win, seems reasonable: technology incumbents are very powerful, and companies can use their strong market position in one technology to build a strong position in another (think Microsoft's move from PC operating systems to cloud computing). I'm not sure what to make of the first half of the bet – that AI won't become a capital-intensive knife fight in which no one makes much money.

To assess the robustness of the bull market, we need to take a closer look at non-AI stocks. Here's how the S&P 500 sectors performed after excluding AI stocks:

The four companies' capital spending is expected to increase by $54 billion from last year through 2025, more than 40% of NVIDIA's projected $100 billion revenue increase, but likely only a fraction of the big tech companies' capital spending goes to NVIDIA GPUs. That means either the big tech companies will spend more or NVIDIA's revenue will fall. “We are concerned that either tech cash flow or NVIDIA's revenue may be overstated,” Kara wrote.

Spending on Nvidia by other tech companies could surge next year, helping to pick up the slack from the big tech companies, but it will also show just how competitive the AI ​​business will become.

Good read

Social media is a tough business.