AI: Ticking time bomb? Can artificial intelligence stocks avoid a dot-com style crash?

We are living in an era where artificial intelligence is transforming the way we interact with technology, driving innovations that were once considered science fiction. Just as the dawn of the internet revolutionized our world in the late 20th century, AI is now reshaping industries and everyday life with unprecedented speed.

Today, companies are harnessing AI across a wide range of applications. In cloud computing, AI enhances data management and security. Office software integrates AI to streamline workflows and improve productivity.

The automotive industry leverages AI in electric vehicles to advance autonomous driving and optimize performance. E-commerce platforms use AI to personalize shopping experiences and enhance customer service. Search engines utilize AI to refine search algorithms and deliver more accurate results.

Experts are calling this a new industrial revolution that's set to change how we live. Major tech companies are pouring billions into AI infrastructure, gearing up for this transformative shift.

Tech rally fuels market surge

The U.S. stock market rally this year so far, has been predominantly driven by a sharp increase in tech stocks, fueled by speculation that big tech companies will benefit from breakthroughs in artificial intelligence.

This surge has added trillions of dollars to these companies' market valuations. Companies such as Nvidia, AMD, and Broadcom have experienced substantial growth due to the increased demand for AI chips and solutions. Nvidia, in particular, has solidified its dominance in the GPU market, which is essential for AI components, and now holds a significant market share.

The share price of Nvidia has jumped 120% so far this year, propelling Nvidia into the $3 trillion market capitalization club alongside Apple and Microsoft. Nvidia's ascent has been the fastest among tech giants, reaching the $3 trillion mark in a record 96 calendar days.

Other tech stocks have also mirrored this rally, driving the S&P 500, the U.S. major index, to hit record highs 36 times this year.

Too far, too fast

Investor optimism about AI's potential has driven tech stocks to elevated levels, creating an environment where strong earnings were necessary to sustain these valuations. As June quarter earnings reports were released, investors eagerly sought signs of when the substantial hype and capital investments in AI would translate into financial gains.

However, the results from major tech companies have been disappointing, failing to meet the high expectations set by investors. This disconnect between anticipated and actual performance has triggered a wave of sell-offs.

The recent earnings season has underscored the challenges these companies face in converting AI advancements into immediate financial returns, causing a reassessment of stock valuations and a subsequent market pullback.

Disappointing earnings

Amazon reported lower-than-expected net sales for the June quarter, sparking investor concerns regarding the extensive capex related to artificial intelligence that these companies are undertaking.

The e-commerce giant also issued soft third-quarter guidance for net sales, below the consensus estimate. This disappointing outlook contributed to a 9% drop in Amazon's share price on Friday, which closed at $167.90.

Tesla shares have dropped by 15.5% since the release of its Q2 earnings report on July 23. The report revealed another quarter of disappointing profits, primarily due to the impact of electric vehicle (EV) discounts on the company's profit margins. These discounts have led to a decrease in the average selling price.

The competitive landscape, particularly in China, has intensified. In response to falling sales this year, Tesla has significantly reduced prices on its popular EV models and introduced other incentives, such as low-interest loans.

Additionally, the company's decision to delay the unveiling of its Robotaxi from August to October has further dampened investor sentiment.

Shares of Alphabet, Google's parent company, also fell after the June quarter results. Despite reporting better-than-expected earnings and revenue, YouTube's advertising revenue was below consensus estimates.

Similarly, Microsoft’s shares declined after its Q2 earnings report, despite surpassing expectations for both earnings and revenue. The focus was on weaker cloud performance, although executives offered optimism by forecasting a faster growth rate for the cloud segment in the first half of 2025.

Worst Intraday drop in 40 years

Intel Corp shares tumbled 26% during Friday's trade, the largest intraday decline in over 40 years after the company gave a grim growth forecast and laid out plans to slash 15,000 jobs to cut down the costs.

The company is facing significant financial losses, with a $1.6 billion loss in the second quarter and a $437 million in the first quarter, as per the recent reports.

The primary issue stems from its production business, where it manufactures chips. Unlike Nvidia, which focuses solely on designing advanced AI chips, the production of these chips is outsourced to companies in countries such as Japan, South Korea, or Taiwan. This outsourcing model helps Nvidia avoid the heavy costs associated with chip manufacturing.

Recession worries mount

In addition to disappointing earnings reports, concerns about a potential recession have hindered the rally in tech stocks. On Friday, the S&P 500 and Nasdaq experienced significant declines following new data that indicated signs of weakness in the U.S. economy.

The July data has shown that manufacturing activity contracted at its fastest rate since December 2023, and job growth slowed significantly. Additionally, the unemployment rate unexpectedly rose to 4.3%, the highest level since October 2021.

Following the July jobs report, many economists have criticized the Federal Reserve for maintaining high interest rates for an extended period. They argue that the Fed should have lowered rates last week to support the economy, as labour market data shows signs of weakening.

On July 31, the Fed kept interest rates unchanged at a 23-year high of 5.25%–5.50% for the eighth consecutive meeting in July 2024, in line with expectations. The Fed has been at these rates for over a year now. However, Jerome Powell indicated that a rate cut could occur as soon as September.

Economists have pointed out that even if the Fed cuts rates in September, the current high rates have already made borrowing more expensive for purchasing homes, cars, or using credit cards. Additionally, it could take several months to a year for the effects of a rate cut to be fully realized in the economy.

Bubble or breakthrough?

When stock prices experience rapid appreciation in a short span, it often signals excessive speculation and a race among investors to capitalize on the perceived opportunity. This kind of explosive growth can create an unsustainable bubble, where prices are driven to levels far beyond their intrinsic value.

As history has shown, these bubbles eventually burst, leading to significant market corrections. Notably, these giants in their respective fields have significantly outperformed small-cap stocks.

For example, Nvidia's shares have surged 745% since January 2023, while Meta Platforms, Amazon, and Alphabet have experienced increases of 305%, 117%, and 106%, respectively. Notably, these gains have remained substantial even after recent sell-offs.

The current surge in tech stocks is showing a similar pattern to that of the dot-com bubble of the late 1990s, a time when rapid price increases in internet-based stocks led to inflated valuations throughout the technology sector. The dot-com bubble burst in March 2000, resulting in a 49% decline in the S&P 500 by October 2002.

The dot-com bubble followed the Gartner Hype Cycle, where initial excitement about the internet led to inflated expectations and excessive valuations in the tech sector. When the bubble burst, the market crashed, and many analysts doubted the internet's future. However, practical applications like e-commerce and cloud computing soon emerged, proving the internet's crucial role in the global economy.

Artificial intelligence may follow a similar trajectory. Gartner estimated in 2023 that generative AI was approaching the peak of inflated expectations and might reach a more stable phase within two to five years. While AI stocks could experience a slowdown and potential drawdown, current valuations suggest any decline would likely be less severe than the dot-com crash.

Disclaimer: The views and recommendations given in this article are those of individual analysts. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.