Are AI Stocks Making The Market Too Risky?

One of the biggest tech exchange-traded funds was set to quadruple its holdings of one of the market’s hottest tech stocks, Nvidia

NVDA
-3.22%
while sharply trimming back on another giant, Apple. The $70 billion Technology Select Sector SPDR

XLK
-0.17%
ETF has returned 17% this year, trailing large-cap tech stocks by nearly seven percentage points.

The fund has an Internal Revenue Service issue. The IRS says individual positions exceeding 5% of fund assets can’t make up more than 50% of holdings. The ETF recently had 22% of its assets invested in Microsoft

MSFT
0.92%
and 22% in Apple, each of which had a market cap around $3.3 trillion. However, Nvidia, whose market value roughly equalled those of its rivals, was only 5.7%. That kept the fund under the 50% concentration threshold.

But on June 14, a key index rebalancing date, Nivida’s market cap exceeded Apple’s and the fund was obliged to buy Nvidia shares, while selling down Apple—despite the fact that Nvidia stock fell last week and now trails Apple in market value.

Two of the larger tech exchange-traded funds track the same sector but differ in​allocations to the biggest stocks. Source: FactSet

Will investors benefit? It depends on how the stocks perform and how concentrated the market remains. “The best approach may be simply to make do” - says Ned Davis U.S. sector strategist, Rob Anderson. Sector ETFs are more convenient than tracking sectors by buying individual stocks and differences often even out. “Over fifteen years, the tech ETF returned 19.9% a year on average” - says Morningstar, versus 20.3% for tech stocks.

Nvidia’s Growth Has Been Stunning, But Now It’s Time to Worry.

Nvidia trades for 20 times next year’s expected revenue. Historically, that’s been a worrisome level for future stock returns. Link

Nvidia Is No Cisco, But It Is Getting Expensive

The chip maker’s valuation is nowhere near those seen in the dot-com boom, but recent gains have erased the stock’s discount relative to its projected earnings. Expect more volatility. Link

So here’s the problem I have with Nvidia

NVDA
-3.22%

What can it possibly do for an encore?

Investors have embraced the graphics chip company as the one sure bet on artificial intelligence. To be clear, Nvidia has come to dominate the market for chips used for AI model training and inference. Revenue in the April quarter was up 262% from the year-ago period, driving a 629% increase in profit. Wall Street’s consensus estimate for the July quarter is for 110% revenue growth, marking a fifth straight quarter of triple-digit growth.

Looking at it in a different way, we’re already seeing growth slow. Over Nvidia’s past four earnings reports, quarter-over-quarter growth has slowed from 88% to 34% to 22% to 18%.

I’m not dumb enough to jump in front of a roaring freight train —I wouldn’t suggest anyone short Nvidia stock, but the whole thing seems a little, if not unhinged, let’s just say unsustainable.

I’m no AI skeptic. I’m not even accounting for increased competition in AI chips, or the fact that enterprise software companies are having some alarming problems turning AI promise into real-world profit, but Nvidia is already worth more than any company on the planet, now or ever.

Another 20% rally would take the stock’s market cap to $4 trillion, a milestone never reached before. It might be time to temper your enthusiasm, at least a little.

For one thing, Nvidia’s forward price/earnings multiple has gone from roughly 25 at the end of last year to a current 45. More eye-opening is that the stock trades for 20 times expected revenue for the January 2026 fiscal year, based on Wall Street estimates.

A few years back, I wrote a column citing data from Bernstein analyst Toni Sacconaghi showing that stocks trading at price-to-sales multiples above fifteen times tend to be terrible investments. From 1970 to 2020, Bernstein’s data showed, those stocks underperformed the market by 18 percentage points over the subsequent three years—and 28 points over five years. For stocks trading above twenty times sales, the returns were even worse.

I know what you’re thinking - it’s different this time, this is AI! Sure, maybe AI really is the most important thing to happen in technology since cloud computing, or the internet, or mobile phones, or even the personal computer, but the numbers worry me.

Nvidia’s market value is now nearly five times the industry estimate for next year’s global chip sales—yes, the total from every company worldwide.

Microsoft
MSFT
0.92%
has seven times the number of employees Nvidia does, and twice the sales.

Apple
AAPL
-1.04%
has five times the staff and triple the sales volume. Nonetheless, this past week, Nvidia’s market cap vaulted past them both.

Here’s the other thing - there are picks-and-shovels AI bets that don’t require the same heroic assumptions that Nvidia stock now entails. Here are a dozen ideas, many of which have been highlighted previously in this column. None of these are growing triple digits, but they’ll all benefit from the continued growth of AI.

Micron Technology
MU
-3.22%

You know what AI data centers need beside GPUs? Lots of high-bandwidth memory. Micron is seeing more demand for this memory than it can fulfil. The push for AI capable phones and PCs is going to increase memory demand too.

Arista Networks

ANET

-0.83%

You know what else is needed as data centers grow? Networking hardware. Microsoft and Meta Platforms, which account for about half of Arista’s sales, are both ratcheting up spending to respond to growing AI needs.

Corning: I laid this one out in detail last week, but the bottom line is that the more GPUs you combine into AI server racks, the more fiberoptic cable you need to connect them all.

Arm/Qualcomm/SoftBank: Qualcomm’s Snapdragon X processors are poised to steal market share from Intel and Advanced Micro Devices as AI-capable PCs become a real market. Those processors are based on Arm’s chip designs. SoftBank, meanwhile, owns 90% of Arm, while trading at about a 50% discount to net asset value. Their fates are intertwined.

Oracle: I was early on this one —Oracle is now competing head-to-head with Amazon.com, Alphabet and Microsoft in the cloud and gaining share. While growth had been stagnant at the enterprise software giant for years, it is now poised to return to double-digit expansion. Oracle recently signed OpenAI as a customer, and it’s partnering with Microsoft and Google to make their AI clouds more easily interoperable.

Taiwan Semiconductor: There is geopolitical risk here, but when it comes to building AI chips, there aren’t good alternatives to TSMC. Nvidia, AMD and even Intel are relying on Taiwan Semi’s cutting edge fabs to make AI chips.

HP Enterprise/Dell: Both hardware companies are seeing surging demand for their Nvidia-based AI servers; Dell is also poised to benefit from the coming AI PC wave and they’re bargains. Both trade for about one times forward revenue.

Microsoft: Microsoft is a multipronged bet, which benefits from the rise of OpenAI, improving demand for the company’s Azure cloud, an assortment of AI Copilots, and the gradual return of Bing as at least a marginal competitor to Google in search. No software company is better positioned.

Adobe: The dominant player in creative and marketing software, Adobe has gone all in on AI. Wall Street has been worried about competition from AI upstarts—the stock is off 12% this year—but Adobe has already started generating real revenue from AI-enhanced versions of its content creation software.

AI Stocks Are Soaring on Hope. Why Their Dominance Puts Markets at Peril, and 4 Other Things to Know Today.

The spell was finally broken yesterday. After seven record closes, the Nasdaq ended the day lower. There was no obvious reason; traders may have just been selling up to lock in profits after a nice bump.

Of course, we say that markets have been rising but by now everyone knows artificial intelligence stocks have been doing all the driving. Nvidia

NVDA
-3.22%
is the poster child, having topped 

Microsoft
MSFT
0.92%
earlier this week to become the biggest company by market value, and then lost it late Thursday. The magical hold AI has on investors was also demonstrated by Dell Technologies and Super Micro Computer

SMCI
-1.35%
which were boosted by Elon Musk mentioning this week that he would use their server infrastructure for his xAI start-up.

The market’s record-setting performance of the past week hasn’t been helped much by the prospect that the Federal Reserve will lower interest rates. Jobless claims data Thursday might have been a bit higher than expected, but it looks like rate cuts, if they arrive, will be both little and late.

That leaves just AI as the great catalyst for profits. When you look at how many companies are actually making money from AI at the moment, that’s kind of scary. Chip makers such as Nvidia are the only ones that can say AI has already put money in the bank.

For almost everyone else, it’s just hope that’s puffing up valuations. You would expect companies such as Microsoft to be the next beneficiaries, but that hasn’t filtered through yet to the bottom line.
Apple

AAPL
-1.04%
has received a lot of credit for plans to harness AI, but such optimism could be misplaced as there is no guarantee AI features are going to sell more iPhones. Meta might be better placed to benefit with its use of AI close to lifting advertising sales, but it’s not a sure thing.

For most, AI is a cost rather than a source of revenue. If AI is also the main thing driving stock gains, that could make the market vulnerable to even bigger pullbacks.

Nvidia lead the market up and could lead the market down.

- Richie

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