The parabolic rise in artificial intelligence stocks is leading skeptics to believe these names are in a bubble. Taking a few factors into account, “bubble” is just too strong a word for a group with more potential wins.
(NVDA), Advanced Micro Devices (AMD),
(GOOGL) are among the companies most impacted by AI — and their shares have soared.
Microsoft is integrating AI into its cloud offerings, making the company even more competitive in this space. The company is also launching ChatGPT – and the earnings outlook for the last quarter has been excellent. The software giant's stock is up more than 35% year-to-date. Alphabet, which integrates AI into its advertising offering and is launching Bard, a ChatGPT competitor, has seen its shares rise nearly 40% so far this year.
Meta and Nvidia shares have more than doubled in 2023. Meta, the parent company of Facebook and Instagram, was down in 2022, making it particularly cheap ahead of the AI rally. Nvidia is expected to sell more chips in its data center business to drive AI-related cloud advances. That's boosted AMD stock more than 80% year-to-date, as this chipmaker also derives a portion of its revenue from the data center.
On the surface, these gains appear to have spiraled out of control. The recent outperformance of these large-cap tech stocks relative to the rest of the market has been consistent with previous bubbles, as Evercore strategists have recently pointed out. The combined market value of seven of the largest U.S. tech stocks now accounts for just under 30% of market value
Market value, the highest percentage since at least 2013, according to Bank of America. Bank strategists are calling the AI rally a “baby bubble.”
It seems tempting to draw an analogy with a bubble regardless of its size, but some key factors just don't support this case.
First off, valuations are up, but they're not in bubble territory. The aggregate forward price to earnings ratio for the technology sector
Nasdaq Composite Index,
that includes these AI inventories is about 27 times that. That's less than 35 times before the pandemic-era bubble began to burst in 2020, and nowhere near the dot-com peak of over 60 times in early 2000, according to RBC. Back then, the Nasdaq “looked heavily congested, but that's not the case today,” wrote Lori Cavlasina, RBC's chief US equities strategist, in a research note.
Furthermore, these multipliers are fundamentally justified. According to FactSet, analysts expect Nasdaq annual earnings per share growth to be nearly 18% over the next three years. That means the current multiple is about 1.5 times the growth rate. Simply put, this “PEG ratio,” which stands for price-to-earnings-to-earnings growth, means investors pay 1.5 P/E points for every percentage point of earnings growth they achieve. That's not that high considering the S&P 500's PEG ratio is just over 2.
The metrics could remain stable for the next several years as both earnings and share prices rise and more investors jump in. Nvidia stock, for example, could trade at just over $530 by the end of next year, about 39% up from the current $381; That assumes shares continue to trade at the current 45 times earnings and that 2025 earnings per share estimates remain at $11.84. The current multiple seems reasonable, as it doesn't even account for the 50% growth in annualized earnings per share that analysts expect over the next three years. This is very different from the real bubble of the dot-com era, when unprofitable companies traded at high valuations relative to estimated sales.
Of course, AI stocks may need to take a breather. They are already moderating near their recent highs. There might even be a slight pullback in the near term, but that might just be a drop in the bucket compared to the larger uptrends these stocks are in — and buying dips could prove prescient.
Write to Jacob Sonenshine at [email protected]