Investors have long had a love affair with U.S. tech stocks, from the boom cycle of the late 1990s and early 2000s, which famously ended with the dotcom bust, to the market-induced highs artificial intelligence of Nvidia’s current stock rally. Romantic relationships, however, often end badly, and this one could leave investors with a sore wallet and a broken heart. Artificial intelligence has officially thrown the US tech industry into a bubble and Silicon Valley may be on the verge of another collapse, according to a top analyst from BCA Research chief strategist Dhaval Joshi.
“We’re in an AI bubble,” Joshi says Fortune. “We were amazed by some of the results.”
Few stocks have embodied this wow factor like $1.7 trillion AI chip giant Nvidia, which reported earnings on Wednesday, blowing analysts’ expectations. The chipmaker, dubbed “the biggest stock on planet Earth” by a Goldman Sachs analyst, posted revenue of $22.1 billion in the latest quarter, compared to a forecast of $20.6 billion. Revenue for the company’s data center chips, used in AI models and generative AI applications, reflected increased demand and reached $18.4 billion, up 27% from third quarter and 409% compared to last year. Stock prices rose 7% in after-market trading, adding more than $100 billion in value.
“Accelerated computing and generative artificial intelligence have reached the tipping point,” Nvidia founder and CEO Jensen Huang said in a press release. “Demand is increasing around the world among businesses, industries and nations.”
While Joshi didn’t comment specifically on Nvidia, its stellar results can be seen as evidence supporting his case.
According to Joshi’s calculations in an analyst note published last week, the technology sector trades at a 75% premium to the global stock market. Its red-hot growth became the backbone on which much of the rest of the U.S. stock market’s growth was built and took the Nasdaq to near-record highs last year, just 6.5% off its all-time high of November 2021. the so-called Magnificent Seven, which includes Nvidia, Apple, Microsoft, Alphabet, Meta, Amazon and Tesla, contributed two-thirds of the S&P 500 index’s total market gains.
And while these gains are impressive and profitable for savvy investors, Joshi says they are unsustainable.
Unlike Nvidia, some companies will not be able to meet the high expectations imposed by the market. This could create problems because valuations and stock prices are often measured against expectations as much as against actual results. If the major technology companies that contribute largely to the growth of the sector (and the economy) do not meet analysts’ expectations, they could drag the others down with them. While Joshi cautions against underestimating AI as a whole, he believes the market is pricing in far too much productivity growth from the new technology. And when new innovations fail to meet those expectations, the market will punish the companies that made them.
“Because these few stocks have become such a massive percentage of the market cap, any disappointment will mathematically impact the overall index,” Joshi says.
For the U.S. tech sector to avoid bubble territory, it would have to continue trading at a 10% premium to the market, a scenario Joshi believes is unlikely.
Joshi doesn’t blame the market for valuing tech companies so highly. In fact, they have proven their worth over the last 10 years by achieving stellar results time and time again. Over the last decade, the stocks of major technology companies have soared. For example, since February 2014, Nvidia’s shares have increased by 14,927%, Microsoft’s by 964%, and Apple’s by 875%. The numbers pale in comparison to the still-robust 163% the S&P 500 has seen over the past 10 years. While he doesn’t believe this will continue, he says it’s rational for the market to continue to price in more explosive growth in the tech sector.
“If you get very strong earnings growth, for a year or two, the market looks at it another way: ‘This situation cannot be sustained.’ So if anything, you give it a low rating, because you say these are abnormally high earnings. But if the market sees 10 years of exceptional performance, it no longer considers those results abnormal and comes to expect them forever, Joshi says.
For Joshi, however, the last 10 years of highly successful earnings growth have, in fact, been abnormal. Largely because most of that growth was the result of the network effect, which allowed a select few companies to expand in size and effectively gain control of a market. Amazon has conquered the online shopping market, Google has done the same with search and Meta has conquered the online communication market, Joshi writes in his note.
“Once you have networks, there are winners and losers,” he says. “Those winners become natural monopolies, and if you are a natural monopoly, then you are in a very strong position to increase your profits.”
Without a clear indication that the network effect will translate into the world of artificial intelligence, these companies will not have the same dominant position, Joshi argues. “The market is saying, ‘hey, the baton will now be passed to generative AI and this trend will continue for the next five to ten years.’ I’m very cynical about it because there is no network effect in generative AI.”
There is a possibility that some particularly popular AI tools could see a network effect if they attract more users because they will be able to train on all the tasks they are asked to perform.
Even without AI, it appears that the benefits of the network effect may be diminished in the near future due to the push by elected officials to regulate Big Tech. “The Web 2.0 revolution has reached its limit due to negative consumer reaction and much tougher and stricter regulation on what data can be collected and how it can be used.”
In Europe, the EU has already passed several key pieces of legislation intended to dismantle some of the energy technology giants such as Apple and Alphabet already on the market. In the United States, however, although there is no national privacy law, there is an unprecedented level of bipartisan and public support for a series of new laws that would limit the amount and type of data that technology companies can collect on users.
But despite the obstacles Joshi sees on the horizon for technology, he doesn’t expect the entire industry to collapse like it did with the dotcom bust. In fact, he will continue to outperform the overall market just at a slower pace. This could still lead to major losses for investors, especially when the market eventually readjusts to a tech sector that no longer offers hundredfold returns.
To be sure, whether or not the market is in the midst of an AI bubble is still hotly debated. Joshi isn’t the only one who thinks there is one. Morgan Stanley has warned against rushing headlong into artificial intelligence, lest investors have adequate ground before the bubble bursts. Meanwhile, Goldman Sachs and others argue that skyrocketing yields are not a bubble, but just the market rewarding the future of technology.
As for what investors should do to mitigate the risks of a possible AI bubble, Joshi has some simple advice: Invest in other parts of the market like healthcare and luxury goods.