The once-invincible megacap tech stocks, known collectively as the Magnificent Seven, have begun to show signs of weakness. Since the second week of July, these tech giants—including Amazon.com and Tesla—have seen their stock prices plummet. This past week was particularly tough, with Alphabet reporting slower revenue growth in its YouTube business and Tesla’s earnings being hit by lower electric-vehicle prices and deliveries. This has exacerbated the downward trajectory of these tech behemoths, leading to concerns among investors and analysts alike.
Investor Rotation: From Big Tech to Small-Caps
One explanation for this downturn is the ongoing investor rotation from Big Tech to small-cap stocks. Around July 10, the tech-heavy Nasdaq Composite started to lag behind the Russell 2000 index, which tracks smaller companies. Wall Street analysts quickly pointed to the Russell’s breakout as an opportunity to revive interest in overlooked small-cap names. However, no single factor fully explains market trends, and the smaller stocks in the Russell 2000 cannot entirely absorb the vast sums of money previously invested in megacaps. The current divergence in the fortunes of these indices merely reflects a partial retracement of the Nasdaq’s earlier outperformance of the Russell and the S&P 500 this year.
The trend towards small-caps has been driven by various economic indicators. For instance, the weaker-than-expected consumer price index (CPI) data in June prompted investors to anticipate a potential rate cut by the Federal Reserve in September. This expectation fueled a rally in small-cap stocks, as these companies are generally more sensitive to interest rate changes due to their higher debt levels and economic exposure. The Russell 2000’s performance relative to the S&P 500 and Nasdaq Composite underscores this shift, highlighting the market’s nuanced response to macroeconomic signals rather than purely political events.
AI Investment: A Cause for Concern?
Another factor contributing to the sentiment shift is growing investor concern that spending on artificial intelligence (AI) might soon decelerate. Big Tech has dazzled the world with innovative generative-AI platforms, leading to massive expenditures on AI chips, primarily benefiting Nvidia, the leading supplier of these chips. Companies like Amazon, Apple, Google (under Alphabet), Meta Platforms, and Microsoft have collectively spent tens of billions of dollars on AI data centers. Despite the impressive capabilities of these AI models—such as writing code and composing music—they have yet to generate significant revenue for anyone beyond Nvidia and a few other hardware vendors.
The critical question now is what returns investors can expect from these substantial capital expenditures. Back in May, the issue was already raising concerns, with no clear answers in sight. When I posed the question to the AI models themselves, their responses ominously hinted at workforce reductions as a likely outcome. This skepticism about AI’s immediate financial returns is echoed by industry experts.
David Cahn, a venture capitalist at Sequoia Capital, has also questioned the return on AI investments. In June, he updated an influential analysis, estimating that Nvidia’s customers would need to generate $600 billion in AI revenue to achieve an acceptable return on their investments. Currently, he believes they might collectively reach only $100 billion in new revenue. While Cahn acknowledges that AI will transform the economy much like the internet and railroads did, he also cautions that many early investors in these technologies suffered significant losses when initial valuations crashed—paving the way for broader, long-term benefits.
As investors grapple with these uncertainties, the stock prices of major tech companies have been under pressure. The anticipation of slower returns on AI investments has led to a reevaluation of these companies’ stock valuations, contributing to the broader market selloff. This recalibration reflects a more cautious approach by investors who are now questioning the immediate profitability of the hefty investments in AI infrastructure.
Continued AI Spending: The Reality of Big Tech’s Strategy
Despite the market’s recent selloff, it would be a mistake to conclude that Big Tech is scaling back its AI investments. If anything, these companies are doubling down. Alphabet’s recent quarterly report revealed that its capital spending had nearly doubled from the previous year, driven by aggressive investments in AI. CEO Sundar Pichai emphasized the importance of investing heavily in AI, which he believes will revolutionize all of Alphabet’s core businesses, from search to YouTube to cloud computing.
“When you go through a curve like this, the risk of underinvesting is dramatically greater than the risk of overinvesting for us,” Pichai told investors.
This sentiment is not limited to internet firms. Moderna co-founder Noubar Afeyan recently discussed plans by his biotech venture firm, Flagship Pioneering, to allocate billions towards AI models for drug discovery. “We don’t know if it’s going to work,” he admitted. “Do you sit there and let somebody else figure out if it works? No.”
These statements from industry leaders underscore a fundamental belief in the transformative potential of AI. They highlight a willingness to invest heavily despite uncertain short-term returns, driven by the conviction that AI will play a pivotal role in shaping the future of various industries. This commitment to AI is a strategic bet on long-term innovation and market leadership.
The Near-Term Outlook
While predicting the long-term winners of the AI race remains challenging, one thing is clear: the money will continue to flow into AI in the near term. Despite the current volatility, Big Tech’s commitment to AI investments suggests that they are betting on these technologies to drive future growth and transformation across various sectors. This sustained investment is likely to keep the AI narrative alive and may eventually yield significant breakthroughs and revenue streams.
For investors, the recent market dynamics underscore the importance of diversification and a balanced approach. While the Magnificent Seven have faced headwinds, the broader market still offers opportunities. Holding a mix of tech stocks, small-caps, and other sectors can help navigate the current uncertainty. Additionally, maintaining some cash reserves allows investors to capitalize on potential buying opportunities as market conditions evolve.
In conclusion, the recent selloff in megacap tech stocks reflects a complex interplay of factors, including investor rotation to small-caps, concerns about AI investment returns, and broader economic indicators. However, the underlying commitment to AI by major tech companies remains strong, suggesting that the long-term prospects for these investments are still promising. As the market continues to adjust, staying informed and diversified will be key to navigating the evolving landscape.