AI stocks aren't in a bubble

US technology stocks haven’t been swept up in a financial bubble, even after their meteoric rise this year amid enthusiasm for generative artificial intelligence, according to Goldman Sachs Research. These companies are likely to continue driving returns for investors.

However, a handful of tech stocks account for an uncommonly high share of market capitalization. The high concentration does, indeed, pose a risk to investors, writes Peter Oppenheimer, chief global equity strategist and head of Macro Research in Europe. 

“Investors should look to diversify exposure to improve risk-adjusted returns while also gaining access to potential winners in smaller technology companies and other parts of the market, including in the old economy, which will enjoy the growth of more infrastructure spend,” he writes.

Technology stocks have outperformed other sectors

The technology sector has generated 32% of global equity returns and 40% of the US equity market returns since 2010. Oppenheimer says this comes down to stronger financial fundamentals rather than irrational market speculation. The global tech sector’s earnings per share have risen about 400% from its peak before the great financial crisis, while all other sectors together have risen 25% during that span.

Lately, the tech sector’s powerful returns have stemmed from a small number of hyperscale companies in the US. Again, these companies’ earnings have dwarfed the broader market, which Oppenheimer says justifies their gains.

“The drivers of this success have reflected their ability to leverage software and cloud computing and to fuel high profitability generated by extraordinary demand growth,” he writes. “But their more recent surge in performance since 2022 owes much to the hopes and aspirations around AI. Despite continued powerful earnings growth, valuations have been rising, led by an increasingly narrow group of 'hyperscalers.’”

Oppenheimer points out a consistent pattern that’s played out over hundreds of years, from canals in the 18th century to the telephone in the last one: Radical new technologies tend to attract significant capital and competition. While they don’t always end up with a spectacular bubble (and collapse), there’s usually a sharp, industry-wide decline in prices as returns moderate.

“Even in cases where a bubble bursts and many companies eventually collapse, this does not mean that the technology itself fails,” he writes. “However, rising competition is central to reducing returns relative to market expectations at the peak of the cycle.”

Investor considerations during technology booms

“Eventually the market for the original technology tends to consolidate into a few large winners, and the growth opportunity shifts to secondary innovations or products and services that follow the original technology,” he adds.

The batch of companies that are dominant, so far, in the AI era are unusual because they were already at the top of the pack in the last technology wave — notably in software and cloud services. Their scale and sheer profitability have put them in a unique position of being able to absorb the high cost of AI investment.

Oppenheimer sees signs that new competitors could emerge, however. The number of AI patents has boomed, surpassing 60,000 in 2022, up from about 8,000 some four years earlier. There are indications “that the typical pattern of large-scale capital growth and competition is happening in the AI space, just as occurred in previous waves of technology,” he writes.

This could be opportunity for investors. Historically, market participants have more or less understood the growth potential of new technologies, Oppenheimer writes. What they sometimes misjudge, however, is that the companies that pioneer the technology aren’t necessarily the ones that will ultimately create the most market value from it.

As an example, he notes that investment poured into telecom companies at the onset of the internet revolution. But even as internet usage exploded in the years that followed, competition crushed the price of broadband internet access. Instead, the biggest winners in the internet era, from social media to ride sharing, piggybacked on that infrastructure. 

“So, while the leading tech companies today will most likely remain dominant in their respective markets, rapid innovation, particularly around machine learning and AI, will likely create a new wave of tech superstars,” Oppenheimer writes. “It is probable that AI and robotics will not only create new faster-growing innovative companies but also raise the prospect of major restructuring gains in non-technology sectors.”

AI is capital intensive

Today’s tech-stock winners in the equity market are capital-intensive companies. That’s a major shift from the late 1990s, when software companies started building very high-margin businesses that had low capital expenditures.

“Just as we saw with the networking companies of the internet, AI is driving a major capex boom and threatens to stifle the high rates of returns that have characterised the sector over the past 15 years and which current valuations imply will continue,” Oppenheimer writes.

There’s a risk that, as competition increases, the returns and margins for the now dominant companies will begin to fade. In turn, the growth rates of these high-flyers would likely decline.

The risk of high market concentration

At the same time, the largest stocks are even more dominant than was the case in other technology cycles.

High market concentration may not be irrational, Oppenheimer writes. The scale of investment needed to compete in AI rules out smaller companies. But even if it’s rational, it’s a risk for investors.

“With markets being increasingly dependent on the fortunes of so few, the collateral damage of stock-specific mistakes is likely to be particularly high,” he writes. “A market that becomes dominated by a few stocks becomes increasingly vulnerable to either disruption or anti-trust regulation. Even companies that have enjoyed near monopoly power in the past have ultimately succumbed to these pressures.”

To illustrate this point, Oppenheimer notes that there are only 51 companies that have appeared every year in the Fortune 500 since 1955. That means just a little more than 10% of the Fortune 500 companies in 1955 have remained on the list during the past 69 years. If history is any guide, most of today’s Fortune 500 companies will no longer exist as they do now in 70 years.

They “will be replaced by new companies in new, emerging industries that we can’t even imagine today,” Oppenheimer writes.

As concentration has increased, diversification is more important

While technology stocks may not be in a bubble, Oppenheimer writes that it may be important to diversify and reduce the risks from market concentration.

He points out that there are plenty of companies outside the tech sector that have high margins and returns on investment, that reinvest for future growth, and that have strong balance sheets.

Meanwhile, companies outside of tech will likely make use of AI advances as well. Healthcare and biotech companies are likely to benefit from AI innovation, and banks and financial companies may be able to improve their return on equity by adopting AI. New consumer products and services are likely to emerge, eventually, on the back of these technologies. There are signs that AI will provide more sophisticated cyber-security services and allow for the development of much more advanced robotics.

“Of course, it is not possible to anticipate what these products may be or who is likely to develop them,” Oppenheimer writes. “But that is another reason for ensuring broad diversification in equity exposure.”

 

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