(Bloomberg) -- The fate of the S&P 500 is increasingly resting on whether a handful of the biggest technology companies can parlay artificial intelligence investments into even higher profits.
Seven firms including Microsoft Corp. and Nvidia Corp. have driven about three-quarters of the index’s gain this year, in a rally stoked by an investor obsession with AI’s potential to disrupt vast parts of the economy. Valuations are high, with the companies’ shares trading at an average of about 32 times earnings. Pressure is mounting on companies to deliver on some of the earnings hope embedded in their ever-rising stock prices.
“We’re getting closer to the moment when the companies that are claiming AI-related profits will have to start showing them,” said Mark Lehmann, chief executive at Citizens JMP Securities. “I am not calling for an expansion of multiples next year; the returns will have to come from companies actually turning in better profits.”
The companies just delivered record profits of $99 billion in the third quarter. Now more is being asked of them, testament to how high the stakes have become for the stocks that have added around $5 trillion to the market’s value this year. At nearly 30% of the S&P 500, they have more sway over the benchmark than ever before.
The Nasdaq 100 Index was little changed on Monday.
Nvidia Corp. has been the engine powering much of the group’s profit growth this year. It’s the only megacap that has delivered a significant jump in results as a result of demand for AI. The chipmaker is projected to generate about $28 billion in profit this year, up from about $4.4 billion last year. Most of the gains stem from sales of so-called accelerator chips used to train the large-language models that underpin applications like ChatGPT.
Others in the group haven’t yet shown many AI gains. Microsoft, arguably the company in the next best position in AI owing to its $13 billion investment in ChatGPT owner OpenAI, earned a bit less in the fiscal year ended in June than the period before. For its next fiscal year, analysts on average expect earnings to rise 17%.
Stock prices are climbing faster than earnings estimates. The average price-to-expected earnings ratio in the group of seven is up from about 21 times at the start of the year but below a July peak at 36. Some, like Facebook parent Meta Platforms, are relatively cheap at 19 times. Tesla Inc., on the other hand, is the most expensive at 63 times estimated earnings.
Some investors believe these levels may be too low. Nick Rubinstein, technology stock portfolio manager at Jennison Associates, is confident that profits from AI will help make some Big Tech stocks look like bargains at current prices.
“I’m more excited now than I have been for a very long time,” he said in an interview. “So many industries can benefit, while the arms dealers for AI should benefit even more.”
Other members of the largest seven include Apple Inc., Amazon.com Inc. and Google parent Alphabet Inc. Future gains for these giants, and the S&P 500 as a whole, will hinge at least in part on the macro backdrop. Investors are pricing in rosy scenarios, where the US avoids a recession and the Federal Reserve pivots from hiking rates this year to cutting them as soon as the first half of 2024.
Many are reluctant to forecast that tech stocks will drop next year. If there’s anything money managers have learned in 2023, it’s the folly of believing too strongly in year-ahead forecasts.
But even if the stocks don’t fall, it’s not clear how much they can rally if valuations are already so high, said Phil Segner, senior research analyst and co-portfolio manager at Leuthold Group. Nvidia’s shares have hovered in a range for most of the second half of 2023 even as profits have jumped, for example.
“To call a top in this trend has been a fool’s errand,” Segner said. “I can’t say that it’s going to keep going into next year but at some point, I think people should be aware of the risk that those stocks have in their portfolio.”
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Earnings Due Monday
- No major earnings expected
--With assistance from Subrat Patnaik and David Watkins.
(Updates to market open.)
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