(Bloomberg) — Investors were disheartened by the prospects of artificial intelligence on Wednesday, sending the Nasdaq 100 Index plummeting $1 trillion as questions swirled about how long it would take for big investments in the technology to pay off.
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The Nasdaq index fell more than 3%, its biggest drop since October 2022. Laggards included a host of AI technology darlings, led by semiconductor companies such as Nvidia, Broadcom and Arm Holdings.
The selloff was sparked by Alphabet Inc.’s middling earnings report late Tuesday that highlighted ballooning capital spending. The company’s shares fell more than 5%, its worst drop since January. Tesla Inc. tumbled more than 12% after CEO Elon Musk offered few details about the company’s self-driving car vision.
“The biggest concern is where the ROI is on AI infrastructure spending,” said Alec Young, chief investment strategist at MapSignals. “There’s a lot of money being spent, and it will probably pay for itself over a few years, but it will take time to see that payback, and I think investors are realizing that the revenues of the hyperscalers are being hurt in the short term by how much they’re spending on AI infrastructure.”
As a result, traders are paying more to bet on volatility in tech stocks. Volatility on Nvidia options has risen to its highest level since mid-March, and the premium for Broadcom put options is at a three-month high.
The selloff came two weeks after weaker-than-expected inflation triggered a major shift away from tech stocks and toward the companies that would benefit most from the Federal Reserve’s interest rate cuts, primarily small caps. On Wednesday, small caps outperformed their larger peers for the fourth straight day and the 10th time in 11 days. The Russell 2000 is up 0.5% this week, while the S&P 500 is down 1.5% and the Nasdaq 100 is down 2.6%.
Violent sales
The rotation out of technology stocks is still continuing, but the move in tech stocks has been intense enough to suggest something else is going on. Specifically, investors appear to be heeding a rumor circulating on some parts of Wall Street that the AI stock rally that fueled the bubble that added $9 trillion in value to the S&P 500 over the past year is bound to pop. Wednesday may not be the start of that, but the magnitude of the drop is cause for alarm.
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“In the short term, there may be a bit of AI fatigue as some of the investments big tech companies have made in AI may not pay off in the time frame investors expect,” said Neville Jhaveri, portfolio manager at Allspring Global Investments.
Shares of makers of hardware used in AI computing fell the most on Wednesday after soaring this year. Supermicro Computer fell 9.15%, Nvidia fell 6.8% and Broadcom fell 7.6%. Mega-caps also fell, with MetaPlatforms down 5.6%, Microsoft down 3.6% and Apple down 2.9%.
But other traders see the moves as temporary.
“Following Google’s failure to deliver on its wildly better than expected earnings and fundraising, I don’t think we’re going to see anything other than profit-taking in some stocks that have been exceptionally strong and have had very strong year-to-date returns,” said Michael Sansoterra, chief investment officer at Sylvant Capital Management.
The selloff caused a Bloomberg index of the so-called “Magnificent Seven” technology stocks to fall 5.9%, dropping below its 50-day average for the first time since May. It has risen 33% this year.
Concerns about the AI bubble
Jim Covello, head of equity research at Goldman Sachs Group Inc., is among market experts who argue that commercial promise for AI is overblown and question the huge costs of building the computing infrastructure needed to run and train large-scale language models.
Talk of a bubble in AI stocks was fueled by activity in the derivatives market, as investors flocked to bullish options on indexes and individual stocks, particularly Nvidia, which acted as rocket fuel for the upside. That sentiment could have changed as the rotation out of tech stocks accelerated, adding to Wednesday’s selloff.
Last week, for example, demand for bearish puts on Nvidia surpassed calls at their highest level in the past five months. Tail-risk hedges, which pay off in a stock market crash (perhaps a 30% drop), have risen at their fastest pace since October. And the cost of protection against a roughly 10% drop has risen to its highest since August 2023.
Tech stock valuations have entered historically overheated territory. Two weeks ago, the S&P 500 Information Technology Index’s forward earnings ratio hit its highest level since 2002. Many of the big tech companies are still trading at premium levels despite selling pressure. Nvidia’s stock trades at 36 times expected earnings over the next 12 months, compared with the S&P 500’s average of 21. Apple and Microsoft are both trading at more than 30 times. Risks to earnings come at a tricky time as tech giants’ profit growth slows.
Alphabet’s earnings report dampened hopes that AI would be a big contributor to mega-cap results, but investors have yet to hear from other companies. Microsoft is due to report on July 30, while Meta Platforms, Apple and Amazon.com are due to report later this week. Nvidia, the biggest beneficiary of AI investments, is scheduled to report earnings for the last time on Aug. 28.
“We still maintain our view that this is large, high-quality growth stocks,” said Kayla Seder, macro multi-asset strategist at State Street. “Even if there are concerns about tech earnings, tech is still a more attractive option given its earnings growth and fundamental strength.”
—With assistance from David Marino, Carmen Reinicke, and Alexandra Semenova.
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