Will AI Software's 'Reckoning' Trigger a Broad Market Correction?
Here's my strategy as the 'AI-hope' premium dissipates — and three key steps for individual investors to navigate this market.
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Large-cap technology stocks took a hard hit on Tuesday, effectively killing the bounce in the Nasdaq 100 (QQQ) that had briefly flickered after poor earnings from Microsoft (MSFT) initially slammed the tape. Microsoft has continued its downward trek and is now trading back at levels seen a year ago, wiping out a massive amount of "AI-hope" premium.
The Two-Edged Sword of AI Development
The primary problem is a growing recognition that AI is a two-edged sword for many software companies. In some cases, new developments from Anthropic and OpenAI are cannibalizing business from established software firms that were simply using the technology as a layer for software development. In other cases, developers are finding it nearly impossible to maintain reasonable profit margins despite the tremendous capital expenditures required to stay relevant.
Investors are rightfully growing concerned about AI software profitability. Although Palantir (PLTR) posted a very strong earnings report on Monday with a significant jump in guidance, the stock struggled to maintain momentum on Tuesday, closing well off its highs after a volatile session.
Infrastructure Fatigue and the Chip Sector
In addition to the software issues, we are seeing growing competition in the AI infrastructure area, which is putting chip stocks under pressure. Nvidia (NVDA) had a particularly poor day on Tuesday, losing 2.8%, with reports circulating that Chinese companies are increasingly looking elsewhere and not placing the same volume of orders.
On Wednesday morning, Advanced Micro Devices (AMD) is trading down about 7% in the premarket despite reporting a beat on the top and bottom lines and providing solid guidance. In a different environment, a report like this would be a catalyst for more upside, but the current concern is that valuation remains elevated even with stellar numbers. AMD’s P/E sits around 59 with EPS growth of roughly 60%, but chip stocks are typically assigned lower multiples due to the cyclical nature of the business.
A Necessary Evolution
The reevaluation of the AI theme should not come as a big surprise. Much like the internet sector back in 2000, the market is currently sorting out the winners from the losers. The term "artificial intelligence" is no longer a magic formula that pushes a stock higher regardless of the underlying math.
Just as internet stocks once became inflated on unrealistic metrics like pageviews, many AI stocks have become stretched on unrealistic expectations of immediate profitability. Microsoft is perhaps the best example of this "pay now, profit much later" tension.
Is a Full Correction Imminent?
The immediate question for investors is whether this reckoning for the AI sector will drag the entire market into a broad correction. So far, that is not happening. There has been strong rotational action, and much of the market has held up quite well.
The business media remains largely blinded by its bias toward mega-cap coverage, ignoring the healthy action in small-caps and certain defensive groups. However, stock pickers are well aware that there are pockets of safety while AI undergoes this necessary reshuffling.
Strategy and Game Plan
So far, it looks like the broader market can withstand a reevaluation of AI stocks, but it is imperative that individual investors stay focused on managing individual stock positions.
- Strict Trade Management: This is not the time for complacency. Don’t be hesitant to cut losses. You can always rebuy. Selling is a powerful form of insurance.
- Avoid "Falling Knives": Be extremely cautious about trying to catch names that are breaking technical support levels. If you are going to use this approach. Stay very patient and move very slowly
- Ignore the Indexes: Do not be deceived by the headline index moves, which are being jerked around by a handful of mega-cap AI names.
There are plenty of other opportunities in this market as the AI sector navigates this painful but necessary period of evolution.
At the time of publication, Rev Shark was long NVDA.
