Nvidia didn’t save the market. What’s next for the AI trade?

(Bloomberg) — Wall Street thought blowout earnings from Nvidia Corp (NVDA). would calm investors’ nerves about a bubble forming in artificial intelligence stocks. They didn’t.

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So where does the AI trade stand now? It depends who you ask.

On one side you have the skeptics. They’re concerned about soaring market valuations as investors chase growth in a small collection of stocks tied to the AI boom. They see the hundreds of billions of dollars these companies are spending to stay in the race as unsustainable, particularly as they start to take on debt in order to keep up. In addition, the circular nature of these financing arrangements creates a potential systemic risk in which one company’s weakness can bring down the entire trade.

The other side are the optimists, who see the recent pullback in AI-related shares as a healthy correction on the way to further growth. To them, the mega-cap technology firms at the heart of the AI trade — Microsoft Corp. (MSFT), Amazon.com Inc. (AMZN), Meta Platforms Inc (META). and Alphabet Inc. (GOOG, GOOGL) — are going to keep spending to develop their offerings, with no signs of slowing anytime soon. Plus, with the industry’s strong demand and a regulatory environment that’s considered accommodating for growth, they view the AI investment cycle as just in the early innings.

“There is certainly a division,” said Dec Mullarkey, managing director at SLC Management. “We have had such a long bull run and valuations are stretched so the fear of a blow up in AI is high. But then there is another group of investors looking to sources of stimulus to extend the cycle, such as prospects of Fed rate cuts, less regulation, more M&A and increased IPO activity.”

The uncertainty was highlighted by the stock market’s wild swing Thursday in the wake of Nvidia’s earnings report. The chipmaker’s shares initially jumped more than 5%, supporting a host of other AI plays, before reversing direction and closing down 3.2%. The S&P 500 and Nasdaq 100 indexes responded in kind, climbing out of the gate and then quickly wiping out those gains to finish well in the red.

“We saw an initial relief rally on the confirmation that demand is strong, but investors are now asking the next questions, which are, what about the power needs, what about margins, what’s the ROI?” said Natalie Hwang, managing partner of Apeira Capital Advisors. “Relief rallies can’t hold so long as the market has unanswered questions.”

Investors did get some relief on Friday, as the major equities indexes vacillated between gains and losses in the morning before turning decisively positive.

Nvidia’s results arrived just as skepticism about AI is starting to spill over into the broader market. Investors are increasingly spooked by the signs of a potential bubble: elevated valuations, circular financing deals, debt issuance, and lofty aspirations that might be difficult to meet, particularly for OpenAI, the privately held ChatGPT owner that is burning through cash.

The chip giant’s robust earnings weren’t a surprise since the spending plans of its major customers were telegraphed well in advance. Microsoft, Amazon.com, Meta and Alphabet — which taken together represent more than 40% of Nvidia’s sales — are projected to increase their combined capital expenditures by 34% over the next 12 months to $440 billion, according to data compiled by Bloomberg.

“The quarter itself was, frankly, exceptional,” said Daniel Pilling, portfolio manager at Sands Capital Management, which owns Nvidia shares. “The forward looking guidance on a revenue basis was 5% ahead of consensus.”

Beyond Nvidia, other semiconductor companies are struggling all of a sudden as Wall Street questions the durability of AI spending. An index of chip-related stocks is down 11% in November and on pace for its worst month since 2022, with companies like Advanced Micro Devices Inc. and Arm Holdings sliding more than 20%.

On the fringes of the business, Sandisk Corp., the maker of memory chips that went public in February, was up almost 700% for the year when it hit a high on Nov. 12, but that figure has been sliced by about a third after a precipitous decline in the past two weeks.

However, it’s the other side of the spending equation — return on investment — that investors are really starting to question. When that pile of cash will translate into faster growth and improved profitability for the companies offering AI software and services is now a serious issue. Wall Street needs to have some clarity on ROI for the trade to pick up steam again, according to Mark Luschini, chief investment strategist at Janney Montgomery Scott.

“It may take another quarter or two for us to get evidence of that, and until we do, this is a story that will remain a point of focus for investors,” Luschini said. “So long as this percolates in the background, it could jeopardize the otherwise sanguine outlook for AI.”

A full reckoning of the ROI question may have been delayed by Nvidia’s report, since it eased immediate concerns about the sustainability of AI investments. While Nvidia is the “lynchpin” of the artificial intelligence trade and its results were solid, they didn’t quell doubts about the big spenders, according to Kevin Cook, senior strategist at Zacks Investment Research.

That’s where the serious cracks are starting to emerge. Meta shares are down 21% since the company reported earnings on Oct. 29, as investors grow concerned about its aggressive capex plans. Microsoft has fallen 13% since its results on the same day for a similar reason. Companies with weaker balance sheets have taken an even bigger hit, with CoreWeave Inc. (CRWV)’s stock plunging 46% this month and Oracle Corp. (ORCL) sinking 24%, on track for its biggest monthly drop since 2001.

“For all the bubble blowers out there, maybe they were right about stocks like Oracle and CoreWeave getting ahead of their skis because both of those companies need to borrow a lot of money to just play in the game,” Cook said.

All of which leaves investors divided based on their perspectives – glass half empty or full. The one area of agreement appears to be that the AI ride is going to get even bumpier along the way.

“You’ve got questions about the macro, divide over where we are in the progress of the AI revolution and cryptocurrencies melting down,” said Art Hogan, chief market strategist at B. Riley Wealth. “I think all of that is part and parcel to the volatility we’ve seen.”