Peter Brown: AI-driven big tech stocks are ridiculously over valued and are set for a slide

The US tech-heavy Nasdaq index has climbed 27% since the start of the year and the broader S&P 500 is up 15%.

However, the same seven stocks are driving both indices: Apple; Microsoft; Google-owner Alphabet; Amazon; Nvidia; Tesla; and Facebook-owner Meta.

Investors are piling in on the prospects of artificial intelligence, or AI, to drive valuations of these mega companies.

It’s a safe bet that AI is set to change the world, but looking back to the year 2000, the Nasdaq was correctly foreshadowing huge gains for tech stocks over a longer timeframe, over 20 years.

However, famously, the index did drop 83% at the time from its peak to its trough in less than two years. Back then, Scott McNealy was the chief executive of Sun Microsystems, one of the darlings of the dotcom bubble.

At its peak, the valuation of Sun Microsystems was valued at 10 times its total revenues.

Speaking a few years later, Mr McNealy expressed incredulity at the unfeasibly high valuation of the company he ran at the time.

“At 10 times revenues, to give you a 10-year payback, I must pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate,” he said.

And he added: “Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” Fast forward, and the valuations of mega-cap AI stocks are currently even more ridiculous.

The market loves a trend and this one has run its course. These are great companies for sure, but valuations matter, and at some stage there will be a reckoning. There are good reasons for this.

For a start, inflation is not going away and the hope that interest rates in the US would start to be cut before the end of the year is fading.

The mega-tech stocks have billions in cash but they also have substantial levels of debt which must be serviced at rates which are at least 4% higher than a year ago.

The effect of higher interest rates on earnings has yet to be reflected in their share prices.

And note that the current rally has been solely based on expectations for AI to drive earnings.

Normally, rising interest rates hit stocks badly, but this rally has so far bucked the trend.

AI will change lives and create many hugely successful companies, as happened with the birth of the internet.

However, it was not necessarily the corporate darlings leading the tech rally of the late 1990s that were the winners. Which companies are going to be the most successful in an AI era? The answer is we do not know yet.

The current valuations of the seven tech giants say they are the ones. However, that prediction is too optimistic, and is made too soon.

A correction of 30% to 50% in tech share prices would not be unrealistic. That would still leave valuations at elevated levels; it might be time to take some profit and do not buy into it at this stage.

A major correction will shock some investors, but will not mark the end of investors seeking to buy AI-related companies. It will be an end to the false start, however.

Peter Brown is managing director of www.Baggot.ie

Reporting on: www.irishexaminer.com