Mega-Cap Tech Sell-Off Hints at Why Some Investors Are Souring on AI

Hedge fund manager Dan Niles warns that the recent sell-off in mega-cap tech stocks indicates significant trouble for the sector, as investors become increasingly impatient with the lack of revenue generated from artificial intelligence investments.

Market reactions and investor sentiment: The market’s negative response to Alphabet’s quarterly results serves as a wake-up call for investors, who are starting to demand tangible revenue from AI spending:

• Alphabet shares tumbled 5% on Wednesday following the company’s earnings report, signaling growing investor impatience with the lack of returns on AI investments.
• Niles believes that the market’s reaction to Alphabet’s results exposes the underlying risks in the mega-cap tech trade, particularly for the “Magnificent Seven” stocks, which include Tesla, Nvidia, Alphabet, Meta Platforms, Microsoft, Apple, and Amazon.

Potential risks and overbuilding concerns: Niles suggests that major tech companies may be overinvesting in AI, potentially leading to a slowdown in spending and negative sequential quarters for some companies:

• Prior to the recent market developments, Niles assumed that AI spending would slow down, but Nvidia would not experience a down sequential quarter for many years, similar to Cisco’s experience during the tech buildup.
• However, he now questions whether Nvidia could face a down sequential quarter next year, as large tech companies admit to potentially overbuilding in the AI space.

China’s role and market frothiness: Niles highlights the risks stemming from China’s overordering of tech components, which could contribute to a bubble and subsequent fallout:

• China appears to be overordering various components, possibly in anticipation of a potential change in the U.S. administration, creating a rational but unsustainable demand for tech products.
• Some capital equipment companies report that China accounts for nearly 50% of their revenues, suggesting a significant drop-off in demand from China next year, which could have severe consequences for the tech sector.

Investment outlook and long-term perspective: Despite the current challenges, Niles maintains a long-term bullish outlook for mega-cap tech stocks, but he believes there is not enough downside yet to add exposure:

• In the short term, Niles is focusing on the short side of the market, having recently covered one of his “Magnificent Seven” shorts that experienced a significant decline.
• However, he believes that the bull case for mega-cap tech stocks remains intact over the long term, with multiple years of growth ahead before reaching a sustained peak.
• Niles compares the current situation to Cisco’s experience during the tech buildup, where investors had to endure three significant drawdowns before the stock ultimately achieved a 4,000% return.

Analyzing deeper: While Niles’ perspective provides valuable insights into the current state of the mega-cap tech sector, it is essential to consider the broader context and potential counterarguments. The tech industry’s rapid advancements and the transformative potential of artificial intelligence suggest that the long-term outlook for the sector remains promising. However, investors must carefully evaluate the near-term risks and challenges, such as the potential for overinvestment, market frothiness, and geopolitical factors like China’s role in the global tech supply chain. As the situation continues to evolve, it will be crucial for investors to monitor market reactions, company performance, and shifts in investor sentiment to make informed decisions about their tech sector exposure.