AI stocks could be headed for a pullback.
Shortly after ChatGPT was launched in November 2022, talk of an artificial intelligence (AI) bubble began to emerge.
The introduction of this groundbreaking AI chatbot has sparked an unprecedented arms race in new AI technology, sending demand for NVIDIA's (NVDA -2.17%) graphics processing units (GPUs) soaring, propelling the company to a market capitalization of more than $3 trillion, vying with Apple and Microsoft as the world's most valuable company.
Despite billions of dollars being spent on AI infrastructure, many critics point out that there is relatively little end-user demand for AI products and services. AI still lacks a “killer app,” and businesses and consumers seem to be struggling to figure out how to take advantage of this new technology.
One such skeptic is David Kahn, a partner at well-known silicon venture capital firm Sequoia Capital, which has backed at least 70 AI companies, who wrote a paper in June arguing that the AI bubble is reaching a tipping point.
Image source: Getty Images.
A $600 billion AI shortfall?
In Khan's view, the tens of billions of dollars being spent on AI infrastructure need to generate even more revenue for their owners to justify the expense.
For example, based on some rough math, they estimate that if Nvidia's data center revenue reaches $150 billion by the end of the year, companies spending $150 billion on Nvidia components would have to generate $600 billion in revenue to recoup their investment.
The calculation is based on the fact that data center chips account for half the cost of running a data center and that software running on cloud infrastructure services that buy Nvidia hardware, such as Amazon Web Services, Microsoft Azure and Google Cloud, has a 50% margin.
He also claims that supply shortages will ease starting in the second half of 2023, GPU inventory is rising, and pure-play AI companies are making only modest revenues, most of which are attributable to OpenAI, which recently hit $3.4 billion in annual run-rate revenue but is also on track to lose $5 billion this year.
For example, Microsoft has highlighted its spending on Azure OpenAI, but Cahn rightly points out that direct revenue from generative AI is relatively small so far.
The story continues
Khan said he believes AI is in a bubble, but that it will be short-lived, and that he believes “tremendous economic value will be created by AI.”
But he also called the current environment in AI a “speculative frenzy” among both major cloud infrastructure companies and investors, suggesting that valuations of stocks like Nvidia and its peers could fall sharply.
Big tech companies like Alphabet and Microsoft are already facing backlash from investors over their surge in AI capital spending, with their shares dropping after reporting earnings, and that backlash is likely to accelerate until investors are convinced they can generate the kind of revenue Khan outlined above.
Is it time to sell AI stock?
At some point, we'll likely see some pullback in AI stocks like Nvidia, as the first signs that demand isn't as strong as expected or that GPU prices are starting to fall send investors scrambling to get out.
But there's a reason why so many tech giants believe generative AI will be as transformative as the internet, and why the stakes are so high: The new technology is still in the early stages of adoption, and it will be years before its usefulness grows enough to justify current spending.
When we think about the innovations on the horizon, such as self-driving cars, artificial general intelligence (AGI), and the creative potential of generative AI, this technology will be disruptive if it works, and it will require the massive infrastructure being built today to function.
Although a sell-off in AI stocks is likely, the long-term future of the sector remains bright as the technology looks set to be as transformative as its proponents hope, and a temporary sell-off should not deter long-term AI investors.
John Mackey, former CEO of Amazon subsidiary Whole Foods Market, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Jeremy Bowman invests in Amazon. The Motley Fool has invested in and recommends Alphabet, Amazon, Apple, Microsoft, and NVIDIA. The Motley Fool recommends long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.
