The excitement in artificial intelligence (AI) has led to companies spending millions of dollars on new projects and upgrading their existing infrastructure in the hopes that they can cash in on new growth opportunities. Chipmaker Nvidia (NASDAQ: NVDA) has been tripling its sales due to incredible AI-fueled demand for its next-gen chips. Palantir Technologies (NYSE: PLTR) has also experienced an acceleration of its growth rate as the data analytics company is seeing an uptick in demand due to its new AI-powered platform.
Tech stocks, as a whole, have done well this year. The Vanguard Information Technology ETF rose 30% in the past 12 months, which is far higher than the S&P 500's gains of around 21%. But the danger is that the hype could fizzle out. Companies could scale back on spending, especially if a recession hits. Then, the stocks that have been flying high due to AI could come back down to reality. Here's why a slowdown could happen as early as next year.
Companies could end up abandoning generative AI projects
When there's a flurry of spending activity, oftentimes there is correction that happens afterward, when companies stop to decide whether those expenditures were truly justifiable. A recent example of that was the pandemic-fueled spending that took place back in 2020 and 2021. Many companies went on hiring sprees due to the strong consumer demand. It wouldn't be long afterward, however, that layoffs would take place after many businesses, particularly in tech, realized they overestimated demand and hired too many people.
A similar situation could happen with generative AI. Research and consulting company Gartner projects that by the end of next year, businesses could abandon 30% of generative AI projects. The company points to not just high expectations but also to just how intensive the spending can be. Distinguished VP Analyst Rita Sallam says, "After last year's hype, executives are impatient to see returns on GenAI investments, yet organizations are struggling to prove and realize value. As the scope of initiatives widens, the financial burden of developing and deploying GenAI models is increasingly felt."
This could be bad news for AI stocks trading at inflated valuations
Many stocks have soared to sky-high valuations due to the expectation that there will be more growth coming due to AI. And while AI spending may rise in the long run, the pace it has been on may simply be unsustainable. Nvidia, for example, is now generating nearly as much in revenue per quarter as it previously did on an annual basis before all the AI hype. For the period ended April 28, its revenue came in at more than $26 billion. Back in fiscal 2023 (which ended on Jan. 29, 2023), its annual revenue was just under $27 billion.
Nvidia's stock is expensive, and the main counterpoint to its lofty $2.7 trillion valuation is that it's cheap when you factor in its future growth. However, the problem is that those future growth prospects can be overly optimistic. If you assume the business can continue growing at a rate of 50% or more per year, then you might conclude the stock is cheap.
If there's a recession, however, or if companies start to think twice about their generative AI projects and realize they aren't paying off as lucratively as they may have expected, executives may stomp on the brakes and significantly slow their investments into AI, including into new chips. Looking at Nvidia's valuation, investors don't appear to be considering that possibility, which is why it can be a bit of a risky stock to hold, as there is almost no margin of safety with this type of investment.
Palantir is another example. The company's CEO routinely pumps up the growth opportunities for its business. While its growth rate has been accelerating, investors are also paying a hefty premium for the stock based on its future prospects. At more than 170 times earnings, it's an even more expensive stock than Nvidia based on how light its bottom line is.
These are just a couple of examples, but there are many other AI stocks that could struggle if there's a slowdown in AI-related spending.
Should you sell AI stocks?
Not all AI stocks are bad buys. But investors should be careful not to ignore valuations and simply assume that in the long run these businesses will continue achieving incredibly high growth rates. That bakes in a highly optimistic scenario, that, should it fall through, could result in a significant sell-off.
Valuations are important when considering stocks, and if you're paying an exceedingly high multiple for a stock, you should be aware of the risks that you're taking on by doing so and be aware of the assumptions you're justifying a high premium on. In some cases, a high valuation can be justifiable, but in many others, it isn't.
Nvidia, for example, is a leading company in chips and could continue to do well in the long run, but if there are any cracks in its growth rate next year, then 2025 could be a tough year for the stock.
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David Jagielski has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia and Palantir Technologies. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.
