Understanding Where the “Bubble” Is in AI
Last week, tech mega-cap stock ORCL exploded higher by 40% after it revealed more than 300% growth in its order backlog (called RPOs in the earnings report), boosting expectations for greater profits in the year ahead. But late last week, it was revealed that one customer, Open AI, was responsible for $300 billion of the backlog increase by itself!
ORCL gave back some of Wednesday’s big gain on that news and for valid reasons. First, RPO’s aren’t actual money. They are promises of orders that can be cancelled. Second, having one, relatively new AI company responsible for that amount of backlog introduces concentration risk, and ORCL slid on Thursday appropriately.
But the revelation that Open AI was responsible for the majority of the backlog also provides a near perfect example of what’s happening in the AI industry and why it matters to markets. Put simply, the ORCL results, and Open AI news illustrates this point: If there is a bubble in the AI space, it’s a cap-ex bubble.
I have generally don’t believe that major AI driven tech stocks (MFST, NVDA, AVGO, AMZN, META) were in a bubble. The main reason is because those AI darlings were seeing actual earnings explode higher. Semiconductor companies (NVDA, AVGO, etc.) were seeing massive increases in chip orders as AI companies/ Mag 7 rushed to secure semiconductor capacity. MSFT, AMZN and other cloud-computing giants saw demand for cloud capacity explode as AI companies, like Open AI, etc., rushed to secure server space, boosting those revenues. This is very good news for stocks.
Networking and database companies, like ORCL, saw earnings surge as those same companies rushed to secure computing capacity and storage space for data. All the while, the P/E’s of many of these companies have actually declined despite huge price increases because the earnings are growing much faster than the price can appreciate. So, even with the huge rallies in these stocks, many of these names are trading at lower valuations than before.
If we look at the 11 sectors of the S&P 500 on a price-to-earnings to-growth ratio (PEG), the tech sector is one of the cheaper sectors in the market! This makes it very different than the tech bubble of 25 years ago. 1990’s tech darlings weren’t making more money! And that is why the markets collapsed in 2000.
Today, major tech companies that have powered this rally in the S&P 500 are rallying because they are actually making much more money than they have before. But, as ORCL’s backlog increase showed us (which was powered by one AI company), the increased earnings are because AI-focused companies (like Open AI, CoreWeave, etc.) are spending hundreds of millions and billons to build out AI infrastructure!
As long as Open AI actually is able to 1) Raise capital to fund these purchases and 2) Can execute properly to turn ChatGPT and other AI models into actual profitable enterprises, then the rally in ORCL is legitimate and this stock will go higher because other companies will likely follow in Open Ai’s footsteps.
But what if Open AI cuts the orders? What if they can’t find the financing at attractive terms to fund this R&D? What if AI adoption is a disappointment? What if the majority of the population ultimately views ChatGPT and others like Alexa or Siri—something that’s fun and kind of cool, but not something anyone’s going to pay for? If that’s the case, then the AI companies and major tech firms will cut AI-linked cap-ex and the “bubble” will begin to deflate, just like ORCL shares would drop sharply if Open AI announced it was cutting its orders.
Bottom line, AI isn’t in a valuation bubble. And the long term secular bull market is far from over. Remember during secular bull markets, that last as long as 20 years, the average return is over 13%. Also consider that the economic growth which is slowing this quarter will accelerate in the fourth quarter and beyond.
We remain bullish on the market and do not see any major downturns on the horizon.
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