What happened

No one disputes that the astonishing market recovery so far this year has been driven by recent developments in artificial intelligence (AI). On the heels of its worst performance in over a decade, the stock market is firmly in rally mode in 2023. Market watchers are undoubtedly anticipating the potential for widespread productivity gains made possible by generative AI.

With that as a backdrop, shares of semiconductor specialist Nvidia (NVDA -0.84%) slipped 4%, enterprise AI software provider C3.ai (AI 0.14%) fell 8.3%, and data mining and AI specialist Palantir Technologies (PLTR 4.49%) slumped 9.9% as of 3:24 p.m. ET on Wednesday.

While the downgrade for numerous U.S. banks was no doubt a contributing factor in the stock market's gloomy mood today, a pronouncement by a Wall Street analyst about the state of AI stocks helped fuel the pessimism.

A business person looking at charts on a computer with light reflecting off their glasses.

Image source: Getty Images.

So what

The excitement regarding the prospects of AI has been something of a phenomenon this year, causing stocks in the space to surge. Indeed, each of our trifecta of AI stocks has led the rally, with C3.ai, Nvidia, and Palantir soaring 195%, 194%, and 139%, respectively, (as of this writing) so far this year.

This exuberance has some on Wall Street calling foul and suggesting that while the potential for AI is real, the rally might have gotten ahead of itself.

That's the position taken by Morgan Stanley equity strategist Edward Stanley. He cites the stock surge as evidence of an AI stock bubble, which he believes might be near its peak. He suggests that if Nvidia is a proxy for AI, then we're in the "later innings," and the ongoing market gains could be running out of steam. 

To put the situation into historical context, Stanley cites precedent, writing, "Bubbles tend to rally a median 154% in the 3 years pre-peak." He qualifies that position by pointing out that while Nvidia stock has nearly tripled so far this year, broader AI benchmarks -- including the MSCI USA IMI Robotics & AI Select Net USD Index -- have climbed more modesty, up roughly 47%.

If the analyst is correct, the broader stock market gains, driven by AI stocks, could come to a screeching halt.

Now what

Not everyone is on board with Morgan Stanley's assessment. Veteran technology analyst Dan Ives of Wedbush says that AI could spark the "fourth industrial revolution" and that the current bull market could run for years.

"While many of the tech skeptics will point to today as a '1999 moment' à la on the verge of the dot-com bubble/collapse given the significant move in tech valuations, we strongly disagree," Ives said. He goes on to say that the "massive $800 billion AI opportunity (our estimate) is now on the doorstep for the tech sector for the next decade."

This brings up an important point. There could be a near-term correction in the stock market; we could also be in the midst of a sea change in technology that could drive stocks higher for the next decade. The two aren't mutually exclusive. Furthermore, if the AI revolution has legs, calling this a "bubble" might be technically correct and still be misguided.

Yet, today's sell-off may also be missing the forest for the trees:

  • Nvidia's state-of-the-art processors are the gold standard for AI, and the company dominates the competition, controlling a 95% share of the machine learning market, according to data compiled by New Street Research. Nvidia is also a leader in providing semiconductors to the data center industry, which will eventually need to upgrade to keep up with the latest advancements in AI.
  • Palantir has a long track record of providing data mining and AI solutions to government agencies and is in the process of building up its book of business for enterprises. The company recently added its Artificial Intelligence Platform (AIP) and is making progress with onboarding new customers, though that process will take time.
  • I have long cited C3.ai as an outlier, with its price gains partly driven by its prescient ticker: AI. The company supplies turnkey AI applications to businesses but continues to forecast essentially flat growth -- even in the midst of the AI boom.

AI Chart

Data by YCharts.

I'm a firm believer and shareholder in both Nvidia and Palantir and have no qualms about their futures. I continue to have my doubts about C3.ai and am waiting for financial or operational evidence that proves me wrong.

Furthermore, if the adoption of AI continues over the coming decade, the stocks leading the charge will no doubt ebb and flow; no stock goes up in a straight line for long.

Lastly, each of these stocks sports a lofty valuation, with Nvidia, Palantir, and C3.ai selling for 19 times, 13 times, and 10 times next year's sales, respectively. However, with trillions of dollars in potential economic gains at stake, the companies that seize on the AI opportunity could eventually grow into their valuations, depending on the scope of their revenue increases. But stocks with valuations of this magnitude won't be for everyone.

That said, there's plenty of time for the AI revolution to play out, so long-term investors should stay the course.