After soaring higher through the first half of the year, artificial intelligence (AI) stocks aren't looking like the sure thing they were a few months ago. Perhaps the best example of the change in investor sentiment was the response to Nvidia's (NVDA -1.72%) recent blowout second-quarter earnings report last month.
The AI chipmaker blew past estimates on the top and bottom lines as revenue nearly doubled in the quarter. Its guidance for the third quarter also was well ahead of the Wall Street view.
While you might expect the stock to soar on such a report, it finished the trading session flat after initially jumping 6% on the news. That could be a signal that investors have already priced in the surge in revenue and profits at Nvidia.
A look at other AI stocks shows that the honeymoon phase could be over. Over the last three months, it seems that most of the AI stocks seen as pure plays have fallen or underperformed the market.
Let's take a look at a few of the obstacles facing AI stocks right now.
1. Market sentiment is shifting
After several months of stocks marching higher, all three major indexes pulled back in August. This was based on two things: fears that interest rates could move even higher and the Federal Reserve's attempts to squeeze the economy to squash inflation were finally starting to yield results. The S&P 500 is down slightly this month through Sept. 11, as well, showing that the next bull market may not come as soon as Wall Street watchers hoped.
Tech companies are still generally reporting sluggish growth as the waves of layoffs in the industry in the first half of the year play out. Other industries, such as entertainment, also seem to be in a recession, plagued by the Hollywood strikes and a streaming industry that's been mostly unprofitable.
Investors may have adopted a wait-and-see approach as they wait for more evidence that the stock market deserves to go higher.
2. AI stock valuations have gotten stretched
Many of the stocks above soared through the first half of the year as investors bet on the AI revolution. But increasing valuations bring higher expectations, and many of the valuations have now gotten stretched.
As you can see from the chart below, price-to-sales ratios have ballooned. This is an indication that trailing revenue and revenue forecasts over the next year haven't kept pace with skyrocketing valuations.
NVDA PS Ratio data by YCharts.
Except for Nvidia, the buzz around artificial intelligence hasn't seemed to have a notable impact on revenue growth or profits at most of these companies or the broader tech sector.
In some ways, it makes sense that Nvidia would be the first big winner. It sells the building blocks for AI infrastructure, and the soaring demand for its graphics processing units (GPUs) and other hardware is meaningful for the rest of the tech industry. However, investors seem to be realizing that it will take time for the transformation to play out and not every company tied to AI will be a winner.
C3.ai, for example, forecast revenue growth at a modest 15% this year, and Upstart is still experiencing year-over-year revenue declines as the consumer lending market has shrunk substantially due to higher interest rates.
It's unreasonable to expect those stocks and their peers to perform well without fundamentals showing that their businesses are healthy and growing. Touting an AI-based business model isn't enough anymore, and investors want to see real growth.
What it will take to turn things around
In order for AI stocks to regain their mojo, investors are likely going to need a solid and lasting rebound in the economy, showing that we're at the start of a new expansion bull market. More importantly, investors will need to see that artificial intelligence is actually moving the bottom line for these so-called AI stocks.
Thus far, that hasn't materialized except for Nvidia. With valuations inflated and expectations high, investors seem to be expecting a significant near-term tailwind from AI. If it remains that way, expect AI stocks to continue to wither.
