Artificial intelligence (AI) dominated the stock market narrative in 2023, and it was a major reason why the S&P 500 jumped 24% and the Nasdaq Composite soared 43% during the year. It's also why the "Magnificent Seven" stocks (the leading tech stocks) skyrocketed last year.
Despite the stock price boosts, few companies -- except for Nvidia (NVDA 6.18%) -- have seen a significant business impact from artificial intelligence over the past year.
It's natural to ask then if last year's AI-fueled stock-market surge is sustainable or if the AI boom is really just market hype.
Image source: Getty Images.
Great expectations are baked into AI stocks
One thing is clear. Last year's surge in tech stocks was primarily fueled by expectations that generative AI will be the next transformative technology. It's easy to see why investors are so excited about the trend. Tech luminaries like Bill Gates and Oracle's Larry Ellison have said as much, speculating that it could be as big as the internet.
While those expectations have yet to be reflected in the financial numbers of most companies, the chart below shows how those expectations led to increases in the price-to-earnings (P/E) ratios of most of the Magnificent Seven stocks over the past year.
NVDA PE Ratio data by YCharts.
As you can see, with the exception of Nvidia and Amazon, which both saw profits surge last year, the Magnificent Seven saw their earnings multiples expand, and four of the seven increased P/Es by double-digit percentages. That kind of multiple expansion isn't sustainable, and investors shouldn't expect the same kind of growth we saw in 2023 this year as share prices were beaten down after the 2022 bear market at the start of last year.
So will investors see an AI-related surge or an AI-related hangover next year? Let's take a look at the most likely scenario.
The AI boom is real, but...
There's plenty of evidence that the disruptive potential of generative AI is real. There's a shortage of the chips, made by Nvidia, needed to run AI training models as comments from Oracle, OpenAI, and other AI leaders have made clear.
Tech companies are rapidly investing in AI technology, and Nvidia just announced a number of new partnerships in a wide range of industries, like healthcare, gaming, retail, and the auto industry.
However, some stocks have jumped from the boom in AI in what looks more like hype than deserved gains.
C3.ai (AI 3.02%), for example, was also a big winner last year, jumping 158%. However, that company has reported only modest growth in its business and wide losses despite management's hyping its opportunity in AI.
What will happen with AI stocks in 2024?
Following last year's boom in AI stocks, this year we're likely to see a bifurcation between genuine AI winners and pretenders like C3.ai. Investors are going to become more discerning and demanding of these stocks to bid them higher as valuations have increased.
We're also likely to see a normal progression through the hype cycle, meaning at some point we could see AI stocks fall broadly as investors become disillusioned with the technology.
However, that doesn't mean that the technology is only hype. The dot-com boom of 1995-2000, for example, yielded to a massive crash from 2001-2005, but the internet which emerged at that time was a very real disruptive technology. The disruption and the real impact on business just took longer to play out than many expected.
Who will the AI winners be?
Nvidia has emerged as the biggest AI winner so far, and the semiconductor sector seems set to be the first to capitalize on the new technology. After all, these companies make the infrastructure required to run AI models, and other chipmakers like Advanced Micro Devices and Broadcom have given bullish forecasts for AI-related sales this year, though they're still well behind Nvidia. Foundries like Taiwan Semiconductor Manufacturing should also benefit from the trend as these components need to be manufactured.
In big tech, Microsoft and Alphabet are currently the companies that have made the most progress in turning the disruptive technology into a meaningful business, but there's still a lot more work to be done. And there's potential for new applications like autonomous vehicles, which is part of the reason why Tesla is worth nearly $1 billion.
More winners are likely to emerge, but much like during the dot-com boom or even the mobile era, investors will have to be patient.
