As I expected, Nvidia's (NVDA +2.59%) rocket-ship rally is beginning to stall, with shares down by roughly 21% over the last 30 days. And while Nvidia is still a great company, the combination of a high valuation and low diversification leaves room for continued downside. Let's explore how recession fears and artificial intelligence (AI) fatigue could play out over the next three years.
Economic storm clouds gather
It is impossible to predict a recession for sure, but data is pointing toward a possible slowdown in economic activity. In July, the U.S. only added 114,000 jobs compared to expectations of 175,000, while the unemployment rate hit 4.3% -- its highest level since 2021. And while the Federal Reserve is expected to stimulate growth by cutting interest rates, it might be too little too late to avoid a so-called hard landing. Rate cuts can be a helpful tool, but they can't magically fix every problem in a shaky economy.
NASDAQ: NVDA
Key Data Points
For Nvidia, a recession could be a disaster. While the company has dominated the AI industry by producing cutting-edge graphics processing units (GPUs) needed to run and train these complex conversational algorithms, it can't prevent its business model from being undermined by macroeconomic factors outside its control.
Nvidia sells luxury products
Nvidia's business has historically been cyclical. When money is tight, consumers are less likely to spring for expensive computer upgrades, instead opting for cheaper used options -- or foregoing them altogether. While a shift to enterprise-level hardware shields Nvidia from the whims of PC gamers, similar dynamics could also arise in the market for AI chips.
Analysts are beginning to sound the alarm about the billions being spent on AI hardware with limited results on the bottom line. Goldman Sachs analyst Jim Covello puts the situation in stark terms, stating: "Despite its expensive price tag, the technology is nowhere near where it needs to be in order to be useful. Overbuilding things the world doesn't have use for, or is not ready for, typically ends badly."
Image source: Getty Images.
While tech companies are content to speculate on unprofitable AI investments when the economy is good, the current level of spending may not hold up when conditions weaken. During recessions, businesses usually downsize their non-essential and non-profitable segments first, and right now, AI seems to fit solidly into that troubled category.
Nvidia may be underdiversified
Nvidia's first-quarter revenue jumped 262% to $26 billion, driven by data-center chip sales, which rose by an eyewatering 427% to $22.6 billion. But while this growth is impressive, it puts most of Nvidia's financial eggs in one basket. Data-center sales now represent 87% of total revenue driven by a few flagship products, such as the A100 and H200, which power typical large language models (LLMs) such as ChatGPT.
Other segments, like gaming (10% of revenue) or professional visualization (2% of revenue), have faded into irrelevance in the current market, making Nvidia vulnerable to any potential slowdown in demand for AI accelerator chips.
Is Nvidia stock a buy?
After rising by over 450% over the last three years, Nvidia stock has historically been a spectacular investment. And there is still a lot to love about the company because of its industry leadership in the global-chip industry. That said, shares seem to have peaked for now.
With a forward price-to-earnings (P/E) multiple of 42, Nvidia's valuation prices in future growth that may not materialize, especially if the U.S. economy begins to slow and enterprise clients start to rethink their massive AI chip purchases. Nvidia looks overexposed to this fragile industry and may experience a major correction in the coming years.
