The artificial intelligence frenzy has turned the stock market into a playground for tech giants. Over the past two years, companies like Nvidia, Microsoft, and others in the so-called “Magnificent Seven” have redefined success.
Together, these giants make up roughly one-third of the S&P 500’s value, and their combined market cap has surged by 100% while the index itself rose just 50%. But this boom raises a critical question: can the market sustain this level of concentration and hype, or are we on the verge of an AI-induced bubble?
The European Central Bank (ECB) recently warned about this risk in its financial stability review, calling out the dangers of “concentration among a few large firms.” The term “bubble” isn’t something central banks toss around lightly, yet here it was—written in plain, unambiguous language.
The ECB flagged how any earnings misstep from these AI titans could create ripple effects across global markets, given the outsize role of the U.S. in the global financial ecosystem.
AI stocks dominate the market like never before
AI has made a small number of companies indispensable. Nvidia’s GPUs are at the heart of the AI boom, making the company the undisputed leader in the chip sector. Microsoft has leveraged AI to boost its cloud computing and productivity tools.
Together with other tech titans, they’ve sucked up so much of the market’s gains that many investors are uneasy. The S&P 500 is unbalanced, and tech stocks have been topping fund managers’ lists of concerns for almost two years.
The idea that balance will eventually return is popular, but so far, there’s no sign of it happening. Investors initially thought 2023 would see a softening of U.S. tech dominance and a spread of gains to other sectors or regions.
Instead, the opposite has occurred. The gap between the U.S. and the rest of the world has widened, and the so-called benefits of AI haven’t trickled down to other industries in any meaningful way. For context, compare today’s market to the dot-com era.
Back then, the hype was based on speculative valuations with little earnings power to back it up. Today’s AI leaders, like Nvidia, are delivering blockbuster earnings that justify their lofty price-to-earnings ratios. A note from investment firm GMO earlier this year argued that “the stakes are lower today” because investors expect less from mega-cap companies compared to the overblown expectations of 2000.
Yet there’s a catch. These companies have to maintain meteoric growth to sustain their valuations. The risk of any slip (whether technological, geopolitical, or regulatory) could be devastating, not just for the companies but for the entire market.
Changes in the AI trade: Chips vs. software
A noticeable pivot has occurred in the AI sector. While chipmakers like Nvidia and ARM dominated the first phase of the AI boom, Wall Street is now favoring software companies. November has been a defining month.
Data shows software ETFs surging 16%, their best one-month performance in a year. Meanwhile, semiconductor ETFs managed less than 1% growth. Investors are pulling back from chipmakers, spooked by their high valuations and the growing risks of U.S.-China trade tensions.
Nvidia’s latest earnings report exemplified this change. Despite beating Wall Street expectations, the stock failed to generate excitement. Compare that to software-focused companies like Palantir and Snowflake, which delivered strong forecasts and saw their stock prices soar.
Analysts believe the tailwinds in AI are moving from infrastructure—the chips and servers needed to power AI—to software and services. This transition makes sense. Chips had their moment because everyone was scrambling to build the foundation for AI.
But now, companies are looking to monetize AI applications. Palantir, for instance, is thriving on demand for its AI-driven data analytics tools. Microsoft continues to integrate AI into its services, creating recurring revenue streams that investors find attractive.
The semiconductor sector, however, is beginning to look stretched. The Philadelphia Semiconductor Index trades at 24 times estimated earnings, well above its 10-year average of 18. Stocks like Nvidia are some of the most expensive on the market, leaving little room for error.
In contrast, software companies have lower exposure to trade wars and are less vulnerable to the type of cyclical downturns that often hit hardware.
Still, skepticism remains. The everyday applications of AI often fall short of the hype. Customer service bots struggle to handle basic queries, and AI-generated content is riddled with errors. For many, it’s hard to reconcile these limitations with the idea of AI transforming productivity on a massive scale.
Trade wars and AI growth
Trade tensions under President-elect Donald Trump are another wild card. Trump’s promise to impose additional tariffs on China, Canada, and Mexico has already shaken investor confidence in the chip sector.
The Chips Act, designed to boost domestic semiconductor production, faces criticism, adding more uncertainty to an already volatile space.
Software companies are less exposed to these risks. Their business models rely more on intellectual property and services rather than manufacturing, making them a safer bet in the eyes of investors. This divergence is driving a rotation out of chipmakers and into software-focused firms.
Still, the chip sector isn’t going away. Bloomberg Intelligence estimates that semiconductor earnings will grow by 40% in 2025, compared to just 12% for the software and services industry. The AI trade has clearly entered a new phase.
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