Big Tech’s AI Profits Hold Key to S&P 500’s Fate

The S&P 500’s destiny is increasingly tied to the ability of a few major technology companies to leverage their investments in artificial intelligence (AI) for higher profits.

Seven companies, including Microsoft Corp. and Nvidia Corp., have been responsible for about 75% of the index’s gains this year. This rally has been fueled by investors’ fascination with AI’s potential to disrupt large sectors of the economy. With valuations high, averaging around 32 times earnings for these companies’ shares, there’s growing pressure on them to fulfill the earnings expectations embedded in their soaring stock prices.

Mark Lehmann, CEO at JMP Securities, remarked, “We’re getting closer to the moment when the companies that are claiming AI-related profits will have to start showing them. I am not calling for an expansion of multiples next year; the returns will have to come from companies actually turning in better profits.”

These companies recently reported record profits of $99 billion in the third quarter. However, there’s increasing demand for them to deliver more, underscoring the high stakes for stocks that have added roughly $5 trillion to the market’s value this year. Constituting almost 30% of the S&P 500, these companies wield more influence over the benchmark than ever before.

Nvidia Corp. has been a major driver of the group’s profit growth this year, fueled by demand for AI. It is expected to generate around $28 billion in profit this year, up from about $4.4 billion last year. Most of these gains come from the sales of accelerator chips used to train large-language models, such as those underlying applications like ChatGPT.

However, not all members of the group have shown significant AI gains. Microsoft, despite its $13 billion investment in ChatGPT owner OpenAI, earned slightly less in the fiscal year ending in June compared to the preceding period. Analysts anticipate a 17% increase in earnings for the next fiscal year.

While stock prices are rising faster than earnings estimates, with an average price-to-expected earnings ratio in the group of seven increasing from about 21 times at the start of the year to 36 in July, there are varying levels of valuations. Facebook parent Meta Platforms, for instance, is relatively cheap at 19 times, while Tesla Inc. is the most expensive at 63 times estimated earnings.

Some investors believe these valuation levels may be conservative. Nick Rubinstein, technology stock portfolio manager at Jennison Associates, is confident that AI profits will eventually make some Big Tech stocks appear like bargains at current prices.

“I’m more excited now than I have been for a very long time,” he said in an interview. “So many industries can benefit, while the arms dealers for AI should benefit even more.”

The future gains of these tech giants and the S&P 500 as a whole will also depend, in part, on the broader economic context. Investors are factoring in optimistic scenarios where the U.S. avoids a recession, and the Federal Reserve shifts from rate hikes to cuts as early as the first half of 2024.

Despite reluctance among many to forecast a decline in tech stocks next year, it remains uncertain how much they can rally further with already elevated valuations. Phil Segner, senior research analyst and co-portfolio manager at Leuthold Group, noted that Nvidia’s shares have plateaued in the second half of 2023, despite surging profits.

“To call a top in this trend has been a fool’s errand,” Segner said. “I can’t say that it’s going to keep going into next year, but at some point, I think people should be aware of the risk that those stocks have in their portfolio.”