Wall Street’s AI bet is now too big to hit: McGeever

By Jamie McGeever

ORLANDO, Florida, Oct 12 (Reuters) - The hurdle for continued AI-driven equity gains is strikingly high. And with cracks starting to appear in the seemingly impenetrable tech edifice, there are mounting signs AI risk is now far more than just a case of "bad vibes."

While the S&P 500 .SPX and Nasdaq .IXIC climbed to fresh highs last week, a string of negative headlines related to AI – from a shelved initial public offering (IPO) in Australia to reports that ChatGPT maker OpenAI's revenue is falling short of earlier estimates – suggests markets could soon run into some serious obstacles.

Earnings releases and forecasts from the big AI players in the coming weeks may ease those concerns. But the bar is high – very high. Analysts expect S&P 500 earnings to rise more than 30% year-over-year for the third quarter, with two-thirds of that coming from tech and AI, according to Tajinder Dhillon, LSEG's head of earnings and equity research. Some analysts say up to 80% of the anticipated increase in total profit growth from S&P 500 companies will come from this one area.

Investors are right to be cautious.

On Friday, Australia's Firmus, a data center operator backed by Nvidia NVDA.O, shelved its $5 billion IPO. It would have been the country's second-largest initial share sale ever, and the fourth largest globally this year.

That was obviously a negative twist, but even positive news from AI firms may not be good enough. On Thursday, South Korea's Samsung 005930.KS, the world's largest memory chipmaker, said it expects to announce third-quarter earnings of around $80 billion, which would be a record quarterly profit for any tech company.

On the same day, Taiwan's TSMC 2330.TW, the world's largest contract chipmaker, reported record third-quarter revenue of $46.7 billion, beating forecasts and rising 50% from a year earlier. Yet shares in both companies fell.

Of course, isolated share price moves and company-specific announcements aren't indicative of the trajectory of a multi-trillion-dollar industry.

But they are part of a steady drip of less-than-stellar headlines. Let's not forget, it also emerged last week that OpenAI's annualized revenue for September was around $50 billion, down $20 billion from previous indications.

This all suggests the bigger AI picture could face some seriously harsh scrutiny this earnings season.

THE HIGHEST BAR

The sums being spent on the AI revolution, and therefore those required to make it profitable, are eye-watering.

The total cost of financing the AI buildout from last year to 2032 is estimated at $10.3 trillion, or an average of 3.63% of US gross domestic product per year, according to Columbia University professor Stijn Van Nieuwerburgh.

Assuming a conservative 10% return — below the 15-20% return on investment many analysts say AI investment is targeting — Van Nieuwerburgh estimates the annual revenue required "to recover the investment, replace depreciating capital, and compensate investors for the opportunity cost of capital" is around $3.55 trillion by 2032.

That's more than 9% of GDP, roughly what Americans spend on motor vehicles, transport, household furnishings, clothes, and energy combined. When you consider that annual combined revenue of OpenAI and Anthropic is currently around $100 billion, total revenue would need to grow more than 80% a year through 2032 to get to the required $3.55 trillion total, Van Nieuwerburgh says.

"If the economic life of IT equipment is shorter, the revenue requirement rises substantially," he said.

BIGGEST MISALLOCATION EVER?

AI and tech firms' profits have, so far, mostly met Wall Street’s soaring expectations. Can they continue to do so?

JPMorgan Private Bank's Michael Cembalest says AI-related stocks, which he narrows down to 41 names, have accounted for 75% of S&P 500 returns, 80% of earnings growth and 90% of capital spending growth since ChatGPT launched in November 2022. That’s an extraordinarily heavy burden for so few companies.

The outlooks provided by the CEOs and CFOs of these 41 firms in the coming weeks could indicate whether a market correction could be on the horizon – and just how large it could be.

AI is far and away the biggest investment boom in US history. Could it also end up being the biggest misallocation of capital?

(The opinions expressed here are those of the author, a columnist for Reuters)

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