Wealth Insights | August 2, 2024

Artificial Intelligence Impact on Equity Markets

Written by Damian Barry, CFA

Investor enthusiasm for generative artificial intelligence (AI) has propelled U.S. equity markets to all-time highs as of June 2024. The impressive performance of AI-related stocks, particularly among mega-cap companies, has raised concerns about a potential scenario similar to the dot-com bubble of 2000.

Drawing a parallel to the 2000s, Cisco Systems was a major beneficiary of the internet boom as the leading provider of networking equipment. However, during the dot-com crash, Cisco’s stock plummeted by approximately 88% and has never recovered to its peak of March 2000. This underscores the importance of diversification. While investing in the current leaders can be profitable, it’s also essential to spread investments across various sectors and industries to manage risk and capitalise on a broader range of opportunities.

Despite these concerns, AI could be one of the most transformative technological advancements of our era, akin to the industrial revolution. Its impact on corporate earnings may just be beginning to be realised and, so far, only the direct beneficiaries are seeing significant gains in share price.

Whilst we recognise AI as a global phenomenon, we advocate for a diversified investment approach. While specific stocks like NVIDIA may be the initial beneficiaries of the AI boom, over time, various sectors and industries could reap the benefits of AI-driven efficiencies. The lesson from the dot-com bust is clear: not all initial leaders remain the best investments, and new companies may emerge as key players in the AI landscape.

Source: Dimensional Fund Advisors, using data from CRSP. Includes all US common stocks excluding REITs. Largest stocks identified at the end of each calendar year by sorting eligible US stocks on market capitalization. Market is represented by the Fama/French Total US Market Research Index. Ten largest companies by market capitalization. Returns after joining the 10 largest are measured as of the start of the first calendar year after a stock joins the Top 10. Annualized excess return is the difference in annualized compound returns between the stock and the market over the three-, five-, and 10-year periods, before and after each stock’s initial year-end classification in the Top 10. Three-, five-, and 10-year annualized returns are computed for companies with return data available for the entire three-, five-, and 10-year periods, respectively. The number of firms included in measuring excess returns prior (subsequent) to becoming a Top 10 stock consists of 44 (56) for the three-year period, 43 (54) for the five-year period, and 35 (49) for the 10-year period.

Economic Impact of Generative AI

While some impacts of AI on the economy remain speculative, several potential benefits can be foreseen. Firstly, AI has the potential to significantly boost productivity by automating routine tasks, optimising business processes, and enabling better decision-making through data analysis. This can lead to cost savings and the creation of new products and services.

Secondly, AI is expected to contribute substantially to global GDP. McKinsey estimates that AI could add around $13 trillion to the global economy by 2030, increasing global GDP by about 1.2% annually.

The impact of AI can vary across different sectors. In healthcare, AI can improve diagnostic accuracy and efficiency. In finance, it can enhance fraud detection and refines investment strategies. In manufacturing, AI can optimise production and reduces waste. Essentially, each sector will experience unique benefits and challenges as AI adoption increases, highlighting the importance of a diversified investment approach to capitalise on the broad, long-term opportunities AI presents.

NVIDIA: The Main Beneficiary of AI Boom

NVIDIA has emerged as the epicentre of the AI boom, and there are several reasons why it currently holds the global stage. NVIDIA has pioneered and dominated the market for Graphics Processing Units (GPUs), which have proven to be highly effective for AI workloads. GPUs excel at simultaneous processing, making them ideal for the complex computations required in AI and machine learning tasks.

Additionally, the company has developed specialised AI accelerators, such as its H100 chips, designed specifically for data centres to develop and run advanced AI tools. These chips have become essential for training large AI models. Furthermore, NVIDIA has established itself as the go-to provider for AI infrastructure. Major tech companies like Amazon, Meta, Microsoft, and Google, which account for about 40% of NVIDIA’s sales, rely heavily on NVIDIA’s technology for their AI initiatives.

Diversified Investment Approach

“Keeping your money spread across many stocks and industries is the only reliable insurance against the risk of being wrong. But diversification doesn’t just minimise your odds of being wrong. It also maximises your chances of being right.” – Benjamin Graham

When considering AI in our portfolio construction, we adhere to a time-tested approach of diversifying across sectors and industries. This strategy helps mitigate risks associated with market concentration. Currently, AI-related stocks, notably NVIDIA, have driven a significant percentage of the U.S. stock market’s year-to-date performance, with NVIDIA alone contributing to 29.90% of the S&P 500’s return as of the end of June. This has led to a market highly concentrated around a single theme.

It’s crucial to recognise that all seven companies are part of the same technology sector, with significant overlap in their business lines. This commonality leads to a high correlation among their stock performances. Moreover, their notable returns over the past year have been largely fuelled by the surge in investor enthusiasm for artificial intelligence (AI). Given this context, any downturn in AI sentiment or a decline in any individual stock could potentially precipitate a collective downturn, impacting the overall value of the broader cap-weighted index. Notably, the concentration of the largest ten stocks in the MSCI all country world index has reached a level not seen in over 60 years , underscoring the heightened impact these companies can have on the index.

While the companies driving these returns are undoubtedly strong, it’s crucial to distinguish between the price of a stock and its intrinsic value. Despite NVIDIA’s impressive gains, such stocks can be prone to significant volatility, experiencing sharp moves both upwards and downwards. Moreover, while NVIDIA is currently the primary beneficiary, there is likely to be a trickle-down effect benefiting other companies that might not be on every investor’s radar. By maintaining a diversified portfolio, we position ourselves to own some of these potential future winners.

In conclusion, our diversified approach not only mitigates the risks associated with market concentration but also positions us to capture the long-term potential of AI across multiple sectors. This strategy aims to ensure a smoother investment journey and enhances the likelihood of identifying and benefiting from future winners in the AI landscape.

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