The Bear Case for AI Stocks: 5 Reasons Sector Could Struggle in Future

Since November 2022, artificial intelligence stocks have been the place to be in the market.

Nvidia is up 761% over that time. Palantir is up 604%. Taiwan Semiconductor has returned 165%. And Microsoft is up 88%. It’s been a gold rush.

But how long can the AI trade last? Some experts, like Morgan Stanley’s Head of Global Research Katy Huberty, have said that we’re still in the early innings of the technology and robust returns still lie ahead.

Few seem to refute the idea that AI will transform the US economy to some degree and be an eventual boon for profits. But some have urged caution about investing in the theme after such a huge run of outperformance. Irrational exuberance and greed are running rampant, they worry, potentially setting AI stocks up for a spectacular bust somewhere down the line.

While the outlook on the technology’s role in the economy is bullish, there are some threats to AI’s dominance in the stock market. Five of them are detailed below.

1. Valuations

Generally speaking, AI stocks are expensive with their prices relative to their earnings over the last 12 months at elevated levels.

For example, the iShares Future AI & Tech ETF (ARTY) has an average trailing 12 months PE ratio of 35.2, and the The Technology Select Sector SPDR Fund (XLK) is trading at 36.7 times earnings. Nvidia trades at a 45 PE ratio. By comparison, the S&P 500, which is at historically expensive levels, has a 23.7 PE.

While AI stocks may have stronger growth prospects than those in other industries, high valuations mean those prospects are already priced in. If actual earnings performance underwhelms compared to expectation, then the stocks could start to underperform.

High valuations tend to weigh on long-term performance. For example, Microsoft traded at 72-times trailing earnings in 2000. While it went on to lead the way in internet technology, it didn’t recover its 2000 highs until 2016.

2. AI technology doesn’t end up being quite as impactful as investors think

AI may make tasks more efficient, but perhaps not to the degree the market thinks, said Jim Covello, head of Global Equity Research at Goldman Sachs, in a June 2024 report.

“People generally substantially overestimate what the technology is capable of today. In our experience, even basic summarization tasks often yield illegible and nonsensical results,” Covello wrote.

“This is not a matter of just some tweaks being required here and there; despite its expensive price tag, the technology is nowhere near where it needs to be in order to be useful for even such basic tasks,” he continued. “And I struggle to believe that the technology will ever achieve the cognitive reasoning required to substantially augment or replace human interactions.”

This could hurt AI firms, which are pumping hundreds of billions into building out AI infrastructure. What if, in the end, the mammoth spending isn’t worth it?

3. Current leaders may not remain

Another risk is that you end up investing in the wrong stocks altogether.

Just because certain stocks are pioneering a technology, doesn’t mean that they will continue to do so.

The presumption five years ago “would have been that Intel would be the dominant player” in the AI space, Research Affiliates Founder Rob Arnott told BI in November. “Well, Intel is teetering perilously close to irrelevance, and Nvidia wasn’t on anyone’s radar screen five years ago. So disruptors get disrupted.”

4. Rising long-term interest rates

As foreign investors start to pull back from US Treasury bonds amid an expanding national debt, and as tariffs and Trump’s tax cut bill threaten to boost inflation, long-term Treasury yields are trending upward.

When long-end yields go too high, it has historically hurt growth stock performance and brought down valuations. Higher-risk free yields start to attract money, and risky and expensive stocks start to lose their luster.

5. Geopolitical uncertainty

One of the key players in AI development is chipmaker Taiwan Semiconductor.

If China were to invade Taiwan, as it has threatened, the AI supply chain could be severely interrupted.

“The moment conflict starts in the Taiwan Strait, you have to assume that TSMC shuts down very, very quickly regardless of what any of the players decide to do — regardless of whether anyone decides to disrupt the supply chain or destroy this or that or not,” said Chris Miller, author “Chip War,” in an interview with BI last year.

“Taiwan imports a big chunk of its energy and chip factories need energy. And there are a bunch of critical chemicals and materials that are imported into Taiwan, and those would stop,” he continued. “What’s more, you couldn’t get the ships out of Taiwan if there was a shooting war going on. And so your incentive to produce a lot also declines very rapidly if you can’t actually sell chips or get them off-island.”