The Froth Surrounding AI Is More Than $3 Trillion

By Ven Ram, Bloomberg markets live reporter and strategist

Investors are assigning a market value of more than $3 trillion to the artificial-intelligence industry, an analysis based on valuations of the entire technology complex shows.

The aggregate fair valuation of the more than 3,000 stocks that comprise the Nasdaq Composite Index is 11,101, an examination of the technology complex viewed as a bunch of long-duration bonds shows. The index closed at 13,018 on Monday, meaning stocks are overvalued by 1,917 points.

That overvaluation is roughly equivalent to about $3.1 trillion in market capitalization.

The analysis is predicated on the premise that the 26% rally in the Nasdaq Composite through the first three quarters of this year that propelled it past fair value was due mainly to investor enthusiasm surrounding the promise and potential of stocks linked to artificial intelligence.

Investor fervor about artificial intelligence reached a peak in July, propelling the Nasdaq Composite to as much as 14,447. Traders were assigning a market capitalization of about $5.5 trillion to the AI complex then.

While investors have since trimmed their positions in the wake of conflict in the Middle East, there is still considerable froth left in the market that is liable to being mopped up.

Indeed, should those geopolitical tensions escalate, the first point of stop for technology stocks may be a complete surrendering of the premium associated with artificial intelligence. In other words, the Composite Index may tumble as much as 15% to fair value.

The analysis, similar to a study last month, essentially assumes that dividends that accrue from the index will increase at a compounded annual rate of 8.6%, mimicking the growth rate over the past 10 years. It uses a discount rate of 5% and assumes that the growth rate will slow to 5% beyond a forecast horizon of 30 years.

Technology stocks are also vulnerable to soaring Treasury yields beyond here. While they could withstand higher rates as yields successively shot through 2%, 3% and 4%, a 10-year yield above 5% has bigger implications. This is because the discount rate that many investor groups use is 5%, and a level above that on Treasuries implies a higher rate will be used to value future cash flows. A higher discount rate will lead to lower valuations.

A combination of the war in the Middle East and soaring Treasury yields is bound to test stock valuations from here. As the analysis shows, the correction from current levels may be considerable.

Should the geopolitical fallout be contained, however, technology stocks may be inclined to revive their fervor toward AI.