Tech stocks are racing higher again, leaving all other sectors trailing far behind. However, it’s a bit different this time as it is no longer a broad rally in everything that is tech. This particular upswing is a lot narrower and is being driven by the buzz in artificial intelligence (AI), with anything AI-related getting caught up in the excitement. But with many AI stocks already notching up year-to-date gains of more than 100%, how sustainable is this rally?

Riding on the back of the AI boom

The big star of the AI revolution is of course Nvidia. The graphics card maker had been outperforming Wall Street all year, but its shares really took off after the company issued guidance that was well above expectations on the back of the AI boom. Since then, any stock that has the potential to benefit from what is projected by many to be the exorbitant growth of AI technology has been swept up by the market mania.

Sceptics would argue that what goes up must come down and that has certainly proven to be the case time and time again with overblown rallies. But that may not necessarily be a sign of what’s to come this time. At least not yet and probably not with Nvidia.

AI stocks are defying gravity

Whilst there can be no doubt that Nvidia is presently extremely overvalued with a trailing price-to-earnings ratio of about 200, its forward multiple has come down sharply following the upgrade to its earnings outlook and it’s not that much above its peers’. For investors who are eagerly searching for the next growth opportunity, the rally in AI stocks might not seem at all overstretched and Nvidia’s $1 trillion market capitalization may only be the start.

The sudden emergence of generative AI tools and their endless applications is even helping to ease recession worries on hopes that the sector would provide a pocket of growth during an economic downturn.

Big Tech vs new opportunities

However, there are other downside risks for equity traders on the horizon. The US Treasury will likely need to build up its cash balance as soon as a deal on suspending the debt ceiling is reached in Congress. But doing this could involve a flood of new debt issuance, which would suck liquidity out of the financial system, hurting risky assets.

The possibility of the Fed keeping rates higher for longer is another concern. Big tech stocks such as Microsoft and Alphabet that have defensive attributes and are additionally attracting interest because of their investments in AI, might be deemed as safer bets in a worsening economic climate.

Smaller rivals that have caught the AI fever are more at risk, especially those such as the likes of C3.ai whose share price exploded in May. Nvidia may have recently joined the ranks of the Big Tech, but it remains more exposed to downside reversals, not just due to the exponential surge of its stock, but also because it does not have a very diversified revenue stream.

A new bubble?

For the time being, however, AI will likely remain all the rage, exacerbating the widening disparity between tech and AI stocks and the broader market. When excluding the Information Technology sector from the S&P 500, the index has barely risen this year even as tech shares have rallied about 33%.

 

This doesn’t paint a very optimistic picture about the prospects for the wider economy in the United States and may be masking the true extent of the slowdown. It also supports the view that the tech sector has entered another bubble. The question is, given all the frenzy, how big will this new AI bubble get before it bursts?