AI bubble: tech stocks plummet with another potential 25% drop, analysts warn

The rout in these stocks sparked fears of an AI bubble that, should it burst, could send the tech industry, and perhaps the entire market, into turmoil. Over the past month, major semiconductor companies have taken a beating in the stock market. Nvidia fell 14%; Advanced Micro Devices (AMD) 19%; TSMC, which is facing its own set of geopolitical complications, dropped 15%; and ARM, the British manufacturer of chips dropped 31%—including 24% since the start of this week. Intel’s stock had its worst day in 50 years when the stock fell 27% on Friday on news it was suspending its dividend and laying off 15,000 employees. 

Semiconductor stocks could see a further decline of between 15% to 25%, according to Sandeep Rao, an analyst at investment firm Leverage Shares. Rao added that Nvidia and Arm could be near the top of that range, while TSMC would be somewhere in the middle. 

The problem with the AI hype, Rao argued, is that it has simply taken too long to materialize. Investors were promised a world-beating technology that would revolutionize personal electronics and business. Instead they’ve been forced to confront sky-high valuations and longer investment horizons than they had originally planned for. ​​”This common-sense realization is only now beginning to sink into the investor space as FOMO peters out and economic considerations are being examined critically,” Rao told Fortune.  

The market for AI stocks hasn’t been helped by the fact that investors are now preparing for another major macroeconomic narrative: imminent interest rate cuts. Under the assumption the Federal Reserve is poised to cut interest rates as early as September, investors have started recalibrating their portfolios. That meant a rotation away from overpriced large cap tech stocks toward small cap stocks, which usually benefit the most from lower interest rates. 

Despite the industry-wide sell off, the performance of those individual semiconductor companies is positive. Further evidence that points to broader market trends to explain the stock declines rather than issues with the manufacturers themselves. 

After a year and a half of record-breaking performance, many of those companies had little room to climb any higher. At the same time the hyperscalers like Amazon, Meta, Microsoft, and Alphabet that are among their biggest customers gave squishy guidance about the upside of all their AI spending. That did little to proactively excite investors. 

For tech, only perfection will do

And those same investors weren’t helped by recent reports that contraction in manufacturing continues, another dismal sign for B2B companies. The July Institute for Supply Management report, which gauges U.S. manufacturing, on Friday showed the fourth consecutive month of declines in factory production. Falling demand in the manufacturing sector could mean a shaky future for the semiconductor companies that have highly sophisticated chip foundries across the world. “This tends to be a more forward looking index,” said Richard de Chazal, an equity researcher at William Blair. 

Throughout the week there were other factors that caused investors to worry about tech companies, which were already teetering on the cusp of being overvalued. 

With tech valuations so high, anything short of a stellar earnings report can cause the stock to drop. Many of these tech stocks are priced “to perfection,” which means their current valuation leaves virtually no room for any hiccup or piece of bad news, no matter how small, according to de Chazal. 

“Over the last year or so, the continued stellar performance from the Magnificent Seven has justified such valuations,” de Chazal wrote in an analyst note on Friday. “Now, however, when activity is only slightly disappointing, those large tech companies are being taken to the woodshed.”

And each of these semiconductor companies did face some disappointments over the last month. On an industry level they were hit hard by reports that some of their biggest customers, like Meta, Amazon, and Microsoft, admitted that while they planned to continue investing billions in AI, which is powered by chips, they expect it will be a long time before they see any meaningful returns. 

When an analyst on Meta’s earnings call earlier this week asked CEO Mark Zuckerberg how long he expected to wait for the company to monetize its new suite of AI products, Zuckerberg preached patience. “I don’t think that anyone should be surprised that I would expect that that will be years,” he said. 

ARM CEO Rene Haas provided a more definitive, but still lengthy timeline during the company’s Wednesday earnings report. Haas said it would take roughly four years for the company to capture a windfall from its new AI server chips. ARM wasn’t helped by the fact that many of its chips are used for smartphones, which have yet to make any meaningful progress incorporating AI. 

Meanwhile, investors had hoped for guidance that promised speedier returns. “People are also questioning the impact of AI and how soon it will start to materially impact earnings—and the answer seems to be not as quickly as they thought,” de Chazal said. 

Investors want to buy the tech dip 

Even promises from tech CEOs to “overinvest” in AI didn’t calm investors. Many are concerned that big expenditures in the present will inevitably lead to a slowdown in the future, according to Morningstar tech analyst Brian Colello. 

Some, though, found that logic puzzling, wondering how increased spending on AI would be a bad sign for companies that supply AI-related products or services. “That’s the disconnect I don’t get,” said Paul Meeks, tech investor and professor at the Baker School of Business at the Citadel.

Some companies have been victims of their own success, none more so than Nvidia, which is the poster child for the AI stock market rally. A lot of investors want to sell to realize their profits. “Nvidia’s stock price had a tremendous run-up over the past 18 months, so profit taking alone might explain some of the retreat in the stock price in recent weeks,” said Colello. 

Others thought the recent declines represent a chance to cash in even further. In a UBS analyst note published on Friday, analysts eyed the dip as nothing short of an opportunity. “We maintain our positive view on the AI growth story, and think that the recent share price correction offers a good opportunity,” the note read. 

Meanwhile, Meeks was even clearer on his intentions for stocks like Nvidia and TSMC. “I already got all these stocks, and I’m gonna buy more,” he quipped.