Strategists say it's time that investors protect against downside
Goldman Sachs warns that investor expectations for the artificial intelligence trade may be racing ahead of reality.
A summer swoon for tech stocks may be taking hold, as another bumpy ride looms for Tuesday after South Korea's red-hot stock market slumped 10%.
Our call of the day from Goldman Sachs strategists warns investors may be racing ahead of what the artificial intelligence trade can ultimately deliver. While the AI investment boom remains on track, "the tension between favorable fundamentals and high valuations continues to grow," strategists Dominic Wilson and Vickie Chang told clients in a note late Monday.
In a previous comparison of the AI boom to the 1990s tech bubble, they saw no signs of the main four macro imbalances marking the end of the dot-com run. Six months later, that picture is largely holding, with profit margins still high, the corporate sector financial balance largely stable and the current-account deficit narrower.
However, the strategists noted a big change for a fourth factor: "the AI capex boom is neither as broad based nor as long-lived as the 1990s tech boom, but it is now matching its scale."
That's as market gains for those AI related plays now "comfortably exceed" Goldman's baseline estimates of just how much growth increased revenue can inject into the U.S. economy. "It is still possible to reconcile this market value with a macro estimate of future profit gains. But it requires more optimistic assumptions about adoption, capital shares, productivity or U.S. companies' ability to capture global revenues," said Wilson and Chang.
"We think the most credible upside stories rely on AI-related companies capturing a higher share of AI-related productivity gains than normal," they said. For microchip makers and hyperscalers, earnings have been strong and margins are high, but over time, innovation, competition and investment could erode profit gains for even the main AI players. It also remains to be seen how solid the entry barriers are to protect those incumbent players from any profit erosion, they said.
That's as they worry "markets are extrapolating near-term trends - including profits fueled by the investment boom itself - too far into the future." With lots of value built into that AI trade, markets will be more vulnerable to views that challenge that optimism, said the strategists.
So what's the bottom line? They don't recommend bailing out of tech stocks - "until the peak in the investment cycle draws closer, robust earnings may dominate macro concerns, so we want to find ways of staying invested while limiting downside."
How to limit that downside? Options, they say, although they don't recommend a particular trade. Investors can either use puts - options to sell stocks at a lower price - or a "call replacement" to protect against downside, they say. A call replacement strategy is when an investor sells the stock they hold but takes a fraction of the proceeds to reinvest in call options.
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