Over the past two weeks, a wave of earnings reports from technology giants was expected to provide some clarity for a stock market that had been wobbling amid numerous risks, especially doubts about massive artificial intelligence investments. After those results were released, the outlook did indeed become clearer, but unfortunately also considerably dimmer. Although the earnings of major AI spenders showed cloud computing businesses continuing to boom, investors were not buying it. Instead, they focused on soaring data center construction costs that are eroding free cash flow. This triggered a sharp selloff on Friday, pushing the technology-heavy Nasdaq 100 Index's October decline to 6.7%, its worst monthly performance since the tariff panic in March 2025. "This reflects investors becoming more selective, because I don't think every hyperscaler will be a winner going forward," said Anthony Saglimbene, chief market strategist at Ameriprise. "Ultimately it comes down to how much companies are spending, how much return they can generate, and how deep their moats are, so whether they can continue to grow revenue."
Alphabet shares plunged 13% on Thursday, the largest single-day drop in its history. Earlier, the Google parent reported disappointing sales in its core search business and negative free cash flow for a second consecutive quarter, something that had never occurred since the company went public. Amazon's subsequent earnings showed its negative free cash flow was much worse than analysts expected, mainly due to increased capital expenditures and e-commerce growth slowing to its weakest pace in three years. The stock fell a combined 5.6% on Thursday and Friday, its worst two-day performance since July. "Investors are assigning higher risk to companies with negative cash flow," said Brian Mulberry, chief market strategist at Zacks Investment Management. "I do think what you're seeing now is investors voting with real money, redefining what they consider 'quality' to mean."
In fact, the AI trade was already on the back foot early in the week. Meta Platforms Inc. raised its capital expenditure plans for the year when it reported earnings on October 21. Since then, the stock has fallen 12% cumulatively. A measure of the company's credit risk rose to a record high. On Friday, S&P Global Ratings downgraded the credit rating outlook for the Facebook parent from stable to negative, noting it remains unclear when Meta's spending will generate revenue exceeding rising costs. "Investors are starting to reward companies that can demonstrate the ability to convert spending into revenue and actual investment returns, while punishing those that have yet to do so or are still increasing spending," said Chris Osmond, chief investment officer at Fifth Third Wealth Advisors.
Pessimism has grown to the point that even companies capable of generating stable free cash flow are being sold off. Microsoft reported faster-than-expected revenue growth in its Azure cloud business, with free cash flow approaching $19 billion. But its stock was still dragged down this week, falling 1.6% on Friday. Concerns about AI are not limited to mega-cap companies. Software developer ServiceNow issued a disappointing quarterly sales forecast, once again triggering market fears about AI disruption, sending its stock down a record 31% on Thursday. Meanwhile, Fortinet Inc. cut its service business sales forecast, sparking a selloff in cybersecurity stocks. With U.S. midterm elections set for Tuesday, traders already face plenty of risks. Here is where the AI trade currently stands as voters prepare to cast their ballots.
Alphabet's Existential Challenge
Perhaps no company better represents the contradiction between AI risks and rewards than Alphabet. Its results showed strong growth in AI search queries. But because Google earns less from such traffic than from traditional search, the business's revenue was disappointing. Search accounted for nearly 56% of the company's revenue last year, so any decline could have an extremely severe potential impact. Alphabet had already faced concerns that its search market share could be challenged by chatbots from companies like OpenAI. Strong results in recent quarters had temporarily eased those worries, but this earnings report showed that Alphabet may be disrupting its own business. "Alphabet is building infrastructure, but in doing so it may be risking cannibalizing its own business," Saglimbene said. "The next phase of AI will enter a 'prove it to me' stage. The market has very high expectations for companies building AI infrastructure, and every quarter will be like a report card, either justifying those expectations or casting doubt on them. When reality doesn't match the market narrative, stock price declines can be very sharp, as we have already seen."
Software Stocks Slide
This earnings season has once again revived market fears about AI disrupting the software industry. Products from companies like Anthropic and OpenAI could weaken software firms' pricing power and squeeze margins. According to compiled data, so far this earnings season, 90% of software companies in the S&P 500 have beaten earnings expectations, but only 70% have beaten revenue expectations. Both figures have deteriorated from the previous quarter, when 100% beat earnings expectations and more than 80% beat revenue expectations. "The market is very uneasy about which software companies can survive in the AI era," said Ben Connard, chief investment officer at Carnegie Investment Counsel. Several software stocks have been sold off this earnings season due to weak results or guidance. In addition to ServiceNow and Fortinet, communications software developer Twilio Inc. fell 18% on Friday due to disappointing guidance. Industry research called this "clearly concerning" because it "implies a significant slowdown in growth compared with the third quarter."
Cash Consumption
Massive spending on AI infrastructure continues to erode the free cash flow of mega-cap technology companies. Among the four hyperscalers, three — Amazon, Meta and Alphabet — posted negative free cash flow this quarter. Amazon's negative free cash flow approached $35 billion, compared with free cash flow of $430 million a year earlier. Microsoft was the exception, with positive free cash flow of $18.6 billion. "We used to look at technology companies in a particular way," said Saglimbene of Ameriprise. "They used to be asset-light companies with abundant cash flow and very reliable growth. Now they have become asset-heavy companies, their cash flow profiles have changed, and in some cases the reliability of growth has changed too. All of this means they need to be viewed differently. Given the scale of the money these companies are investing, you have to value them differently than in the past."
The Capital Expenditure Challenge
Data center capital expenditures remain in full swing. Meta Platforms slightly raised its spending forecast for this year in this area, with future spending commitments rising to $825 billion. Microsoft's capital expenditures in the first fiscal quarter came in below expectations due to bottleneck issues, but the company said spending will increase in the second half of the fiscal year ending next June. Meanwhile, Alphabet's future spending obligations jumped to well over $1 trillion. "I think demand for AI tools is still astonishingly high, which means this capital expenditure is necessary," said Mulberry of Zacks Investments. "But now the question is, we've already spent $800 billion this year, how do we monetize it? And when you do monetize it, can it translate into positive cash flow — that is, can it be profitable?"
Comments