The artificial-intelligence revolution is supposed to improve the financial fortunes for companies in a wide swath of sectors. AI should help businesses cut costs and make them more efficient, lifting profit margins. So far, however, things aren't playing out that way.
Torsten Sløk, chief economist at Apollo, noted in a recent report that the net profit margins for the technology and communications services sectors have gone up since the end of 2022, which is when OpenAI introduced ChatGPT. But margins for numerous other sectors, such as healthcare, consumer staples, energy, and materials, are either flat or down over the same period.
In other words, Nvidia and the hyperscalers in the Magnificent Seven are benefiting from the massive amount of spending on AI. But the so-called Other 493 in the S&P 500 aren't. At least not yet.
"The AI capex boom is so far only showing up in the sellers' margins, not the buyers'," Sløk wrote. "This is important because the longer it takes the S&P 493 to generate [returns on investment], the bigger the downside risks to an economy and a market this concentrated in the AI trade."
According to data from Sløk, net margins for the Magnificent Seven are hovering around 25%, up from about 15% in late 2023, compared with about 10% for the Other 493 companies in the S&P 500. Margins for the Other 493 have mostly held steady over the past three years.
Sløk added in an email to Barron's that he eventually expects margins to expand in sectors outside tech and telecom services. "But the speed with which this happens is key for markets," he said.
Sløk wrote in another report in early July that many investors are expecting tangible benefits from AI spending by 2028 -- so the market needs to see the proverbial proof in the pudding over the next two years.
"With so much riding on so few names, a slower payoff wouldn't just be a sector problem, it would risk tipping the economy into recession and the S&P 500 into a correction," Sløk said.
The major indexes are all at or near record high levels, thanks in large part to gains fueled by optimism about AI. So it will be key for adopters of ChatGPT, Anthropic's Claude, and other large language models to prove to investors that the money they are spending on AI will have clear, positive effects on earnings.
"This cycle is dependent on AI being able to monetize at the rate the market thinks it will," said Rob Almeida, global investment strategist at MFS Investment Management, adding that given the bull run of the past few years, "investors need to be careful and thoughtful, and they usually aren't" and that a "lot of retail money is in risk on mode."
This isn't to say that AI is a bubble about to burst. But it may take more time before companies in nontech sectors like retail, financial services, and healthcare truly reap the rewards from their AI spending.
With that in mind, Jonathan Curtis, a portfolio manager at Franklin Equity Group, said that investors should probably focus most on the companies that are helping to "run AI" -- namely the hyperscalesrs.
"You're starting to see investors feeling comfortable going back into the safety of the Magnificent Seven," Curtis said. The Roundhill Magnificent Seven exchange-traded fund, which owns Nvidia, Apple, Alphabet, Microsoft, Amazon.com, Meta Platforms, and Tesla, is up nearly 5% so far in August. The resurgence of the Big Tech trade has helped push the S&P 500 up 3.5% so far this month too.
That's fine for now, as investors applaud strong earnings for the tech sector. But the AI spending has to bear fruit -- especially with the S&P 500 trading at just below 22 times earnings estimates for this year. If profit margins don't start to meaningfully improve for all the companies writing those big AI checks to the hyperscalers, that will make it tougher to justify further gains for the broader market.
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