This article first appeared in Forum, The Edge Malaysia Weekly on September 25, 2023 - October 1, 2023

The boom led by artificial intelligence (AI) created a buzz in 2023 with the Magnificent Seven stocks (Apple, Amazon, Google, Meta Platforms, Microsoft, NVIDIA and Tesla) accounting for 80% of the growth in the S&P 500 year to date. Jointly, these stocks have a market valuation of over US$11 trillion (RM51.5 trillion), or nearly one-quarter of the entire US market capitalisation. They are valued at an overall price-to-sales of seven times and price-to-earnings of 40 times, superior to the S&P 500, which trades at 2.5 times sales and 26 times earnings.

This rally made it opportune for SoftBank Group to seek the re-listing of its crown jewel, chip designer Arm Holdings. Arm’s initial public offering (IPO) on Sept 14, seven years after being delisted, achieved a record equity value of US$54.5 billion, priced at a whopping 20 times revenue, plus a staggering price-earnings ratio of 136 times. These valuations reflect the market’s appreciation of Arm’s market dominance where 99% of all smartphones have an Arm-based processor.

Advanced RISC Machines, later abbreviated to Arm, was set up to supply Apple with a chip solution for its Newton handheld project. Being low cost and of low power usage, ARM designs laid the groundwork for today’s iPhones. When it was listed in 1998, Arm was valued at £280 million but was privatised by SoftBank in 2016 for £24.3 billion, nearly 87 times over the initial listing valuation.

This time round, the IPO only floated US$4.9 billion worth of shares, about 10% of the company, of which US$735 million was allocated to strategic investors including Apple, AMD, Google, NVIDIA and TSMC. A small public deal size, combined with the infatuation for AI-themed stocks, made it easy for the listing to create its own momentum.

The performance of the Magnificent Seven and the tech rally have buoyed American household wealth and confidence. In the second quarter of this year, US household assets rose to US$174 trillion, gaining US$5 trillion from the prior quarter. Thus, despite repeated rate hikes by the US Federal Reserve, households have not felt pressure to cut back significantly on spending, meaning that there may be room for inflation to stay higher for longer.

The sustainability of the current rally seems to defy belief. The rest of the world is expecting a recession with the ongoing Ukraine war dragging down Europe, and Chinese economic growth lagging. How do investors expect equity markets to outperform? After all, valuations are at record levels corresponding to an earnings yield of 3.9% for stocks, while US benchmark interest rates are 5.25%-5.50% per year.

AI-darling stock NVIDIA now has a market cap of over US$1 trillion and a price-income ratio of 105, four times the S&P 500’s ratio. The market is impressed by the fact that the popularisation of large language models, the likes of which power ChatGPT, would benefit NVIDIA because the company supplies most of the processors needed to train these AI models in the cloud. This reality has helped secure a 40% revenue growth for NVIDIA in the first half of the 2023 fiscal year. Maintaining this rate of growth for the next two years would validate investors’ faith in the stock and would translate into annual revenues rising to US$80 billion, no mean feat. Are we confident that the current investment and revenue cycle can persist amid acute monetary tightening?

The recent release of the Huawei Mate 60 Pro smartphone surprised markets by offering a challenger to the iPhone despite technology sanctions against Huawei and China. The revelation caused outrage among US politicians and led to calls for greater restrictions against China. Concurrently, rumours that China would move to ban the iPhone led to a slide in Apple’s share price. There is concern that tit-for-tat action could cause US-China tensions to rise and could hurt the stock market.

In sum, we do not believe that the US tech stocks can be entirely immune to monetary tightening measures. In the last three rate hike cycles (1999-2000, 2004-2006, 2015-2019), the equity market initially rallied after the Fed rate hikes had tapered off, but ultimately fell as recession hit. Warren Buffett said famously that we should buy when markets are fearful and sell when markets have no fear. We simply do not know whether the promise of AI is sufficiently rich to protect the heady valuations of the current tech rally.

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong. 

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