US stocks are overvalued due to unrealistic expectations for AI-driven economic growth, says Vanguard

• Investors are too bullish on AI’s near-term prospects, Vanguard said.

• The firms would need to grow profit by 40% annually over the next three years to match the valuations, the firm said.

• “This is double the annual rate of the 1920s, when electricity lit up the nation,” Vanguard wrote.

With tech companies still pushing the boundaries of artificial intelligence, the market’s enthusiasm for it seems endless.

But this enthusiasm is expecting too much from the technology in too little time, Vanguard wrote Thursday.

Wall Street is abuzz with bullish predictions about what AI could do to the economy and corporate profits. Most of them are caught up in a revolution in the US workplace and a boom in productivity.

That optimism has fueled a strong rally in stocks, with the benchmark S&P 500 up 18% year-to-date through Thursday.

But Vanguard global chief economist Joe Davis thinks expectations are too high and says stocks are overvalued even if the AI ​​boom plays out as anticipated.

He estimates that US corporate profits would have to grow 40% annually over the next three years to justify where stocks are trading now. For context, the S&P 500’s one-year earnings growth rate through the second quarter of 2024 was 10.9%, according to FactSet data.

“I am optimistic about the long-term potential of artificial intelligence to generate large increases in worker productivity and economic growth,” wrote Global Chief Economist Joe Davis. “But I’m pessimistic that AI can justify high stock valuations or save us from a mild economic downturn this year or next.”

He continued: “This is double the annual rate of the 1920s, when electricity lit up the nation – not to mention economic output and corporate income statements.”

Such a historic uptick in corporate performance looks even less likely if the economy cools next year. Vanguard expects GDP to expand by just 1% to 1.5% in 2025.

It’s not that the investment firm doesn’t believe in AI’s potential — its research suggests a 45% to 55% chance that AI will trigger a labor productivity boom. Between 2028 and 2040, this could spur an annual US growth rate of 3.1% in real terms.

But investors need to let go of any notion that this will happen immediately, Davis said. While firms have poured billions into advancing their position in the sector, some market players do not believe AI investments will reach $1 trillion in the near term:

“A trillion dollars in AI investment by 2025 would require a 286% increase. That probably won’t happen, which means we’re unlikely to experience an AI-driven economic boom in 2025,” he said.

The story continues

Some on Wall Street are much more pessimistic. BlackRock said there is a good chance that big investments in artificial intelligence will trigger higher inflation before any manufacturing boom comes. This could erode corporate profit growth.

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