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“Using our dividend discount model (DDM) and our economists’ assumption that widespread AI adoption could boost productivity growth by 1.5 pp per year over a 10-year period, we estimate that S&P 500 CAGR EPS over the next 20 years would be 5.4%, compared with +4.9% that our model currently assumes, and would support an S&P 500 fair value 9% above today,” the strategists wrote in a client note.
However, they don’t believe that the market will fully price in the AI potential in the near term, given the uncertainty surrounding the timing and ability of companies.
“First, using a range of productivity scenarios, upside to S&P 500 fair value could be as small as +5% and as large as +14%. Second, a policy response such as a higher corporate tax rate could offset some of the AI-assisted boost to earnings. Third, a higher interest rate environment could negate much of the potential increase in S&P 500 fair value. Fourth, equity prices track near-term cyclical dynamics closely, and long-term bullishness on AI contrasts with near-term investor bearishness due to recession risk.”
Discussing the dot-com bubble and its similarities to 2023, the strategists say that high investor expectations are definitely a risk for the market.
“Fast-growing firms often struggle to grow into elevated valuation multiples. During the late 1990s, while many of the largest TMT stocks continued to grow sales, their inability to meet optimistic investor expectations led to a collapse in valuations,” they added.
However, investor optimism about AI is still not at extreme levels given that equity risk premium (ERP) and long-term EPS growth expectations are “roughly in line with historical averages.”
The situation is different at the stock level as Nvidia’s (NASDAQ:NVDA) current valuation is “similar to the valuation accorded in the 2000s to some of the largest Dot Com Boom beneficiaries (MSFT, INTC) but not the most extreme example (CSCO).”
