Santoli: The youthful phase of AI is over. What it means for investors

Santoli: The youthful phase of AI is over. What it means for investors. But the youthful phase of AI – when promise was unlimited and winners were easy to spot and vastly outnumbered losers – is over.

What happened

But there may be a silver lining for investors revealed in the AI slowdown. IXICMSFTFollow your favorite stocksCREATE FREE ACCOUNTGet Mike Santoli's Market Memo in your inbox first. AI is unpopular with the public, projections of order backlogs beyond a few quarters are now suspect and investors might be dialing back their assessment of how quickly a whole class of entrenched businesses will be displaced by the automated hive mind. But that doesn't mean a "lower extreme" won't be reached this cycle, ahead of a payback phase.

Market Temperature GaugeThis indicator from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors are saying and what they are doing. Market breadth has eroded, but that also means internal oversold conditions are building. Much of this is merely a matter of equity-market appreciation, though investors are allowing stock exposures to climb without rebalancing.

The wider picture

The AI narrative has flipped to a focus on the risk with the tech unpopular with the public and projections of order backlogs beyond a few quarters now suspect. Bank of America's wealthy clients have stock exposures at quarter-century highs. Buying opportunity for bonds now offering healthy yields? SUBSCRIBE HERE"We'll never laugh again," said a young admirer of John F. Kennedy in 1963 as she mourned his sudden death. "We'll laugh again," answered the JFK aide Daniel Patrick Moynihan.

"At the risk of seeming to conflate a president's assassination with an investment motif, this is where the AI theme sits right now. There will be cheer and thrills and profits generated by the burgeoning technology in the years to come.

What has been reported

This reality predates the past week's litany of ominous pronouncements about the destructive potential of AI models and the industry's professed desire for some restraint on the velocity of development. Semiconductor shares were already 20% off their June highs prior to Monday's 4% slide. The tech sector of the S&P 500 has seen its forward price/earnings multiple contract from 29 to 21 in the past year with the market unwilling to extrapolate the profit surge in the absence of a clear path back to reaping oodles of free cash flow.

Data centers have a lower approval rating than Congress – to the point where it's hard not to assume the overheated ire will burn itself out after the election. Perhaps not much will change in terms of AI policy, model training or the demand for computing capacity. But in markets, narratives matter quite a bit in the near term. And for the moment, the AI narrative has become more fixated on risks than opportunities. Right or wrong, the breathless talk of throttling the buildout makes it marginally tougher to argue that 2027 earnings projections – enormously dependent on semiconductors – are too low.

What happens next

And anyone already worried that the eyelash-singeing profit growth of the second quarter represented plenty of pulled-forward demand and temporary margin expansion will find only their bias confirmed. If a year ago the most-cited concern was that an AI bubble was forming and speculative exuberance was frothing over, that's been taken care of. The savage purge since June of high-momentum stocks – dominated by AI hardware and related industrials – has sapped the bullish aggression of traders, helping to reset tactical sentiment toward a more neutral level.

Monday's perky action in shares of the huge tech platforms doing most of the AI capex – Microsoft, Alphabet, Meta – reveals a silver lining from a possible slowdown, allowing these companies to take a beat before accelerating their capital raising and deployment further still. The market has already shown a voracious appetite for companies demonstrating copious free cash flows at a time when it's become scarce. Here's the VictoryShares Free Cash Flow ETF, which for two years tracked the Mag 7-dominated S&P 500 until leaving it in the dust the past few months.

This ETF is jammed with software, healthcare and energy stocks that look cheap, at least cosmetically, on FCF yield metrics.