The AI craze is overblown - and the S&P 500 will suffer if the 'Magnificent 7' stocks falter, veteran investor warns

• The AI-fueled boom in the "Magnificent 7" tech stocks has propped up the stock market this year.
• Bill Smead says the craze is overblown, and predicts pain once the handful of stocks capitulate.

The buzz around artificial intelligence has boosted the "Magnificent Seven" stocks this year, pulling the wider market higher. The frenzy seems overblown, and investors could suffer big losses once the hype fades, Bill Smead warned in a memo titled "Artificial (Stock Market) Life Support" this week.

"The whole thing looks very disingenuous to us," the Smead Capital Management president wrote. "First, AI is not new, and they have all been working on it and using it in the last ten years," he said, referring to the group of seven Big Tech companies: Amazon, Alphabet, Apple, Microsoft, Tesla, Meta, and Nvidia.

"Second, interest rates have risen substantially and make futuristic earnings on exciting technology less valuable by discounting those earnings back to today," Smead continued. "Third, this group of companies has been famous for having a lack of forthrightness (just ask the Justice Department)."

The veteran investor noted that tech-industry stalwart IBM's AI system, Watson, was winning games of "Jeopardy" back in 2011. His comment about rates referred to the Federal Reserve hiking borrowing costs from almost zero to over 5% since last spring, which has bolstered returns from risk-free Treasuries and slashed the relative appeal of riskier assets like stocks. His third point was a nod to the US government's spate of legal challenges against the likes of Amazon and Alphabet.

Smead emphasized the Magnificent Seven are "the only thing keeping the rally in the S&P 500 index alive this year." He included a chart showing the 10 largest S&P 500 stocks by market cap have accounted for an unprecedented 96% of the index's performance for 2023.

"The success of this narrow group of stocks has defended the massive amount of capital stuck in the passive index and prevented it from fleeing," he said. In other words, if the handful of high fliers capitulate, investors would sour on stocks and pull their cash out of the market in his view.

"AI looks like tech stock and S&P 500 index life support to us," Smead said. "What happens if the seven stocks that have propped up the passive S&P 500 Index go through what every stock of popularity has done historically? This is just another reason to fear stock market failure!"

The value investor has been raising the alarm about a historic bubble in stocks and a looming crash for a while. For example, he warned in August that the AI-fueled tech craze "made the dot-com bubble look like small change."