The BlackRock warning

BlackRock (BLK) has been the major bull with respect to the GenAI theme. Just this week, BlackRock released the note and “urged for patience in the AI buildup”.

Essentially, BlackRock is warning that:

We’re overweight the AI theme and see winners along the AI supply chain. Yet we eye signposts for changing our view, including stalling revenue growth or sluggish AI adoption.

The key part here is the reference to “the signpost for changing their view.”

According to BlackRock, the bullish theme for GenAI is as follows:

1. Phase 1 of the GenAI revolution is the GenAI infrastructure buildup, where massive data centers are built with the capacity to train LLM models of large data sets, and then in the inference stage to actually produce the desirable output. We are currently in this phase. The winners in this phase include the chipmakers, such as Nvidia, but also the utilities, and real estate companies that allow for the massive data center buildup.
2. Phase 2 of the GenAI revolution is the actual wide adoption of the GenAI applications beyond the tech sector, to healthcare, finance, and other sectors. This is a problem, the wider adoption of GenAI is not happening. We are still not in this phase.
3. Phase 3 of the GenAI revolution is when the wide GenAI adoption starts to produce the economy-wide productivity gains, which would impact the macro environment with respect to higher growth with lower inflation. Obviously, we are not in this phase, and the question is whether we will ever be in this phase. But, BlackRock urges patience, and still believes that we could eventually end up in this phase.

However, BlackRock will watch these “signposts” to evaluate the progress of the GenAI technology.

1. First, BlackRock will monitor whether the GenAI revenue is stalling for the major GenAI companies, such as Nvidia. Based on the recent Nvidia earnings, the growth is revenue is slowing.
2. The most important point in my view, BlackRock will monitor the wider GenAI adoption, or essentially monitor whether Phase 1 is transitioning to Phase 2. In my view, this is the major problem, as GenAI seems to be very expensive to implement, and it has not shown the potential to increase revenues yet. Thus, the wider GenAI adoption is very low.
3. Finally, BlackRock is worried that an economic slowdown or a recession could result in lower GenAI capex. Whether there is an imminent recession, or a slightly delayed recession, it’s very likely that we will have a recession over the next 6–12 months, based on the expectations of aggressive monetary policy easing.

Thus, in my opinion, the current GenAI buildup in Phase 1 is unlikely to transition to the wider adoption in Phase 2, in order to produce the positive macro effects in Phase 3. The likely recession could essentially end Phase 1 as the spending on GenAI stalls, without ever advancing to Phase 2.

As a result, the massive GenAI capex is unlikely to produce a positive rate of return, which will lead to the GenAI bubble burst as the lofty valuations are met with the fading GenAI hype.

Implications for the S&P500 – The top three

Investors who allocate their retirement funds to the S&P500 (SP500) need to understand that the S&P500 index is heavily influenced by the GenAI theme – and the GenAI is possibly a bubble in the process of bursting, as previously explained.

The top three stocks in the S&P500 are:

• Apple (AAPL), with around 7% weight in the total index,
• Microsoft (MSFT), with around 6.5% weight, and
• Nvidia (NVDA) with around 6% weight.

Thus, these top three stocks account for around 20% of the total S&P500 index. The fortunes of these top three companies are heavily tied to the success of Generative AI.

Apple is getting ready to unveil the iPhone 16 with the Apple Intelligence, and the hope is that the consumer will want to actually use the AI features across the Apple ecosystem, which would lead to a massive iPhone replacement cycle.

Microsoft is invested in OpenAI and also is the major player in the AI infrastructure buildup. In addition, Microsoft has now fully integrated Copilot into Windows, and they hope this will lead to a major PC/laptop replacement cycle.

Nvidia, of course, is at the forefront of the GenAI revolution by supplying the GenAI chips, and it’s the primary beneficiary of the GenAI capex in Phase 1.

Essentially, if the consumer actually embraces the GenAI technology and rushes to upgrade their phones and computers, it could accelerate the transition to Phase 2 or the wider adoption of GenAI. If not, then GenAI will be a major flop. Thus, it’s really a do-or-die moment for the GenAI over the next few months, and we will get the early data when Microsoft and Apple report their earnings in October.

If the GenAI technology proves to be a flop, the GenAI valuation bubble will burst, and take the S&P500 down with it. The P/E ratio for S&P500 stands at 24, while the P/E ratios for Apple, Microsoft and Nvidia are 33, 31, and 37 respectively.

The September-November period this year could be very volatile for the S&P500, and we could have a major +20% correction just over the next 3 months, under these conditions:

1. If the early data shows that the Apple Intelligence and the Copilot are flops, and don’t lead to a massive replacement cycle, the valuations for these tech mega-caps could collapse.
2. If we do get confirmation that there is an imminent recession, the valuations for the GenAI capex beneficiaries, such as Nvidia, could also collapse.
3. The wild-card macro variables for the broad market are: the uncertainty with respect to the outcome of the US election in November, and the unfolding geopolitical situation.