AI-driven tech volatility reaches dot-com era extremes: UBS

UBS's latest research reveals that volatility in the global technology sector has reached levels not seen since the dot-com crash. Investors are now questioning the long-term sustainability of AI-driven cash flow returns from hyperscalers and semiconductor companies. UBS attributes this heightened strain to mounting AI infrastructure spending, which is eroding asset efficiency at major hyperscalers despite stable profit margins.

This erosion is lowering cash flow returns on investment (CFROI) for these companies through 2028. The top five hyperscalers—Microsoft, Meta, Alphabet, Amazon, and Oracle—face a combined $227 billion funding gap next year, according to UBS's estimates. Historically, roughly 60% of 650 large capital expenditure surges since 1998 have been followed by a permanent decline in CFROI, particularly among companies with already elevated returns.

Semiconductors present a distinct set of risks, with returns having roughly tripled to around 30%. However, only one percent of companies have managed to sustain such elevated returns since 1990. UBS warns that valuations in the sector are based on an assumption that these elevated returns will persist for five more years, a scenario rarely seen in history.

Chinese AI developers, DeepSeek and Moonshot, serve as examples of how economic moats in the sector may not be unbreakable, given China's propensity for prioritizing market share over profitability. Additionally, software, enterprise data, and services stocks have already witnessed valuations reset, with aggregate price-to-book ratios down approximately 40% over the past 18 months due to concerns of AI-driven disruption.

Historically, 80% of stocks that experienced a similar valuation drop have failed to regain their previous levels within a decade. Nevertheless, UBS identifies Value and Low Volatility as the strongest-performing style factors during past tech-led sell-offs. Value outperformed in all six major episodes since 2004, while Low Volatility stocks outperformed in four of those instances.

However, UBS cautions that both strategies have limitations in the current market. Value's traditional connection to the economic cycle has weakened since 2023, and Low Volatility stocks tend to underperform outside of sell-offs unless they have strong underlying fundamentals.