The S&P 500's Record Profits Are Hiding a Problem Investors Haven't Seen Before
Key Points
The tech sector has grown revenue and earnings rapidly because of the artificial intelligence (AI) buildout.
But there's an accounting issue that may be making the results look better than they are.
A lot of the costs will be depreciated over the course of several years. They may not start showing up until 2027 and beyond.
Record corporate earnings have been the primary driver of higher stock prices for the past several quarters. Current estimates suggest year-over-year earnings growth for the S&P 500 (SNPINDEX: ^GSPC) could hit 29% in Q3. Above-average earnings growth is expected to continue, especially within the mega-cap names, for the next couple of years.
But there's a risk hiding underneath those numbers. And it raises questions about just how sustainable some of those earnings really are. The way companies account for those investments and the revenue associated with them could be creating a problem that won't show up until far into the future.
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The hidden cost of the AI investment boom
Imagine a situation where a tech company decides to make a major investment into AI development. It needs chips. It needs servers. It needs other equipment and infrastructure. Let's say it spends $1 billion in total.
The companies selling those things recognize the revenue as they deliver those products. That spending then can also immediately support sales and earnings further down the AI supply chain.
But the company developing that project doesn't recognize the full $1 billion as an expense on its income statement right away. Instead, it usually chooses to depreciate the construction and equipment costs over their useful lives, which could be several years or more. Plus, depreciation usually doesn't begin until those projects are ready for use.
That creates a potential problem for the big AI companies. The revenue and earnings are showing up now, but the expense won't come until later. What happens when that earnings growth finally slows right at the time that expenses are increasing?
Source: Getty Images.
The markets are finally concerned about AI capex spending
Not long ago, huge planned spending for AI development was viewed as a positive by Wall Street. Tens, if not hundreds, of billions of dollars of capex commitment by all of the big hyperscalers resulted in big rallies in their stock prices.
Now we're on the other side of the mountain. The markets are focused on the return on investment (ROI) from all that spending. Revenue and earnings growth rates have been strong thus far and are expected to continue into 2027 and beyond. But free cash flow is the number that people are watching and they're getting more anxious about what they're seeing.
For example:
Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL) just suffered an historic single-day drop and now sits 30% below its 2026 high after reporting ballooning infrastructure spending. It had a negative free cash flow of over $9 billion in the quarter, reiterated its 2026 capex forecast of around $200 billion and said spending could ramp up further next year.
Intel (NASDAQ: INTC) shares tanked by more than 25% following a weaker-than-expected Q4 outlook and a warning that they probably won't be free cash flow positive in 2027.
Amazon (NASDAQ: AMZN) fell sharply after it said it had negative free cash flow for the second consecutive quarter, a massive capital expenditure forecast of roughly $220 billion for the year, and the expectation that spending will be higher in 2027.
Meta Platforms (NASDAQ: META) dropped sharply as well on similar concerns around heavy AI development spending and negative free cash flow expectations.
Suddenly, investors have moved past the "AI optimism" phase and are looking for results.
What this means for S&P 500 investors
As Warren Buffett would point out, there's a difference between a company whose stock price is falling because the business model is failing and one whose stock price is falling because economic conditions are changing.
The big tech stocks fall into the latter category. They're not going anywhere, and they still generate massive revenue and profits. But there is a legitimate risk that they've pushed too far, too fast. They might be in the second half of the boom/bust cycle that often occurs with these revolutionary new technologies. Their stock prices may have suffered the brunt of it already.
But I think long-term asset allocations should remain intact. Investments in the Vanguard S&P 500 ETF (NYSEMKT: VOO) and the Vanguard Total Stock Market ETF (NYSEMKT: VTI) are still sound even if there will be some heightened volatility. More risk-averse investors might seek out the Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP) to spread out exposure risk.
Free cash flow looks like the signal here, though. The longer that stays negative and the longer tech companies keep spending hundreds of billions of dollar on capex, the longer that risk remains elevated.
David Dierking has positions in Vanguard Morningstar Total Stock Market ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Intel, Meta Platforms, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.