Technological progress is what drives our economy forward. Innovation enables us to use fewer resources to meet existing requirements, or to resolve newly emerging challenges. If no progress had been made on improving processes and products, our standard of living would still be like it was back in the Stone Age.
In a market economy, we create strong incentives for such progress. Advancements benefiting humanity deserve to be rewarded – but not forever. For example, we limit the protection of patents to a specific application, and generally also to a certain period of time. Afterwards, there’s competition and initially high profit levels are eroded by rivals. This has resulted in market economies clearly outperforming other economic systems when it comes to generating wealth. Equally, no other economic system rivals ours in terms of social achievements, medical care, standard of living or promoting individual freedoms.
Why is that relevant to investors? Because tech stocks are increasingly at the heart of market developments and many investors get caught up in the euphoria and start dreaming of endless earnings growth and rising equity prices. New technologies really can produce a sharp rise in revenue and profit for certain highly innovative companies. A current example of that is the chip manufacturer Nvidia. The company launched on the stock exchange at the tail end of the dot.com bubble in 1999. One share was worth 4 US cents then. Its share price is now 135 US dollars.
Innovation in the chips manufactured and the general euphoric mood have driven revenue and profit up by a factor of more than 20 over the past ten years. However, the share price has risen by a factor of more than 300. In other words, the market expects the rapid increase in revenue and profit levels to continue at the same rate. While that may happen for an extended period, profit margins like today of 50 percent and over aren’t conceivable long-term in our economic system.
Artificial intelligence clearly possesses huge potential: generative AI has changed a great deal in a short space of time and has entered everyday life through ChatGPT and other applications. There’s a lot more to come, too, but markets tend towards hyperbole. Nobody knows how long things will last, but what we do know is that future developments at Nvidia won’t be game-changing for the entire market. We’ve seen one new technology after the other since the Second World War. Contrary to the expectations of many people, a new technology has never yet significantly accelerated the rise in profit levels of the entire market. That’s happened for certain companies and over a period of time, but not for the entire market, as earnings growth always returns to potential growth after the initial overperformance.
Things have to be that way too: what many observers forget is that products with high margins soon face competition or expensive products are replaced by cheaper ones. The providers of such innovations are often brought back down to earth after the initial euphoria.
