Cracks are forming in the AI capex boom, warns Morgan Stanley. What to buy and sell.

By Barbara Kollmeyer

Lisa Shalett says steer clear of swept-up small-cap stocks

The data-center growth story has cracks.

As the government shutdown enters its second day, a lack of data may give investors little to hook into for Thursday. A fresh record close for the S&P 500 SPX on Wednesday points to investors willing to add that disruption to the list of things that aren't bothering them.

That likely leaves plenty of room for discussion around the boom in AI and whether the companies pouring money into that technology are going strong or about to hit a wall.

Wall Street has been expressing plenty of doubts, as more news on that front emerges with OpenAI barreling toward mega startup status (see below).

Joining the worried crowd is Morgan Stanley Wealth Management's chief investment officer Lisa Shalett, who warns of "cracks" in the boom story around AI capital expenditure.

"Given the GenAI capex story's centrality to both markets and the economy, the most important question for investors in the next year is: What inning are we in? When it comes to market-discounting scenarios, we believe we are closer to the seventh than the first," Shalett said in a note.

"Since April's low, the three-year bull market's underlying narrative has seemed to make several attempts at evolving beyond one tied to the GenAI capex and productivity thesis," she wrote.

Expectations for more fiscal and monetary easing have reignited rotations into cyclical and small-cap stocks. "While stimulus may improve prospects, it is hard to anticipate this bull market surviving if the GenAI capex-boom story falters. And we are starting to see cracks," she said.

Shalett flags one measure of capex-cycle maturity - inflection of free-cash flow growth. "When cash is abundant and financing costs low, investment can outpace the 'technology dream' in a capitalist 'arms race.'"

Since 2022, annual hyperscaler capex spending has "grown fourfold, depleting cash and halting free-cash-flow growth," she said, citing data from research firm Strategas that forecasts a 16% shrinkage in hyperscaler free cash flow over the 12 months.

"When free-cash-flow growth for the most richly valued names slows or turns negative, not only do valuations come into question, but investors demands for return-on-investment discipline rise," said Shalett.

As a refresher, the AI hyperscaler list, to name few, includes Amazon (AMZN), Microsoft (MSFT), Alphabet's Google (GOOGL), along with CoreWeave (CRWV).

Shalett turns to the "cash cows" next, that is, the digital advertising, search, streaming and cloud services funding the GenAI build-out. Citing another study, she said much of the hyperscaler cash flow funding has come from segments with slowing growth due to market saturation and increasing competition.

Her third concern surrounds the dealmaking behavior for GenAI leaders that she says points to an increasing search for new customers, such as Oracle's pledge to build "compute capacity" for OpenAI, funded by debt financing.

Shalett is watching closely hyperscaler capex guidance trends and signs of competitive pressure in AI feeder businesses.

Now for the CIO's advice: without naming names, she suggests selling small-cap stocks, unprofitable tech and low-quality meme stocks and that investors also get highly selective when it comes to consumer names.

The iShares Russell 2000 IWM has gained 10% this year, while the Ark Innovation ETF ARKK, often a proxy for unprofitable tech, has surged 53%.

"Also consider adding real assets - like gold, REITs, energy infrastructure and industrial and agricultural commodities - to complement passive U.S. equity benchmark weightings," she said. Adding to that she likes large-cap quality U.S. stocks - consistent earnings, strong balance sheets are often characteristics of such companies.

Other suggestions: intermediate duration investment-grade fixed income, such as muni bonds, as well as international stocks, including emerging markets.

Read: The AI trade increasingly hinges on OpenAI - and that's a big risk for the entire market

The markets

Stocks DJIA COMP are rising in early trading, with the S&P 500 SPX on course for the longest winning streak since July. Treasury yields BX:TMUBMUSD10Y BX:TMUBMUSD02Y are edging higher, and crude (CL00) is falling, with gold (GC00) gaining.

   Key asset performance                                                Last       5d      1m      YTD      1y 
   S&P 500                                                              6711.2     1.61%   3.22%   14.10%   17.74% 
   Nasdaq Composite                                                     22,755.16  1.65%   4.83%   17.84%   26.99% 
   10-year Treasury                                                     4.11       -5.80   -5.20   -46.60   25.80 
   Gold                                                                 3891.5     3.27%   7.51%   47.44%   45.19% 
   Oil                                                                  62.1       -4.18%  -2.62%  -13.59%  -12.55% 
   Data: MarketWatch. Treasury yields change expressed in basis points 

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The buzz

Tesla (TSLA) shares are rising after the EV maker said it delivered 497,099 cars in the third quarter, a 29.4% increase from the second quarter.

Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) is buying Occidental's (OXY) OxyChem unit in a $9.7 billion deal.

Shares of TransUnion (TRU), Equifax (EFX) and Experian (UK:EXPN) are slumping after FICO said it would directly license scores for mortgages.

OpenAI's valuation has soared to $500 billion, surpassing the value of Elon Musk's SpaceX.

Due to the shutdown, investors won't be getting weekly jobless claims on Thursday, or factory orders.

Best of the web

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The chart

Morgan Stanley analysts have lifted their Apple (AAPL) price target to $298 from $240 per share, with a bull case of $376, centered on expectations for a stronger cycle for iPhone 17 models. Their chart shows how Apple shares rise when users replace their iPhones more often, as opposed to stretching out the time between new handsets. A team led by Erik Woodring said they expect replacement cycles to pick up into 2027, helped by an "aged iPhone installed base in need of upgrades," and the allure of a new foldable iPhone. Their March survey revealed iPhone upgrade rates improving 19 points to 51%, a 10-year high.

Top tickers

These were the top-searched tickers on MarketWatch as of 6 a.m.:

   Ticker  Security name 
   TSLA    Tesla 
   NVDA    Nvidia 
   GME     GameStop 
   NIO     NIO 
   TSM     Taiwan Semiconductor Manufacturing 
   PLTR    Palantir Technologies 
   PLUG    Plug Power 
   AMZN    Amazon 
   INTC    Intel 
   AMD     Advanced Micro Devices 

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10-02-25 0942ET