Citi: AI is "too hot", recommends selling semiconductor stocks and diversifying holdings in the AI industry chain

The strong rise in the AI sector has already made Wall Street smell a sense of unease.

In a report released on July 8th by Citigroup analysts Drew Pettit and others, based on a comprehensive analysis of multiple dimensions including future fundamental growth expectations implied by market prices, the market optimism for AI-related stocks has reached the highest level since 2019. The bank recommends investors to sell AI-related concept stocks, especially in the upstream semiconductor sector.

Citigroup: AI Surge is Already "Alarming"

Citigroup stated:

The increase in AI high-exposure stocks over the past 6 months has exceeded the historical increase of 3.4 standard deviations of the MSCI ACWI Growth Index. This level of increase has made many, including ourselves, feel uneasy, despite the existence of fundamental momentum.

The pricing in the options market also reflects investors' extremely optimistic expectations for AI stocks. Analysts pointed out that the 30-day 25 delta skew of high-exposure AI stocks has approached the lowest level since the pandemic. More notably, the short-term call option implied volatility of some AI stocks is even higher than the put options, which is very rare.

Analysts wrote: "Negative skew is very rare, even for AI stocks, which may indicate a certain degree of aggressive bullish speculation in this group of stocks."

AI Sector Has Not Entered a Bubble Stage Yet

Despite the high market sentiment, Citigroup analysts believe that the AI sector has not yet entered a bubble stage. Through calculations using a reverse cash flow discount model, analysts emphasized: "We estimate that the market is pricing in 19-27% annual free cash flow growth for high AI exposure stocks in the next 5 years. This is in good shape compared to the consensus expected annual compound growth rate of about 25%. For us, this indicates that the expectations reflected in market prices, although very high, can still be achieved."

However, Citigroup also warned investors to pay attention to risks at the individual stock level. Data shows that nearly 60% of high-exposure AI stocks (market-cap weighted) have market implied growth rates higher than analyst consensus expectations. This is the first time this situation has occurred since 2019.

Pettit explained: "This could be a worrying scenario. In our backtesting, stocks with market expectations higher than seller expectations tend to have greater volatility when rebalanced quarterly, making them more prone to rapid bubble formation and subsequent burst, as experienced in 2021 and 2022."

Based on these analyses, Citigroup advises investors to adopt a more cautious investment strategy:

"We continue to recommend investors to take profits in high-flying AI stocks, especially in upstream sectors such as semiconductors, and rebalance towards a broader range of AI stocks in the value chain."

Citigroup Recommends Buying AI Hedge Instruments

Citigroup pointed out that for many buyers, not holding or directly shorting AI may be difficult. To help investors better manage AI investment risks, Citigroup has introduced an "AI Hedge Basket." This basket consists of 100 global stocks that exhibit the most negative correlation with the relative returns of high-exposure AI stocks Citi's hedge targets include sectors such as finance, energy, essential consumer goods, utilities, real estate, etc.

Citi stated that this AI hedge basket has value and low volatility factor characteristics, but it is more negatively correlated with AI. The report pointed out: "Looking back over the past two years, the basket has a beta coefficient of -0.53 relative to MSCI ACWI with high AI exposure. In addition, it exhibits performance characteristics similar to value and minimum volatility factors, but the negative correlation with AI direction remains stronger."

Analysts explained: "Even if AI is forming a bubble, directly shorting it may be too costly in the short term, at least from a risk perspective."

Overall, Citi remains optimistic about the AI theme. Analysts summarized:

"Overall, the fundamental momentum and market-implied growth expectations that can still be achieved keep us positive on AI theme stocks. However, it would be negligent not to be uncomfortable with the significant rise in stocks since May. Using the gains from soaring stocks to expand into other areas of AI trading remains the best way for us to express our positive view on the theme."