Strong earnings reports have revitalized investor faith in the potential of artificial intelligence (AI), triggering a dramatic turnaround for US tech stocks and adding a staggering $3.5 trillion to the market value of the Nasdaq 100 Index in just four trading sessions. Over this period, the tech-focused benchmark surged 9.3%, its most significant gain since April 2025 when the market was recovering from the turmoil sparked by President Trump’s so-called "Liberation Day" tariffs.

The Q2 earnings season in the US has far exceeded expectations, convincing investors that massive AI investments are not only sustainable but are already beginning to generate returns for some industry giants. Data reveals that the backlog of cloud contracts for major hyperscale operators has soared over 150% year-on-year, reaching approximately $1.7 trillion. This growth rate vastly outpaces the roughly 80% increase in capital expenditure over the same period. JPMorgan points out that this significant gap indicates the potential revenue returns from AI infrastructure investments are surpassing market expectations, suggesting that the pressure on mega-cap tech valuations may be nearing its end.

During the current earnings season, high-flying tech stocks have managed to beat profit forecasts 90% of the time, even with elevated expectations. Analysts have also been consistently raising their earnings projections. However, as earnings forecasts have been revised upward, tech valuations have notably compressed. Following the July market correction, the forward price-to-earnings ratio for the S&P 500 Information Technology sector fell to around 20 times, near its lowest level in a year. This places it at the 1st percentile of its historical range, below the decade-long average of about 23 times. JPMorgan notes that the forward P/E of large-cap tech stocks (excluding semiconductors) is now more than two standard deviations below their historical average since 2018. If valuations were to revert to a level one standard deviation below the historical mean, it would imply a potential upside of roughly 30%. A return to the long-term average suggests a possible rally of about 56%.

Where to begin

This rebound represents a rapid counterattack for the Nasdaq 100. More importantly, the rally has been broad-based, lifting semiconductor companies, software firms, and hyperscale cloud operators investing heavily in capital expenditure. Among the standout performers over the past four days, SanDisk Corporation (SNDK.US) surged 41%, Palantir Technologies Inc. (PLTR.US) jumped 32%, Microsoft Corporation (MSFT.US) climbed 26%, and both Alphabet Inc. (GOOGL.US) and NVIDIA Corporation (NVDA.US) gained 11%. David Rainville, Head of the Sycomore Sustainable Tech Fund, commented, "The trade of shorting the capital expenditure companies—the hyperscalers—while going long the beneficiaries of that spending is over. I think that’s a good thing. The market is no longer a simple binary trade."

The sharp deleveraging that occurred during last month's tech correction led fast-moving money, such as hedge funds, to close out numerous short positions. These funds have now rotated back into the technology sector. According to data from Goldman Sachs Group's Prime Brokerage division, hedge funds bought information technology stocks last week at the fastest pace since December 2022. The Goldman team reported that all of the "Magnificent Seven" stocks saw net buying, but overall positioning remains low, suggesting there is room for further accumulation.

Why only 10 ASX 200 shares?

However, the latest earnings season has also highlighted a clear divergence among the tech giants. Investors are rewarding companies that can demonstrate tangible AI revenue growth, while penalizing those with less clear returns on their AI investments. Roland Caloyan, a strategist at Societe Generale, noted, "The new twist in the AI trade is the significant divergence within both semiconductor companies and hyperscalers. This means portfolio managers who cannot invest in an index and must pick individual stocks face a greater challenge." The scale of this disparity is stark. From the close on July 29 to the close on August 4, Nebius Group (NBIS.US) shares soared 52%, while Apple Inc. (AAPL.US) fell 8.5%. Within the broadly defined group of AI-related tech stocks, the performance gap between the best and worst performers was a massive 61 percentage points.

For strategists like Parag Thatte at Deutsche Bank, the outflow of funds from mega-cap tech stocks bottomed out last week. Since then, there has been a modest recovery in market positioning for this group, indicating further upside potential. The German bank's strategists believe that within the tech sector, hyperscale cloud operators offer the best risk-reward profile. These companies have just emerged from their weakest relative performance against the S&P 500 in three years. The strategists stated, "We believe the trend of fund flows re-entering the tech sector has room to develop further. Historically, tech stocks can achieve about 20 percentage points of excess performance." They added, "This would be the fifth rotation into the tech sector in the past three years, with market focus oscillating between high-growth opportunities and bubble risks, and the pace of this oscillation is accelerating."

JPMorgan believes that if the core narrative around AI shifts from "Is capital expenditure excessive?" to "Returns on investment are materializing," the next phase of tech stock gains may be driven more by internal sector rotation rather than relying solely on a continued rally in chip stocks. Technically, the US "Magnificent Seven" index (MAGS) has bounced nearly 10% from its recent lows, reclaiming its 200-day moving average and approaching its long-term uptrend line from April last year. JPMorgan notes that the 200-day moving average is currently flattening, suggesting the market is undergoing an extended period of consolidation. Historically, the longer the consolidation phase, the stronger the subsequent breakout in the direction of the move.