The cloud computing sector is experiencing a curious split. While investment in the infrastructure underpinning artificial intelligence is surging, many software-as-a-service (SaaS) companies are struggling to justify their valuations. This divergence is playing out in the performance of cloud computing exchange-traded funds (ETFs), with some showing signs of stabilization while others continue to fall. Understanding this dynamic requires looking beyond the broad “cloud” label and recognizing the distinct forces at play.
The First Trust Cloud Computing ETF (SKYY), which leans heavily toward established, large-cap companies like Oracle (ORCL) and Microsoft (MSFT), has recently exhibited tentative signs of a bottom. Whether this signals a genuine recovery, a temporary pause, or a continuation of the downturn remains uncertain, but the shift in its 20-day moving average to an upward trend offers a glimmer of hope for investors. But, the market’s volatility means any gains could be quickly erased.
In contrast, the WisdomTree Cloud Computing Fund (WCLD), focused on higher-growth, mid-cap software names, remains firmly in a downtrend, down more than 20% year-to-date as of November 21, 2023, according to Yahoo Finance data. WCLD is still searching for a floor, hampered by high price-to-earnings ratios and a slower-than-expected translation of hype into revenue from AI applications.
The AI Infrastructure Boom
The engine driving the relative strength of funds like SKYY is the massive investment in AI infrastructure. Gartner projects worldwide AI spending will reach $2.5 trillion in 2026, a more than 40% increase year-over-year. Gartner’s report details this projected growth, fueled by demand for generative AI and machine learning applications.
Hyperscalers – Amazon (AMZN), Google (GOOGL) and Microsoft (MSFT) – are leading this charge, collectively expected to spend over $600 billion on capital expenditures this year, nearly double their 2025 levels. This capital is flowing into cloud infrastructure, AI-optimized servers, and, crucially, graphics processing units (GPUs) essential for training and running AI models. Companies like Oracle, deeply involved in providing this infrastructure, appear to have already established a bottom, with stabilization occurring in late 2023.
SaaS Struggles and Valuation Concerns
The divergence arises as the application layer – the SaaS companies built *on* this infrastructure – is facing headwinds. While the infrastructure is booming, many SaaS businesses are struggling to translate that into revenue growth and justify their valuations. Enterprises are experiencing what some analysts describe as a “trough of disillusionment” regarding generative AI, leading to a slowdown in new software seat growth. The initial excitement has given way to a more cautious assessment of real-world applications and return on investment.
Rising memory prices are also contributing to the pressure. According to a report by TrendForce, DRAM prices are expected to rise in the first quarter of 2024 due to tightening supply, potentially dampening demand for end devices and broader IT spending. If the 10-year Treasury yield remains elevated, the already stretched valuation multiples of high-growth cloud stocks will face continued downward pressure.
A Tale of Two ETFs: Portfolio Composition Matters
The contrasting performance of SKYY and WCLD highlights the importance of portfolio composition. SKYY’s top holdings include established tech giants – the “Magnificent Seven” – providing a degree of stability. WCLD, is weighted towards smaller, more speculative companies with higher growth potential but also greater risk.
The ROAR Score, a technical analysis tool created by Rob Isbitts, reflects this risk assessment. As of mid-November 2023, the ROAR Score for SKYY had turned yellow (neutral risk) after a period of high risk, indicating a potential shift in momentum. This follows a 20% decline earlier in the year. Isbitts’ research, available at ETFYourself.com, emphasizes the importance of risk management in navigating volatile markets.
The current situation isn’t simply about flawed business models or a waning belief in AI. It reflects a growing sense of uncertainty among investors, who are hesitant to commit capital until there’s greater clarity on the path to profitability for SaaS companies and a more stable macroeconomic environment.
Looking ahead, investors will be closely watching earnings reports from major cloud providers and SaaS companies in the coming months. The next key data point will be the Q4 2023 earnings releases, beginning in January 2024, which will provide further insight into the health of the cloud market and the impact of AI investments.
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