Is Nvidia Going to Plunge 40% (or More)? History Offers a Very Clear Answer.

Earlier this year, many hedge funds began betting against Nvidia (NASDAQ: NVDA) by shorting the stock. "Their targeted short bets on companies such as Nvidia...underscore hedge funds seeing at least some of the once-popular Magnificent Seven shares of the biggest U.S. tech firms as expensive," Reuters reported.

Recently, Michael Burry -- the famous investor who bet big against the U.S. housing market before the bubble popped in 2008 -- joined the growing list of Nvidia bears. According to recent filings, his hedge fund is now shorting Nvidia shares.

Could a massive drop be in store for Nvidia? History suggests there could be downside of 40% or more to come. But before you get nervous, just know that there is a catch to Nvidia's potential downside.

Why Nvidia stock could fall by 40% or more

Nvidia has an extremely high valuation. The company has a market cap of $4.4 trillion yet also has a price-to-sales ratio of 28. Such a high valuation multiple is unusual for one of the largest businesses in the world -- it is, after all, easier to grow as a $4 billion business than as a $4 trillion business. For comparison, the world's total GDP right now is around $114 trillion. For Nvidia to double in size, it would need to add nearly 5% of the world's entire GDP to its valuation.

There is a long history of high-hype, high-valuation stocks falling in value by 40% or more. During the dot-com bubble, major tech indexes lost 80% of their value or more. Some high-flying companies went out of business altogether, just years after they were valued in the billions of dollars.

Nvidia, of course, is far from going out of business. It has quickly become one of the largest suppliers to the rapidly growing artificial intelligence (AI) industry, which most forecasts say will grow by 30% or more per year for the next decade or more. Nvidia's graphics processing units have a dominant market share, and this lead likely isn't going away any time soon, thanks to the company's intense research and development as well as a developer software ecosystem that creates customer lock-in.

But none of this means that the market can't overvalue Nvidia shares over the short term. In the past few years alone, temporary drops of 20% to 40% have already occurred. If there is a sharp correction, it's likely that Nvidia will see a dramatic reduction in valuation no matter how bright its future is.

Artificial intelligence is a multidecade opportunity

Seaport Global analyst Jay Goldberg has already predicted a 40% drop in Nvidia stock. And investors should be prepared for such a possibility. It's simply the reality of investing in high-growth stocks like this with huge amounts of market hype. The AI revolution could be as pivotal as the invention of the internet, and investors are racing to make sure they're exposed to this long-term opportunity.

But that's exactly the point: This is a long-term opportunity. Amazon stock was valued at just over $5 on a split-adjusted basis in late 1999, but lost 90% of its value when the dot-com bubble popped. Now the stock is more than $210 a share -- but it's taken literally decades to get to this point. Nvidia investors -- all AI investors, really -- should understand this. Yes, the AI revolution is real. But markets go through cycles, one year dramatically overvaluing an opportunity, the next year undervaluing that same opportunity.

The artificial intelligence revolution is still in the early innings. And Nvidia's competitive moat is impressive. If Nvidia shares demonstrate volatility, patient investors should be willing to dollar-cost average, understanding that their ultimate payout may still be decades away.

Ryan Vanzo has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Nvidia. The Motley Fool has a disclosure policy.