Could the AI megacap bubble burst?

Artificial intelligence (AI) megacap stocks have soaked up much of the stock market’s gains over recent years, but there are fears that this growth is increasingly resembling a bubble that’s fit to burst.

We’ve become used to the tech megacaps being the top stocks for investors over recent years, with the Magnificent Seven seemingly the sole drivers of stock market returns, but the market is showing signs of jitters over stretched valuations.

Recently, OpenAI’s CEO Sam Altman said he thinks the AI market is a ‘bubble’. OpenAI, which almost single-handedly kickstarted the AI stock market bubble when it launched ChatGPT in November 2022, has also dramatically increased its cash burn projections for the period until 2029, from $35 billion to $115 billion, according to The Information.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Altman and his Nvidia counterpart Jensen Huang are accompanying US president Donald Trump on his state visit to the UK this week, with reports that $10 billion worth of technology-focused trade deals could be agreed between the two countries.

“The fact that the King is entertaining not only the president but the decision makers at some of the world’s biggest tech and finance companies has prompted speculation about investment in UK tech and infrastructure,” said Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC). “Big tech has been driving gains in the US market this year, but it’s not certain how long that world-beating growth can continue.”

Are AI megacaps still leading the market?

For all that they have seemed, at times, the only potential source of returns in the stock market for most of the last decade, AI megacap growth looks to be slowing.

In the year to 19 August, the S&P 500 uncharacteristically lagged other global markets, returning 9%, compared to 12.1% for the MSCI World Index, 12.4% for the FTSE 100, 14.1% for MSCI Asia ex-Japan and 32% for Spain’s Ibex 35.

^{Source: LSEG DataStream via Fidelity International, as at 19.8.25, price returns in local currency}

US megacaps have lagged these markets. Over the same period the Bloomberg Magnificent 7 Total Return Index gained 5.2%, trailing the broader US stock market. Individual Magnificent Seven constituents have posted eye-catching performance: Nvidia gained 32% during this period, while Meta gained 28% and Microsoft 21%, but laggards like Tesla (down 18.5% in the year to 19 August) have held the group back.

In part, this reflects the fact that, unlike the period of their ascension, the Magnificent Seven no longer trade in lockstep with one another.

“We don’t look at the seven companies labelled the Magnificent Seven as a homogeneous group,” said Gary Robinson, co-manager of Baillie Gifford US Growth Trust. “They aren’t.”

Is AI a bubble?

The huge multiples at which the Magnificent Seven (even and especially Tesla) still trade only makes sense in a world in which they continue to strongly outperform the market.

But that isn’t guaranteed to be the case. Not only is the share price growth of the Magnificent Seven slowing, but their fundamentals are too. Nvidia’s sales growth slowed from 265% in Q4 of its FY 2024 to 53.5% just a year and a half later.

“It’s possible the Magnificent Seven, or some of them at least, may continue outgrowing and outearning the rest of the global stock market for many years to come, but even Sam Altman, boss of OpenAI and one of the leading evangelists for the new technology, thinks we might be in a phase where investors are overexcited about it,” said Craig Baker, chair of the Alliance Witan investment committee.

Risks to the AI model include competition for energy and computing resources, as well as “scarce AI talent”, with “regulatory and geopolitical uncertainty” overlaying this, in the words of Ben James, investment specialist at Baillie Gifford US Growth Trust.

Ben Rogoff, lead fund manager of Polar Capital Technology Trust, draws attention to the fact that the ability of AI models to continue to improve at the pace they have over the last three years could come into question.

“Any change in model improvement trajectory could challenge the current cadence of infrastructure investment and the ultimate size of the AI market opportunity,” said Rogoff. “While we are confident that so-called ‘scaling laws’ remain intact, we monitor this as closely as we can.”

Could the AI boom diversify?

One of the alternative hypotheses about the trajectory of the AI boom is that, rather than continuing to see returns limited to mostly just the AI megacaps, it could diversify into broader sectors.

“Thinking about the new AI paradigm, two seams stand out,” says Robinson. “First, the application layer: businesses turning frontier models into real services for consumers and enterprises.” He highlights the Baillie Gifford US Growth Trust holdings such as DoorDash (NASDAQ:DASH), Shopify (NASDAQ:SHOP) and Roblox (NYSE:RBLX) that fall into this category.

“Second, the enablers: networks, data and security that form the new stack.” AI-powered cybersecurity stock Cloudflare (NYSE:NET) taps into this theme.

That could also see UK firms rather than US start to see gains, especially in light of the investments into the country being mooted.

“So far, UK-listed firms have largely missed out on the AI party,” said Kenneth Lamont, principal at Morningstar. “Unlike the US Magnificent Seven, which are pouring billions into AI infrastructure, no UK stock can be considered a pure AI play.”

Lamont highlights AstraZeneca (LON:AZN) as he most frequently held US-listed stock in global AI funds, appear in around 10% of portfolios, followed by RELX (LON:REL) (7%), Experian (LON:EXPN) and LSEG (LON:LSEG) (both less than 5%).

“These are all AI applicators – businesses using AI to improve their models, such as AstraZeneca in drug discovery – rather than core AI providers. In the end, it may be these applicators that have the last laugh: by harnessing increasingly powerful and low-cost AI tools to boost margins with little risk, they could prove to be the real long-term winners,” says Lamont.

Protecting against the AI bubble bursting

You are likely more exposed to any potential bursting of the AI megacap bubble than you think. Most of your portfolio, whether that’s investments in a stocks and shares ISA or your pension, will likely comprise index funds that track the global stock market. If sentiment towards these stocks dips your portfolio could take a hit, at least in the short run.

One of the drawbacks of passive investing using index funds is concentration risk. These funds track the movements of the broader market: they naturally put your money mostly into those megacap stocks that have the highest weighting within global indices. But that naturally exposes you to stretched valuations. The effect is also circular, as every index fund for a given market has to buy the stocks that gain the most (further pushing up prices).

You can reduce your concentration risk by buying equal-weight funds, which will cap every holding at a certain weighting of the portfolio. Lamont highlights Xtrackers S&P 500 Equal Weight UCITS ETF (LON:XDWE) as an example.

Or alternatively, you could buy a fund that excludes the megacaps altogether, such as Amundi MSCI USA Ex Mega Cap UCITS ETF (LON:XMGA).

Investors that want to retain some exposure to AI without being over-exposed to the stretched valuations of the megacaps could look for value opportunities in AI and its broader ecosystem, such as the suppliers to companies like Nvidia and TSMC.