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.

OpenAI's CEO Sam Altman said he thinks the AI market is a ‘bubble’. OpenAI also dramatically increased its cash burn projections for the period until 2029, from $35 billion to $115 billion, The Information reported in September.

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The Bank of England also warned about the over-concentration of tech stocks in international stock markets.

“On a number of measures, equity market valuations appear stretched,” the Bank said in its latest Financial Policy Committee meeting, adding that “the risk of a sharp market correction has increased.”

JP Morgan’s CEO Jamie Dimon similarly fears a significant correction in the US stock market within the next 6-24 months.

“I am far more worried about that than others,” he said in an interview with the BBC on 8 October. “I would give [a correction] a higher probability than is being priced by others,” saying he estimated the likelihood of a significant market pullback at around 30%.

“Market attention is clearly focusing in on these companies and the potential for bad news sending ripple effects through the market are growing,” said Ben Barringer, global head of technology research at Quilter Cheviot.

The S&P 500 fell 0.6% on 7 October, though it recovered to new highs on 8 October.

Is AI a bubble?

Barringer highlights a mismatch whereby the ten biggest S&P 500 stocks account for 41% of the index but only 35% of its profits – though the disparity is less severe than one seen in previous tech bubbles, like the dotcom boom.

He adds that the amount of retail participation could be a red flag.

“We are seeing a huge amount of momentum from retail investors desperate to get in on the trade,” he said. “This is usually the sign that a bubble is approaching dangerous territory.”

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.

With its current share price effectively factoring in continued revenue growth for years, there are concerns that Nvidia might be overvalued.

“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, said 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 Gary Robinson, co-manager of Baillie Gifford US Growth Trust. “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.

“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.

“The picture is uncertain and for investors this means diversification is crucial,” said Barringer. “Not just from a sector perspective, but also within any tech allocations to ensure there is not overexposure to one chip vendor or one AI provider.”

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.