Will the AI bubble burst?

Artificial intelligence (AI) megacap stocks have soaked up much of the stock market’s gains over recent years.

We’ve become used to the AI megacaps being the top stocks for investors, but top bankers from the likes of Morgan Stanley, JP Morgan and Goldman Sachs have voiced their concerns that AI stocks’ valuations are reaching bubble-like levels.

This week, leading voices from within the AI world have joined the fray. Sundar Pichai, CEO of Google and its parent company, Alphabet (NASDAQ:GOOGL) told an interview with the BBC that AI is creating some “irrationality” in the markets.

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“When we go through these investment cycles, there are moments where we overshoot collectively as an industry,” said Pichai. He referenced the investment in internet infrastructure during the dotcom boom, saying that while there was clearly some over-investment, the long-term impact was transformative.

And Sebastian Siemiatkowski, CEO of Klarna, told the FT that he is “nervous” about the amount of spending on AI infrastructure taking place.

Earlier in the month a regulatory filing revealed that legendary contrarian investor Michael Burry – famously portrayed by Christian Bale in The Big Short – had allocated over 80% of his fund to bets against Nvidia (NASDAQ:NVDA) and Palantir (NASDAQ:PLTR). Then, on 13 November, it emerged that he had closed his hedge fund, saying in a statement: “My estimation of value in securities is not now, and has not been for some time, in sync with the markets.”

Even as the AI investment thesis seemed to be collapsing, a much-anticipated Nvidia earnings release beat expectations soundly, restoring market confidence. S&P 500 futures rose 1.5% ahead of US markets opening on 20 November, following the results.

So is the AI boom market a bubble? Or is there more value for investors here yet?

Is AI a bubble?

The tricky thing about stock market bubbles is that they can only be definitively identified in retrospect.

“As AI adoption accelerates at unprecedented speed, investors are questioning whether today’s boom is laying the foundations for long-term growth, or inflating the next major market bubble,” said Ian Mortimer, co-portfolio manager of the Guinness Global Equity Income fund.

“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,” said Craig Baker, chair of the Alliance Witan investment committee, “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.”

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.

But these risks are being weighed against the long-term potential of AI.

“Despite bubble fears, early evidence shows AI is already improving business outcomes across major platforms including Meta, Microsoft, and Amazon,” said Mortimer. “Compared with previous market bubbles, today’s leading tech firms maintain strong margins, robust balance sheets, and reasonable valuations, with the Magnificent 7 trading well below the extremes of the dotcom era or Japan’s 1980s boom.”

Protecting against the AI bubble bursting

Pichai warned in his interview with BBC that “no company is going to be immune” in the event of the AI bubble bursting. Sadly, the same appears to apply to investments.

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. This concentration risk is one of the drawbacks of passive investing.

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.

Rob Morgan, chief investment analyst at Charles Stanley, emphasises that diversification is the key to protecting your portfolio against market volatility.

“In today’s context, investors should ensure their portfolios aren’t completely dominated by the theme of big tech and AI, including tracker funds heavily skewed towards large US stocks,” he said.

Morgan recommends bonds as one offset to big tech concentration as well as defensively-minded global equity funds, or equity funds that target resilient, dividend-paying stocks. He highlighted JO Hambro Global Opportunities and Trojan Global Income as two quality-focused funds for investors to consider.

Bear in mind, also, that there are risks to being under-invested during a stock market boom. The table below shows how £10,000 invested into the S&P 500 in various years leading up to the dotcom crash fared compared to the same investment into a safe money market fund in the same year.

Source: AJ Bell and FE, total return in GBP from S&P 500 and IA Standard Money Market fund sector average (31^st December to 31^st December)

“The numbers show that investing in the market in December 1994, 1995, 1996 and 1997 was still preferable to investing in a money market fund, if you held on until the end of 2005, despite the market crash that was coming,” says Laith Khalaf, head of investment analysis at AJ Bell. “Investing in the money market fund was the better course of action in December 1998 and 1999, in the later stages of the bubble.”