Are AI stocks a bubble about to burst?

Despite a turbulent week for the industry, AI and tech stocks keep capturing investors’ imagination.

Global financial markets have been reeling from a bruising summer, with equity indices in the US and Japan plummeting.

Investors are worried that the Federal Reserve (Fed) may have delayed its efforts to bolster the world’s largest economy, sparking fears that a US recession could have global repercussions.

The US tech sector took a massive hit, with the heavyweight stocks known as the Magnificent Seven, being some of the biggest losers. 

But the sector still offers attractive investment opportunities over the longer term, according to investment experts. 

“For long-horizon investors, the tech sector is likely to keep capturing the imagination of markets, business and society itself,” says Arnab Das, Invesco’s global market strategist in the Emea region. 

“Tech — whether big, start-up or early stage — is probably the best place to look for the next generation of Mag stocks”

“Rather than Maga (Make America Great Again) or Make Europe Great Again stocks, tech — whether big, start-up or early stage — is probably the best place to look for the next generation of Mag stocks,” he states. They will provide “a critical source of innovation and creative disruption,” both for traditional objectives like profitability or productivity, and for challenges like modern warfare and security or addressing climate change.

Due to domestic political and geopolitical shifts, some “back-to-the-future” stocks may also become appealing. Some are already performing well and may continue to do so “for some time to come,” Mr Das believes. He points to defence stocks, supported by “the return of great power rivalry, proxy war and tensions”; pharma and healthcare, given ageing demographics; and construction, because of industrial policies, reshoring, friendshoring and nearshoring. 

Is it a bubble?

A recent Goldman Sachs research paper questioned whether the massive investment and high valuations of key players in Generative AI models will ever be justified by their potential revenue streams. 

“Part of the challenge in understanding the AI market is to be clear where the value actually lies,” says Tim Gordon, co-founder of Best Practice AI, which assists organisations in using AI to build sustainable competitive advantages. “In reality, this sits less with the direct financial return from selling access to AI models and more on what they encourage firms to do: shift their data and computing structures onto the cloud,” he adds. 

The major cloud providers — Microsoft, Amazon, and Google — are all key capital providers to major model builders. They make significant and growing revenue from selling the cloud services all firms have to invest in “to get ready for AI,” he notes. 

Yet there is a possibility this may not last, Mr Gordon warns, citing the first internet bubble which saw compelling reasons to invest in telecoms infrastructure and network cables until suddenly this market crashed. 

During the dot-com bubble, the tech-dominated US stock market index Nasdaq rose nearly sevenfold, reflecting a period of enthusiasm. But the dot-com bubble eventually burst in early 2000, after the Fed announced a relatively modest increase in interest rates.

This bubble was like the Railway Mania in the 1840s, when the prices of railway stocks increased unsustainably in the UK and Ireland, before eventually bursting.

Mr Gordon paints a different picture for today’s cohort of tech giants. “This network overcapacity, funded by market exuberance, provided the rich seedbed from which the modern internet would be built. The firms that emerged in the decade after the internet crash — Google, Facebook and Amazon for example — have defined industrial power and corporate success ever since,” he says. 

Invesco’s Mr Das also emphasises the strength of this group of mega cap tech growth stocks. “The Mag Seven are major firms, mostly highly profitable with proven business models, massive profits and cash balances that have already transformed the way we work, live and interact,” he says. 

“By definition, a bubble that never bursts is not a bubble. For the time being, AI is not a bubble as it hasn’t burst.”

He believes some firms may grow into bubbly valuations over the longer term. “Those who can stomach the valuations and volatility likely to occur between now and then, stand to make outsized gains over the long run,” he says. 

Yves Choueifaty, president at TOBAM, the Paris-headquartered asset management company managing $6bn in assets, says: “By definition, in the equity markets, a bubble that never bursts is not a bubble, and you will only know if it was a bubble after it has burst. For the time being, AI is not a bubble as it hasn’t burst.

“Whenever a disruptive innovation erupts in equity markets there is always a moment of exaggeration. A reasonable guess is that AI will not be the exception.”