AI is thought to have the potential to transform the economy and eventually become a $4.8 trillion market, but the question on everyone’s mind right now is: Is the market a bubble? Everyone from tech company CEOs to asset managers to central bankers are worried that the promise of AI will quickly fade if it doesn’t live up to the hype, but many remain optimistic about the long-term outlook. CNBC surveyed fund managers to find out what they think is causing the bubble and whether there are any current signs of it happening. Expectations vs. Reality Stephen Yiu, chief investment officer at Blue Whale Growth Fund, says there’s one main ingredient to an economic bubble: it’s not soapy water. “The simple answer to the definition of a bubble that will eventually burst is that at some point expectations exceed tangible outcomes,” Yui said. It is widely agreed that market bubbles form when asset or stock prices rise rapidly, attracting investors, and ultimately creating a disconnect between valuations and fundamentals. This leads to crashes, just like in the dot-com era. Tech stocks, especially those related to AI, have seen a surprising rally this year. The Nasdaq Composite Index, which has a high proportion of tech stocks, has risen about 30% in the past 12 months, and has repeatedly hit record highs this year, reflecting the strong momentum in tech stocks. Meanwhile, the Philadelphia Semiconductor Index, which includes AMD, Nvidia and Qualcomm, has risen nearly 50% since the beginning of the year. On Wednesday, chipmaker Nvidia’s market capitalization topped $5 trillion for the first time in history. Herd behavior as stocks soar “When you think about an ‘AI bubble,’ some of it applies, but not all of it,” Victoria Fernandez, portfolio manager and chief market strategist at Crossmark Global Investments, told CNBC. “Yes, valuations are down from previous highs, but we have seen prices and valuations go up. We have also seen herd behavior, as I can’t think of a single investor, institutional or retail, who doesn’t talk about AI stocks as part of their market and investment conversations,” she added. But equity investors remain confident that the latter factor, the relationship between valuation and fundamentals, is stable, buoyed by a promising earnings season. “So far, companies have been able to support valuations with strong cash flows and solid profitability,” Fernandez said. “However, outside of NVIDIA, free cash flow growth is currently negative as large capex plans continue to be announced. This is an area we need to watch closely to see if a bubble develops.” The AI race is driving up the market capitalizations of some of the world’s biggest companies, but investors largely agree that these tech giants have healthy balance sheets to fall back on if, or if, the kinks in their burgeoning industry work out. This is in stark contrast to other bubbles where new ecosystems of companies were built but ultimately many companies failed. Lewis Grant, senior portfolio manager for global equities at Federated Hermès Limited, said the story of “well-capitalized mega-cap companies” leading the way and thus acting as some degree of antidote to a potential bubble is “compelling, but it’s only part of the investment process.” “There’s a long period of time where fundamentals and valuations can be ignored,” he said. When a bubble bursts, companies can go bankrupt and large sums of money can be lost, with ripple effects throughout the economy. Investors can mitigate these risks by doing more due diligence and making more intentional bets, said Gurbir S. Grewal, global research analyst at William Blair Investment Management. “Rather than broad exposure or thematic bets, successful AI investments will require detailed bottom-up analysis, and assessing which companies’ moats will be widened rather than eroded by AI will be key going forward,” he said, echoing the stance Goldman Sachs took in October. Cyclicality of AI Trading There are various types of bubbles. According to Nicolas Laroche, global head of advisory and asset allocation at Union Bancaire Prive (UBP), bubbles are defined by “excesses and speculation regarding asset valuations, overinvestment in industries, or unsustainable profit growth.” For example, Amazon founder Jeff Bezos said that AI is in an “industrial bubble” and that even if it bursts, society could be left with new innovations such as life-saving medicines. Blue Whale’s Yiu agreed that even if we are in a bubble, it is a “good” bubble. Regardless of whether the winners are the currently dominant companies or the companies that are stealing checks from investors, AI “has a real and tangible value proposition,” he said. There are other factors to note as well. “The risk today is the cyclical nature of transactions in the AI space, which could lead to inflated future profit expectations and disappointing investors,” Laroche added. But whatever the signs, bubbles take a long time to burst, so we may not know until we come out the other end. “Bubbles are only recognized in hindsight, and usually many years after they burst,” LaRoche said, adding that the 80% drop in asset prices and the 10-year recovery from the previous price peak were retrospectively clear signs. “This pattern is evident in several notable examples: the stock market crash of 1929, the Japanese asset price bubble of the 1980s, the dot-com bubble of the late 1990s, the crypto bubble of 2017, the unprofitable tech bubble during the COVID-19 pandemic, and most recently the real estate bubble in China,” he said. But “we do not foresee such a scenario,” he added.
