Fund managers reveal their bubble recipes and what to watch for as AI stocks soar

Published Wed, Oct 29 20257:30 PM EDT

AI is tipped to transform the economy and eventually evolve into a $4.8 trillion market, but the question on everyone's lips right now is: is the market in a bubble? Everyone from tech CEOs to asset managers and central bankers is worried the promise of AI could quickly turn sour if it doesn't live up to the hype, but many remain optimistic on the long-term view. CNBC surveyed fund managers to find out what they think makes a bubble — and whether the signs are there today. Expectations vs. reality Blue Whale Growth Fund Chief Investment Officer Stephen Yiu says there's one main ingredient to an economic bubble, and it's not soapy water. "The short answer for the definition of bubble, which then ultimately will go bust, is that at some point expectations are going to surpass tangible delivery," Yiu said. There's broad agreement that market bubbles form when there's a rapid increase in asset or stock prices, investors pile in and there's an eventual disconnect between valuations and fundamentals. This, in turn, leads to a crash, just like during the dot-com era. Tech stocks, specifically those related to AI, have staged a stunning rally this year. The tech-heavy Nasdaq Composite is almost 30% higher over the last 12 months and has repeatedly hit record highs this year, reflecting the significant momentum behind tech stocks. .IXIC 1Y mountain Nasdaq Composite Meanwhile, the Philadelphia Semiconductor Index, which includes AMD , Nvidia and Qualcomm , has seen a near 50% increase since the start of the year. On Wednesday, chipmaker Nvidia 's market cap became the first-ever to top $5 trillion . Herd behavior as stocks soar "When we think of an 'AI bubble,' some of these hold true, but not all," Victoria Fernandez, portfolio manager and chief market strategist at Crossmark Global Investments, told CNBC. "Yes, we have seen prices and valuations move higher, although valuations have come back down from their highs previously. We have also seen the herd behavior as I can't think of a single investor – institutional or retail – who doesn't talk about AI stocks as part of any conversation around the markets or investments," she added. However, equity investors remain confident that the latter element – the relationship between valuations and fundamentals – are steady, buoyed by an earnings season that is expected to yield positive results. "So far, companies have been able to support valuations with strong cash flow and solid profitability," Fernandez said. "Outside of Nvidia, however, free cash flow growth is now negative as massive capex intentions continue to be announced. This is the area where we need to watch to see if a bubble emerges." Valuations 'can only be ignored for so long' The AI race has seen some of the world's largest companies' market caps soar, but investors broadly agree that these tech giants have healthy balance sheets to fall back on if — or when — kinks in the burgeoning industry are ironed out. That's in stark contrast to other bubbles, when new ecosystems of companies were created – but many ultimately failed. The story of "well-capitalized, mega-cap companies" leading the charge — and therefore serving somewhat as an antidote to a potential bubble — is "compelling, but that is only part of an investment process," said Lewis Grant, senior portfolio manager for global Equities at Federated Hermes Limited. "Fundamentals and valuations can only be ignored for so long," he said. If a bubble bursts, companies fail and big money can be lost, creating ripple effects across the economy. Investors can mitigate these risks by ramping up due diligence and placing bets more intentionally, according to Gurvir S. Grewal, global research analyst at William Blair Investment Management. "Rather than broad exposure or thematic bets, successful investing in AI will require granular, bottom-up analysis and assessing which companies' moats will be widened, not eroded, by AI will be key moving forward," he said, mirroring a stance taken by Goldman Sachs in October . Circularity of AI deals There are also different types of bubbles. For Nicolas Laroche, global head of advisory and asset allocation from Union Bancaire Privée (UBP), bubbles are defined by "excesses and speculation on asset valuations, industrial overinvestments, or unsustainable profit growth." Amazon founder Jeff Bezos, for example, says AI is in an "industrial bubble," which, even if it bursts, can leave society with new innovations such as life-saving pharmaceuticals. Blue Whale's Yiu agreed that even if we're in a bubble, it's a "good" one. "There's some real, tangible value proposition" from AI regardless of whether it's the companies that currently dominate or those nabbing checks from investors that are the winners, he said. There are other factors to keep an eye on, too. "The risk today is the circularity of deals in the AI space, which could inflate profit expectations and disappoint investors in the future," Laroche added. But no matter the signs, we might not know until we're out of the other end, because bubbles burst over long periods of time. "A bubble is only recognised in hindsight, typically years after it has burst," Laroche said, adding that an 80% drawdown in asset prices or a 10-year recovery from a previous price peak are retrospective tell-tale signs. "This pattern has been 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 cryptocurrency bubble of 2017, the non-profitable tech bubble during the COVID-19 pandemic, and, more recently, the Chinese real estate bubble," he said. However, "we are not expecting such a scenario," he added.

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