AI stocks are falling, but it might be premature to talk about a bubble.
Not long after ChatGPT was released, pundits began warning people that an AI bubble was forming.
Stocks like Nvidia (NVDA -1.78%) were skyrocketing as tech CEOs and luminaries said that generative AI could be as transformative as the internet. The start of the AI boom was also well-timed for investors as tech stocks were at rock-bottom valuations after tech stocks crashed through 2022 after the pandemic ended.
Now, with a number of high-profile AI stocks falling, those same critics are claiming that the AI bubble is here.
It’s true that tech stocks are falling fast. The Nasdaq-100 or the ETF Invesco QQQ Trust (QQQ -2.37%), composed of the biggest tech stocks on the market, is down 9% from its peak just a few weeks ago as of July 30. It is approaching a market correction, which is defined as a decline of more than 10% from a recent peak.
Nvidia, the AI revolution’s flagbearer, is now down 26% from its peak in June. Other high-profile AI chip stocks like Arm Holdings, Super Micro Computer, Taiwan Semiconductor, and AMD are also down substantially. Even Alphabet (GOOG -2.35%) (GOOGL -2.40%) and Microsoft (MSFT -2.07%), two of the top AI stocks, both pulled back on their recent earnings reports despite strong results.
Clearly, investor sentiment is shifting on these stocks, but does that mean that the AI bubble is already bursting? Let’s take a closer look.
Image source: Getty Images.
How stock market bubbles work
The traditional definition of a market bubble is the process of an asset’s price soaring well beyond its underlying value. Once investors realize the price no longer reflects its value, the price tends to come crashing down.
Bubbles form because investors notice a share price moving ever upward and jump on the bandwagon, assuming that they can ride the stock higher and then offload their shares before the stock tumbles. This pattern is known as the greater fool theory, meaning investors buy a stock on the assumption that someone else will be willing to pay a higher price for it. Eventually, of course, someone gets left holding the bag.
Some recent examples of market bubbles include the dot-com bubble when internet stocks crashed in 2000 following exponential growth in the prior years. In real estate, the housing bubble in the subprime market helped trigger the financial crisis, and, more recently, tech stocks also experienced a bubble in the aftermath of the pandemic, especially in subsectors like e-commerce, cloud computing, and video streaming, which all surged during in 2020 and 2021.
What’s happening with AI stocks now
Market bubbles are typically identified by rapidly falling prices after an earlier surge, but there’s more to it than that. Bubbles burst because conditions change in the underlying businesses. It’s more than just a price movement.
For example, when internet stocks crashed in 2000, nearly all of them saw their growth rates stall. Amazon, for example, went from revenue growth of close to 180% in 1999 to just 13% revenue growth in 2001.
When the housing market bubble popped, foreclosure rates skyrocketed as it became clear that many homebuyers couldn’t afford their mortgages.
More recently, in the aftermath of the pandemic, big winners like Zoom and Peloton crashed as the tailwinds that had driven their growth during the pandemic evaporated.
Right now, there isn’t much evidence that demand for AI is slowing or that there’s a fundamental problem with the new technology.
Alphabet just reported 14% revenue growth in its second quarter, and 29% growth in Google Cloud, the cloud infrastructure business that has the most AI exposure of any of its units. At Microsoft, revenue rose 15% with 29% growth in Azure, its cloud infrastructure business, which is seen as the best proxy for AI growth.
Those are strong growth numbers, especially for companies as big as Alphabet and Microsoft.
What it means for AI
Rather than the AI bubble bursting, the recent decline in AI stocks seems to be best explained by two factors. First, there’s a market correction in AI stock prices. After this year’s rally, investors believe the sector may be getting overheated and are selling these stocks and booking profits. Related to this, there are some fears that companies like Microsoft and Alphabet are overspending on AI infrastructure that they may not be able to adequately monetize, but that’s likely just a fleeting market mover.
Secondly, there’s a market rotation happening. Investors are moving money out of large-cap tech stocks like Alphabet, Microsoft, and Nvidia and, anticipating rate cuts from the Federal Reserve, putting it into small-cap stocks, which have badly underperformed in the AI era. You can see from the chart below that the Russell 2000 small-cap index has soared since the Nasdaq-100 peaked on July 10, while the tech-heavy index has steadily fallen.
That rotation makes sense. Tech stocks have surged since the start of 2023, while small-cap stocks have been left behind. Small-caps tend to be more sensitive to interest rates than large-caps, meaning they’re likely to derive a greater benefit from the expected cuts from the Fed.
Should you buy the dip in AI stocks?
Based on the current evidence, AI stocks don’t appear to be in a bubble, as there would need to be weaker results coming from companies like Alphabet, Microsoft, and Nvidia to make a convincing case that the industry is in that fragile state.
While many of these stocks are still expensive, it would be a smart move to keep cash reserved to take advantage if the sell-off continues. The pullbacks at Alphabet and Microsoft, for example, don’t seem justified based on their robust quarterly results.
Just as it’s easy for stocks to get overbought in a rally, we could see many of these AI leaders enter oversold territory if the correction continues.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Jeremy Bowman has positions in Amazon and Zoom Video Communications. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Amazon, Microsoft, Nvidia, Peloton Interactive, Taiwan Semiconductor Manufacturing, and Zoom Video Communications. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.
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