If an AI Bubble Burst Is Coming, History Says This 1 Investing Move Is Crucial Right Now
Key Points
Large tech companies are investing hundreds of billions in AI infrastructure, while some AI stocks trade at massive valuations.
It could be setting up for another blow-up, although investors should remember that timing the market is nearly impossible.
There are steps investors can take to prepare for a major sell-off.
It seems like for several years, investors have been fretting about the artificial intelligence (AI) bubble and when it might burst. After all, companies have been investing hundreds of billions of dollars in AI infrastructure to the point that many of the tech giants that were once oozing with free cash flow are now producing negative free cash flow and halting capital distributions.
Furthermore, many stocks trade at exorbitant valuations, and there are still questions about the extent of AI's capabilities and what could happen to the economy if AI advances as some bulls expect.
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If an AI bubble is about to burst, history says this one move is crucial right now.
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What could pop the AI bubble?
The interesting thing about market crashes is that they are typically unexpected. After all, if everybody is concerned about a crash for a specific reason, they are likely to prepare for it, so whatever ends this current bull market will likely be a surprise.
That said, the big concerns right now stem from the key players powering most of the AI revolution and financing most of it.
Right now, frontier AI large language models (LLMs), such as those from OpenAI and Anthropic, seem to be the main drivers of revenue growth and planned capital expenditures on AI infrastructure for hyperscalers.
However, these companies now have large valuations and are reportedly nearing initial public offerings, which many fear is one of the last main avenues for a big capital raise. If one of these companies were to go down, would there be others to take its place and rent all the AI compute that the hyperscalers are building?
There's also concern that while OpenAI and Anthropic dominate the LLM landscape right now, they could soon have competition from open-source models, which are reportedly much cheaper for businesses to use.
Nvidia, the dominant AI chipmaker, now also seems to be providing much of the industry's financing, whether by helping a hyperscaler fund a data center build-out or by investing in its customers and suppliers.
It's even been discussed that the possibility of creating securities collateralized by chips to fund other big AI projects. Critics have called many of these arrangements circular and see them as a warning sign.
One crucial investing move
I'll reiterate that, just because there are some warning signs and the market may look frothy, it's still incredibly difficult to time the market, so investors should not try.
But if you are concerned about these risk factors and preserving capital in a severe sell-off, history says that diversification is a critical move to ensure that such an event doesn't sink your portfolio.
Most recent market crashes have stemmed from one sector. The dot-com bubble in 2000 hit tech the hardest, as internet companies collapsed. The Great Recession hit banks and other companies in the financials sector the hardest.
Now, individual sectors can certainly take the entire market down in the near term, but if you own stocks less affected by the core issue driving the meltdown, they're likely to navigate the situation and bounce back more quickly.
This also doesn't mean you shouldn't be invested in a hot sector, such as artificial intelligence, or in the broader market, which is now heavily concentrated in AI, especially if you have a long runway ahead.
However, it does mean you should limit your exposure somewhat so it doesn't represent too large a portion of your portfolio. It's also not a bad idea to have some cash available because if AI stocks do get hammered in a sell-off, that could be a great long-term buying opportunity.
Think about the internet. Yes, many internet stocks sold off significantly during the dot-com bubble, but the internet still went on to change everything as we know it, and internet investors still did quite well over the long term.
But again, timing is everything. So, if you're worried that the AI bubble is going to pop, just diversify. You can still hold some AI stocks and exchange-traded funds, but then you should also own sectors better suited for a recession or market sell-off, like consumer staples.
Having some cash available as a buffer, or to buy the dip, is also a great idea.
Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.