Is the AI Boom Becoming a Bubble? Here's What Investors Should Watch.

There are some indicators that artificial intelligence stocks are in a bubble. For one, leadership at the world's leading tech companies, including Sam Altman of OpenAI, thinks we're already there. Second, many small, unprofitable AI companies also have skyrocketing valuations.

So, what should investors do if AI stocks are in a bubble, and what should they look out for? Here are two things to watch.

Image source: Getty Images.

1. Keep an eye on profitability

This one may be a little obvious, but numerous high-flying AI companies have little to no profit. Keeping an eye on a company's profitability, or its roadmap toward profitability if it's not currently there, is always critical -- but even more so amid a frothy market.

That's why it's worth highlighting the highly profitable companies. Some AI leaders, including Nvidia (NASDAQ: NVDA), Taiwan Semiconductor (NYSE: TSM), and Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), are benefiting significantly from the increased demand for their products and services. Consider that:

• Nvidia's third-quarter earnings jumped 60% to $1.30 per share.
• Taiwan Semiconductor's earnings rose 39% to $2.92 per American depositary receipt (ADR).
• Alphabet's third-quarter earnings jumped 35% to $2.87 per share.

There's no denying that some investors have an overly optimistic view of some AI stocks, but just because that's true doesn't mean that investors should shun all of them.

Nvidia commands an estimated 90% market share of data centers with GPUs. That dominance is the opposite of a flash-in-the-pan AI company. Similarly, Taiwan Semiconductor is the world's leading manufacturer of advanced processors, with an estimated 90% of the market. And, of course, Alphabet is a leading AI player with its Gemini chatbot and AI integration into Search, advertising, and other services.

The point here is that dismissing all AI stocks just because there's talk of a bubble isn't a smart move. Nvidia, Taiwan Semiconductor, and Alphabet are all leaders in AI and generating incredible earnings from their businesses -- and will likely do so for years to come.

2. The bubble may not burst the way you think

OpenAI CEO Sam Altman told The Verge in August that,

"Are we in a phase where investors as a whole are overexcited about AI? My opinion is yes. Is AI the most important thing to happen in a very long time? My opinion is also yes."

If one of the world's leading AI companies is saying that there's an AI bubble, then dismissing the idea entirely probably isn't a wise move. But there's also no roadmap for exactly how this could play out.

For example, the AI bubble may end with a gradual deflation rather than a sudden collapse. Let's assume that next year, spending on AI infrastructure investments declines, while earnings for Alphabet, Taiwan Semiconductor, and Nvidia continue to increase, albeit at a significantly slower pace.

The result of this would likely be a pullback of these major AI players. Some investors, undoubtedly, would panic sell, pushing share prices down quickly. However, it's also likely that these companies would not experience the same potential sell-off as smaller, less profitable ones.

In other words, while speculative companies have benefited from the AI boom, they'll be far less capable of riding out AI stock declines as Nvidia, Taiwan Semiconductor, and Alphabet will be. For some large AI players, the burst may be more like a temporary deflation.

No one knows what will happen

While many people are raising the alarm about a potential AI bubble, no one knows how much these stocks will rise, when the bubble will burst, or if there will be a slow and gradual decline.

Which means that if you're inclined to think a bubble burst is imminent, then diversifying your portfolio could be a good strategy. And if significant share price declines occur over the next year or so, remember that it could open up a good buying opportunity for Nvidia, Taiwan Semiconductor, and Alphabet when the time comes.

Chris Neiger has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Nvidia, and Taiwan Semiconductor Manufacturing. The Motley Fool has a disclosure policy.