AI stocks haven't played by the normal valuation rules. Now that rates are higher, they may have to, says UBS

By Jules Rimmer

UBS strategist recommends stocks relatively untouched by AI, including the U.K.

Valuations matter when interest rates are high

In a higher-yield environment, the expensive valuations of artificial-intelligence-fueled stocks suddenly matter and this is why they are starting to underperform.

Michel Lerner is the head of HOLT, an independent research product within UBS, focused on a value-based framework, who published a warning about AI stocks and his recommendation to diversify beyond tech generally in a note published Tuesday.

"Valuations have re-rated to imply that AI stocks are exempt from normal competitive market dynamics and basic corporate finance principles," he said.

With pressure building on the sector's returns, UBS identifies those asset classes that might be expected to outperform AI and AI-adjacent names: chiefly, U.K. equities, value stocks and high-quality, low volatility names in sectors like healthcare and consumer staples.

One observation Lerner makes is that tech now accounts for roughly half of U.S. stock market capitalization, which begs the question: "who is the next marginal buyer?" It's not just the market concentration that troubles him, though. He looks at the cash flow return on investment metric for AI stocks, currently at record levels, and finds that if it were to mean revert, the valuations rise to the 90th percentile most expensive.

AI stock valuations increasingly demand that high CFROIs are maintained.

The CFROI for semiconductor stocks SOX is on target to triple from 2024 levels by 2027. Since 1950 only 1% of companies have managed this explosive growth, and of those only 16% still enjoyed the same CFROI five years afterwards.

Capital expenditure is an issue for Lerner too. Between 2025 and 2028 he expects hyperscaler capex to triple to about $1.28 trillion but historically, "these investment surges have permanently diluted the CFROI of high-return businesses."

The capex boom has also created a funding risk that was largely ignored in the period of ultra-low interest rates and financial repression that followed the global financial crisis. With rates much higher than they were, markets may start to penalize deteriorating balance sheets more than they did, hence the travails of a company like CoreWeave (CRWV), for example.

Other threats to the AI sector cited by Lerner include that of cheaper Chinese competition prioritizing growth over margin, and the existential menace AI poses to the software and services sector IGV.

To diversify some of this exposure and protect against a lasting downturn in the sector, Lerner advocates the U.K. equity market where tech contributes less than 1% of the aggregate CFROI. He suggests value stocks, especially those with momentum like financials and industrials. Lastly he recommends low-volatility, high-quality stocks with positive momentum and attractive valuations like health care XLV and consumer staples VDC.

There are competing opinions, however. In her latest edition of her global macro musings published Monday, Laura Cooper, global investment strategist at $2.6 trillion asset manager Nuveen, said "the AI theme is intact." For her, the AI buildout isn't over, just bumpier. She remains constructive on the AI cycle, while acknowledging expectations leave less room for disappointment.

Nuveen thinks the AI trade is still intact and the backlog for hyperscalers suggests strong future revenue growth

Cooper argues the backlog for hyperscalers signals strong future revenue visibility and that at this stage, credit markets are not yet a canary in the coal mine.

-Jules Rimmer

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10-27-26 0715ET