Burry is famous for shorting the market during the mortgage crisis. Is he going to win big again?

Is there an artificial intelligence (AI) bubble? Is it about to burst? It appears that famed investor Michael Burry thinks so.

Burry, who became famous as the subject of the Michael Lewis book and subsequent movie The Big Short about his shorting the market before the 2007-09 mortgage crisis, has some new shorts in mind. He purchased put options in Nvidia (NVDA 3.65%) and Palantir Technologies (PLTR 6.84%), which implies he thinks that their prices will drop.

Is this move as contrarian as it sounds? Burry successfully employed this strategy in the past, making millions for his hedge fund customers. Could he be right this time, too? And what should investors do about this news?

Image source: Getty Images.

Champion of the short

Shorting a stock involves “borrowing” shares of a stock to sell with the expectation that the price will fall. The seller then “buys” the stock back at the cheaper price and pockets the difference.

Put options allow the investor to sell at certain prices, taking this strategy a step further. They give the investor some more flexibility; if the price doesn’t start going down, you can just let them expire. Many large hedge funds employ some kind of options strategy to hedge their bets.

Burry’s fund, Scion Asset Management, is distinctive because it has very few positions at any given time, and it changes frequently. As of the end of the third quarter, it reported owning only four stocks, but it has options in four other stocks: call options, which give the opportunity to buy at a specific price, in Pfizer and Halliburton, and put options in Nvidia and Palantir.

He seems particularly bearish on Palantir, in which he bought $912 million worth of put options, and less so on Nvidia, in which he bought $186.6 million.

Today’s Change

(-6.84%) $-12.85

Current Price

$175.05

Is there an AI bubble?

AI stocks are responsible for a significant portion of the entire market today. Nvidia itself is worth $4.6 trillion today, and eight out of the top 10 most valuable companies in the U.S. are AI stocks. Together, these eight stocks are worth $23 trillion, or nearly the amount of the U.S. gross domestic product, which is $29 trillion.

Companies like Amazon and Meta Platforms are pouring more and more money into their AI products, and AI is increasingly responsible for more of what’s happening in the economy. It’s certainly a setup for a bubble.

The flip side is that all of the AI investment is resulting in real value. Cloud providers like Amazon and Microsoft have massive engagement from clients who are using their AI platforms to enhance their businesses, and AI is leading to automation and improvements for many businesses.

Today’s Change

(-3.65%) $-7.13

Current Price

$188.08

Nvidia and Palantir are at the center of AI investing

Nvidia is the most valuable company in the world, and it’s not cheap. It trades at a P/E ratio of 53 and a price-to-sales ratio of 28. Nvidia bulls will point to its ever-expanding opportunity and central role in all of AI, making it worth the premium valuation.

Palantir is a much smaller company and a much more expensive stock, setting it up for some kind of fall. It has only $3.8 billion in trailing-12-month revenue, and the stock is worth $483 billion as of this writing. That makes its price-to-sales ratio 116, and its P/E ratio is 417. As expensive as Nvidia might be, Palantir’s valuation is astronomical.

Despite Palantir’s excellent earnings report this week, its stock is dropping. It can only go so high at these levels.

Nvidia stock is falling as well, more likely based on CEO Jensen Huang’s comments that China might be catching up to the U.S. in AI. The disclosure of Burry’s new options probably didn’t help either one.

Should investors follow?

Keep in mind that every hedge fund manager, and every investor for that matter, has a different opinion about where stocks are headed. There are no prophets on Wall Street. If you have positions in many AI stocks, you need to make sure they’re balanced out by value stocks and safe stocks. That gives your portfolio some security no matter what happens, while providing opportunities for growth.