Q&A: Are AI valuations entering a sentiment-driven bubble?What happened to major software stocks today?It seems that some "AI Stocks" are not joing the market's extended party. Several leading software companies posted sharp declines in the last session:These declines came as part of a broader selloff in software shares tied to fears that artificial intelligence could disrupt existing business models. According to Bloomberg, investors are increasingly factoring in the risk that AI tools will allow competitors to develop solutions faster and at lower cost.Why are investors talking about a possible AI valuation bubble, in some parts of the market, right now?A: Not every AI stock is the same. Beyond today’s price drops, the sector has been in a sentiment-driven phase. Reuters notes that valuations in AI and AI-adjacent software are running ahead of the underlying revenue and earnings growth for many companies. This divergence raises concerns about sustainability.What are the red flags that AI valuations might be overstretched?Slowing revenue growth alongside rising EV-to-sales multiples.Capital spending on GPUs and AI infrastructure outpacing cash generation.Flat or declining margins while management leans on future market size projections.Earnings beats failing to lift share prices unless guidance is raised.Heavy reliance on a small number of large AI clients.Surges in options and retail activity without durable price follow-through.Are there green signals that justify high AI stock valuations?AI-related revenue rising each quarter as a proportion of total sales.Strong unit economics with quick payback and falling inference costs.Growing backlogs and multi-year contracts converting into actual cash flow.Clear competitive advantages via data moats or platform integration.How can investors position in an overheated AI market?Trim into sharp rallies and look to re-enter at previous breakout levels.Use a barbell strategy combining stable free-cash-flow compounders with selective AI niche plays.Capture volatility through covered calls or hedge with put spreads.Time trades around earnings reports, AI infrastructure updates, and IT spending surveys.What’s the takeaway?The AI story remains compelling, but current pricing in parts of the sector reflects sentiment more than fundamentals. Watch whether cash flow, margins, and demand trends support these valuations. When multiples get too far ahead of proof points, discipline often beats chasing momentum.The investingLive.com (formerly ForexLive) Educational Takeaways for Traders and InvestorsSentiment cycles matter – Markets often overshoot on optimism and pessimism. Recognizing when a sector moves from a fundamentals-driven phase into a sentiment-driven phase can help you avoid buying at inflated levels or panic-selling near bottoms.Multiples without context can mislead – A high P/E or EV-to-sales multiple might be justified if growth, margins, and cash generation are accelerating. Without those fundamentals, the same multiple could signal risk rather than opportunity. This article was written by Itai Levitan at investinglive.com.