How AI's data center boom is quietly powering industrial stocks

In recent weeks, the siren call of AI stocks has been holding astonishing allure for many investors.

True believers expecting eventual returns and short-termers exploiting this faith have spurred a run-up in the stocks of big tech companies developing infrastructure to harness the still-nascent artificial intelligence technology. This has drawn money away from other sectors, suppressing a trend of broadening market performance.

Economist Jim Paulsen characterizes the current market as being bifurcated into old-era and new-era companies — a natural result of this same bifurcation of the economy.

Hyper-scaling

Prominent among Paulsen’s new-era companies are big tech companies using huge amounts of their abundant free cash to build acres of data centers to eventually process AI functions — a practice known as hyper-scaling. Hyper-scalers include Meta, Microsoft (Azure), Google and Amazon (Amazon Web Services).

Many investors are actually attracted to these big tech stocks because of their huge capital expenditures for AI. Curiously, it seems like a competition to see which company can spend the most.

Though non-tech companies have taken a back seat to hyper-scalers in recent months, some have been doing quite well, unbeknownst to many. A prime example is the industrials sector, which over the past 12 months has placed third in performance among the market’s 11 sectors.

The top sector during this period has been AI-centric information technology. Number two is energy, pumped up by gains from the global oil supply shock from the Iran war’s closure of the Strait of Hormuz, stifling oil tanker shipments; rising oil prices tend to suppress equities.

Eclipsed by AI stocks, industrials’ performance hasn’t received much attention in the what-have-you-done-for-me-lately financial media sphere.

Individual investors who may be overinvesting in AI stocks are probably too focused on the short term. The term in question is the period since the deep dip in March, when the U.S. and Israel attacked Iran. Since then, the overall market has come back but AI stocks have soared.

For institutional investors, quickly and automatically deploying capital opportunistically is business as usual. But this usually isn’t a good idea for most individuals. The appropriate time frame for them isn’t months but years.

For many investors, a reasonable portfolio allocation to big tech is certainly warranted, but overdoing it can bring excessive risk.

Currently, AI and industrials are somewhat connected by hyper-scaling. Industrials are getting a strong tailwind from the hundreds of billions going into data centers under construction across America, most of them in rural areas.

These gargantuan installations require abundant industrial products and services to bulldoze sites, pour concrete foundations and walls, install thousands of miles of wiring, hook up truckloads of electronic connectors and install HVAC — mostly AC to cool humming racks of servers — black boxes literally and, for those not technically inclined, figuratively.

Industrials’ stats show an uptrend in production volumes that started in early 2024, and strong forward earnings project likely growth for the rest of this year and into the next.

FEMO over FOMO

Ed Yardeni, a widely followed market economist, has predicted for years that the current decade will be a repeat of the Roaring ’20s of the 20^th century, when industrials boomed.

Yardeni’s prediction would be belatedly proved accurate if industrials’ momentum continues. More broadly, he’s now saying that the overall market is being driven by what he likes to call FEMO, “Fabulous Earnings MOmentum.” This is a play on FOMO (Fear of Missing Out), the phrase some bears use to explain artificially elevated investor sentiment that, they argue, is creating a market bubble. Rather, says Yardeni, the market is being driven by strong earnings propelled by AI-enhanced economic productivity.

Of course, a wild card for near-term market outlooks this spring has been how long the Strait of Hormuz would remain closed — the status as of this writing in early June.

Though economists generally don’t see a recession as being likely anytime soon, the chances of a correction (a market dip of 10%) interrupting this bull market may be pretty good, as the S&P 500 has been getting pricey lately. In late May, the index’s price/earnings (P/E) ratio hit a several-year high of 32.4

While a correction this year would likely be a close haircut for soaring AI stocks, declines probably wouldn’t be as steep for industrials.

Nevertheless, a correction may offer a good opportunity to invest in the sector. Individual investors expecting a correction could follow the example of professionals by making a wish list of stocks or funds, rather than puzzling over picks while indexes rebound.

Broad sector

Industrials stocks are a broad sector, comprising everything from old-era infrastructure companies moving freight or manufacturing asphalt to aerospace/defense companies developing high-tech fighter jets or submarines. Companies that fall into the industrials sector provide products or services that build things (from roads to skyscrapers), route or manage power; make liquids flow, planes fly or vessels sail or bombs explode.

Household names in this sector include General Dynamics, Lockheed Martin, Caterpillar, Honeywell, Carrier Global, UPS and Otis Worldwide Corp. Less renowned but familiar to many investors are: Cintas, Quanta, Hubbell, Emerson Electric, RTX, Howmet Aerospace, Transdigm, Vertiv, Emcor Group and Quanta Services.

As members of the S&P 500, all of these are, of course, large companies. A good way to play industrials right now is to buy small-caps, which have posted higher returns than large-caps so far this year, a trend that runs across other sectors.

One advantage of smaller companies is that they don’t import as much stuff as larger ones, so they have less exposure to higher costs from tariffs. They borrow more heavily but, as the chances of a Fed interest rate cut are slim (because of persistent inflation), a rate hike anytime soon also seems unlikely.

Industrials exchange-traded funds (ETFs) worth considering include these five:

• Invesco S&P SmallCap Industrials (PSCI). As of late May, this fund was up nearly 33% for the preceding nine months. Major components include construction/engineering product and service companies selected for the fund’s index, the S&P 600 Capped Industrials Index, based on various liquidity and stability criteria.
• Vanguard Industrials (VIS). Up 12.5% this year, VIS is a basic capitalization-weighted fund. Major holdings include Caterpillar, Boeing, Honeywell, Deere and Uber, along with some big power companies.
• State Street Industrial Select SPDR (XLI). As its holdings are similar to those of VIS, performance is also about the same. But its dividend has recently been a bit higher.
• Invesco Dorsey Wright Industrials Momentum (PRN). Though this fund falls into the passively managed category, inclusion in the index is contingent on having strong momentum. Though it has underperformed broad passive large-cap industrials funds like XLI in recent years, it has outstripped them this year, gaining 40%.
• Invesco Building and Construction (PKB). This is a way to leverage the construction industry’s brisk data center business for large companies. PKB has outperformed broad industrials funds since last summer. It’s a good choice for investors who believe substantial capital expenditures by huge tech stocks for data center development will continue indefinitely.

AI stocks have been doing so well in recent weeks that some investors are getting nervous about a tech correction. Though industrials might suffer a bit of collateral damage, post-dip money flows between sectors may help industrials.

Dave Sheaff Gilreath, CFP, is a Partner Advisor Allworth Financial LP, an investment advisory firm registered with the SEC. Investments mentioned in this article may be held by Allworth Financial, affiliates or related persons.