Market performance broadens as cracks appear in exuberance over AI

Dave S. Gilreath: ©Sheaff Brock Investment Advisors

Stock performance is broadening, creating more balanced equity opportunities for investors in a market fixated on huge tech companies.

In recent months, the market has been obsessed with artificial intelligence. AI has investors so excited that some, curiously, have been viewing astronomical capital expenditures on infrastructure development by huge tech companies as a virtue rather than a cost.

AI = Ahead of Itself?

While this latest phase of the digital revolution (now in its fourth decade) is widely expected to ultimately prove commercially successful, some analysts are suggesting that AI-centrism is overdone. The term “AI bubble” has surfaced, suggesting that perhaps AI might stand for Ahead of Itself.

Pointing to a study from the Massachusetts Institute of Technology that casts doubt on the size of the near-term market for AI products, skeptical analysts question whether the massive capital expenditures by companies known as the S&P 500’s Magnificent Seven will ultimately generate proportionate returns.

While these big tech stocks will doubtless continue to do well, more money is starting to flow into other parts of the market.

Regarding large companies, the simplest way for investors to take advantage of this emerging trend is to buy an equally weighted large cap fund such as Invesco Equal Weight S&P 500 ETF (RSP) because it gives all 500 stocks roughly the same weight — unlike the capitalization-weighted S&P 500 (typically referred to simply as the S&P 500). The latter has long been dominated by the Magnificent Seven, whose collective performance until recently had accounted for more than 30% of the entire index. The equal-weighted index represents the average performance of all 500 stocks.

Sector by Sector

A more focused, tactical strategy is to invest in corners of the market likely to gain significantly from the emerging broadening trend. These include:

• Financials. As of Sept. 23, one of the dominant ETF in this space, Financial Select Sector SPDR (XLF), was up more than 12% for the year, with most of these gains coming in the last few months. This sector got good news from the Federal Reserve’s September interest rate cut, as declining rates enable wider margins on loans. Credit card companies like Visa, having long enjoyed a wide spread between the cost of money and their sky-high interest rates, would also benefit. Moreover, the financial industry is generally expected to enjoy growth and increased profits from anticipated consolidation enabled by loosening regulation under the Trump administration.
• Energy. Contrary to Elon Musk’s pie-in-the-sky predictions, everyone probably won’t be driving an EV tomorrow or even in the next few years, nor will we be summoning driverless taxis. So oil isn’t going away. Oil stocks have posted pretty flat performance over the past year, but this commodity is highly cyclical and its price is affected by the above-ground supply, which is easily manipulable: Just stop pumping until the available supply decreases.

Natural gas will remain a dominant fuel source for electrical power plants, as coal is a literal environmental bête noire, solar loses a lot of juice in transition and nuclear fission plants, though benefiting from the industry’s newly rehabilitated reputation, take years to site, build and secure regulatory approvals.

Liquid natural gas — liquefaction enables efficient shipping to global locations where it’s turned back into gas (re-gasification) — is a rapidly growing industry driven by expanding exports to Europe and Asia.

Overall, traditional energy is one of two sectors that excelled in a recent Schwab report citing two key purchase criteria for stock buyers: valuation (meaning reasonable price relative to earnings) and growth potential.

• Utilities. This is the other sector that got the thumbs-up from Schwab. Over the past couple years, utilities’ historically humdrum image has been transformed by power demand from proliferating data centers (and now, AI data centers). This, along with growing awareness that the U.S. power grid needs a lot of work, has given electrical power companies new life. One of the more dominant ETFs in this space is Utilities Select Sector SPDR (XLU). For a more focused investment in products and services needed for power generation, investors might consider First Trust Nasdaq Clean Edge ETF (GRID).
• Small caps. Funds that track the Russell 2000 Small Cap Index — a standard gauge for small-company performance — showed new life over the summer, with iShares Russell 2000 ETF (IWM) gaining nearly 18% in the three months ended Aug. 26, compared with only 12% for the S&P 500.

Laggards

Investors shouldn’t assume that all laggard sectors will soon be revivified by the current broadening trend. While health care and real estate are pretty beaten up, with low prices relative to earnings, the near term remains doubtful for them. So where these two sectors are concerned, bargain hunters seeking to position for growth should currently regard them as long investments requiring patience.

If slowing job creation eventually leads to recession, health care would then be an excellent defensive move, as insured people will always seek medical care. However, although job creation is slowing, recession isn’t on economists’ radar screens these days. The still-strong economy is slowing, but far from shrinking.

Real estate is hurting from sustained elevated interest rates. Though this month’s Fed rate cut may portend a cutting cycle, embers of the persistent inflation that has prompted the Fed to maintain elevated interest rates over the past couple years may ignite, precluding further cuts and forestalling growth in the real estate sector.

Though broadening is likely to be sustained well into 2026, investors still shouldn’t count AI-centric mega-cap tech firms out by any means. For most investors, some portfolio allocation to these stocks is usually appropriate. How much will depend on an investor’s diversification philosophy and risk tolerance.

Granny Shot

One way to manage risk from an AI bubble is to buy highly flexible growth-stock funds whose managers can invest in just about anything, as they have no set playbook.

A current, lucrative example is Fund Strat Granny Shot ETF (GRNY), which holds big growth stocks in various sectors, including tech. That way, when AI stocks falter, managers can shift investment to growth stocks in more promising sectors. This fund is named after NBA legend Rick Barry’s highly accurate underhanded “granny” free-throw style — a metaphor for being unconventional yet highly effective.

This is an especially difficult market to forecast. Yet, narrowing and broadening performance are classic cyclical trends, and a broadening trend is now under way.

Dave Sheaff Gilreath, CFP, is a Partner Advisor at Sheaff Brock Investment Advisors, powered by 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.