Tech stocks' great run is leading to worries about overvaluation. Here are five defensive sectors -- and 13 funds -- that can provide protection. By Ian Salisbury
Fears of an artificial-intelligence bubble bursting may have you thinking about how to build a defensive portfolio. The problem? These days, finding a corner of the stock and bond markets untouched by AI takes some legwork.
Most technology stocks, especially semiconductor makers, are having another great year, leading the market with a 28% gain, even with a sharp reversal last week. It's hardly unprecedented. Over the past decade, tech's average annual return is nearly 25%, compared with 15% for the S&P 500 index. That has led to worries that market-tracking index funds are overvalued and far too concentrated. Today, tech, and its close cousin, communications -- a sector that includes Meta Platforms and Alphabet -- make up nearly 50% of the index. The market's top three chip stocks, Nvidia, Broadcom, and Micron Technology, make up about 12% of the S&P 500.
When -- or if -- the AI bubble finally pops, it's certain to hit your portfolio hard. One market simulation, conducted in May by United Kingdom investment bank Panmure Liberum, looked at three possible scenarios, ranging from a "short correction" leading to double-digit drawdowns in tech and many cyclical stocks to an all-out 2000-style crash, when the S&P 500 plunged 30% in the first year. "We cannot time the end of a market boom," wrote Panmure investment strategist Joachim Klement, but "we are convinced that investors need to prepare."
Of course, that's easier said than done. Simply selling out of the market is too risky. Pundits have been warning about tech concentration for years. Investors who heeded their advice and sold out of the Magnificent Seven three years ago, for example, would have missed out on a gain of more than 100%.
Interest rates are another issue. If the good times do end, the cause could be a slowing economy -- but it could also be another spike in inflation. Each of those two events would probably occasion very different responses from the Federal Reserve, with different implications for bonds and rate-sensitive stocks.
Perhaps the biggest problem, however, is that the AI trade is no longer really about tech stocks -- it has spread into almost every part of your investment portfolio. The boom has touched everything from copper miners to makers of gas turbines and cooling equipment to nuclear power producers. Even auto maker Ford Motor recently got a big stock bump when it announced plans to sell battery storage systems for utilities and data centers.
Overseas stocks and bonds aren't immune, either. South Korea's stock market has more than doubled in the past year, driven by chip makers SK Hynix and Samsung Electronics, despite plunging last week. And tech giants Nvidia and Amazon.com have been issuing debt hand over fist, changing the makeup of the corporate bond market, much the way their ballooning market caps have changed the stock market.
"This is a difficult time to be out of the market. It's also a difficult time to be in the market," says Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management. "Being in the market is very fraught because it's all one trade. It's expensive. It's concentrated, and everything is correlated to it."
Given all of this, investors need to be very careful. Fortunately, there are a number of steps you can take to protect yourself, from defensive sectors and dividend funds to alternative investments and bonds -- as long as you are careful to consider what is and isn't connected to AI. There are plenty of tools available. The proliferation of exchange-traded funds gives investors thousands of ways to slice and dice the market, while active funds offer options like dividends and overseas stocks.
Barron's interviewed a dozen fund managers and strategists about their best ideas. Here are five ways to play defense without getting out of the game.
If you're worried about an AI selloff, your first instinct might be to hide out in another part of the market. The strategy seemed to work a few months ago. From October to March, the Mag Seven stocks entered a near bear market, tumbling 19%, as investors questioned their massive spending. The market rotated from computer chips into "real assets" that felt reassuringly tangible, with energy, materials, and utilities all racking up big gains.
The problem? This wasn't so much a rotation out of AI but out of hyperscalers and into AI picks-and-shovels companies, with names like copper miner Freeport-McMoRan and turbine maker GE Vernova leading the way.
A major AI selloff isn't likely to benefit second-order AI companies but instead true defensive sectors. Traditionally, that would mean utilities, consumer staples, and healthcare. But there's a problem here, too, notes Duncan Lamont, head of strategic research at London-based investment manager Schroders.
Utilities have themselves recently become part of the AI trade. Witness the big run-ups in nuclear energy stocks or NextEra Energy's proposed $67 billion acquisition of Dominion Energy in data-center rich Virginia. They are also interest-rate sensitive. (Note the sector's 4% selloff since March, when rates began to rise.) That's a problem, since investors can't be sure how rates would react in an AI selloff.
That leaves consumer staples and healthcare, two sectors that have been left behind in part because they have so little do with AI. Both look cheap, at least compared with the richly valued broad market. Consumer staples trade at 19 times forward earnings and healthcare stocks at 18, compared with 21 for the S&P 500. These are the "least loved parts of the market," Lamont notes, but adds, "There is more of a margin of safety in their valuations."
The simplest way to add sector exposure is through an index ETF. The Select Sector SPDRs, targeting 11 sectors of the S&P 500, are one time-tested option. The consumer staples fund trades under the ticker XLP and the healthcare one trades under XLV. iShares and Vanguard both offer similar ETF lineups.
There are also active options, like the Janus Henderson Global Life Sciences fund, which has returned an annualized 12% over the past decade, putting it in the top 10% of its health fund category. "Our sector has been pushed aside a little bit, because there has been so much excitement about other areas," concedes co-manager Daniel Lyons. About a third of the fund is drug companies, and another third is biotechnology. The rest is split among medical equipment makers, managed care companies, and others.
The fund's top three holdings are Eli Lilly, Johnson & Johnson, and UnitedHealth Group. Lilly, maker of blockbuster GLP-1 drugs Zepbound and Mounjaro, isn't necessarily cheap at 28 times earnings. But, Lyons says, the company isn't just about obesity drugs -- it has also seen positive developments in cancer care and vaccine acquisitions.
Dividend stocks are a classic defensive play. Steady cash flows tend to provide a cushion against price swings, while the biggest dividend payers are often blue chips with solid, established businesses. And they have protected investors in the past. One recent study by Hartford Funds looked at market corrections going back to 1973. On average, the market declined 19%. Dividend-paying stocks fell just 14% during those drawdowns, while nondividend stocks declined 28%.
But investors need to be careful here, too. The market's most popular dividend fund is the Vanguard Dividend Appreciation, which boasts a standout record, having returned 13% a year over the past decade, putting it in the top 5% among dividend funds tracked by Morningstar.
But because it focuses on companies that grow payouts, its yield is low -- just 1.5%, slightly higher than the market's 1%. And its top three holdings are tech stocks: Broadcom, Apple, and Microsoft. Overall, tech stocks make up about 26% of its portfolio, making it less than ideal as a hiding place to ride out an AI selloff.
A better bet may be the Vanguard High Dividend Yield fund, which offers a yield of 2.2%, or the Schwab U.S. Dividend Equity ETF, yielding 3.2%. Both have less than 20% of their portfolios in tech, according to Morningstar. Neither has matched Vanguard Dividend Appreciation's 10-year returns, but during the October-to-March Mag Seven selloff, they fared much better. While Dividend Appreciation tumbled 2.7%, High Dividend Yield gained 4%, and the Schwab fund rose more than 16%.
Among active funds, Columbia Dividend Opportunity offers a similar profile, with a 2.5% yield and less than 13% invested in the tech sector. While Cisco Systems is among the fund's holdings, so are Exxon Mobil, JPMorgan Chase, Johnson & Johnson, and Philip Morris International. Co-manager Grace Lee says that she has gradually pared back the fund's tech holdings as they have appreciated to make sure the sector doesn't loom too large. In a tech selloff, she expects staples stocks like Philip Morris to hold up comparatively well. While cigarette sales are gradually declining, the company found a new avenue to growth with smokeless tobacco. "The dividend is extremely safe and supported by growing free cash flow," Lee says.
A big AI selloff would probably reverberate around the globe. Joachim Klement, who ran the simulations of an AI selloff, thinks that European stocks could actually be hit harder, at least at first. Their economies tend to be weaker, and U.S. investors would rush to repatriate their investments. Still, in the longer run, he expects defensive European stocks to be "the best hiding place," thanks to low valuations and lack of tech exposure. He recommends food, pharmaceutical, and telecom names. He also likes U.K. construction and German infrastructure stocks, which will benefit from promised government spending increases.
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