Healthcare stocks no longer trade at a discount to the broader market. That isn't a reason to sell.
As investors grow wary of the tech sector, a premium for steadier, less cyclical earnings could have legs. And history suggests that if the AI-driven boom ends the way other boom-and-bust eras have, healthcare could outperform for years.
For the past few years, healthcare has been in the market's bargain bin, largely due to politics and the AI trade. Drug-pricing pressure under both Presidents Biden and Trump, plus surging medical costs for insurers, left investors skittish. A year ago, the sector traded at a 25% discount to the S&P 500.
Over the past year, that has changed amid anxiety about a tech bubble. Last week, as the AI concerns grew louder, the discount vanished. The Health Care Select Sector SPDR ETF (XLV) now trades slightly above the S&P 500, at 19.3 times forward earnings, according to FactSet data.
Over the past few days, worries that rising interest rates could choke off AI spending have sent investors into defensive stocks. Healthcare has been among the best-performing sectors in the S&P 500, and on Monday the XLV gained more than 2%, led by a 6.7% jump for Moderna and a 4.9% gain for Bristol-Myers Squibb.
The shift says something beyond healthcare. The sector tends to command a premium when three things line up. As Asad Haider, a senior biopharma analyst at Goldman Sachs, explains, investors need to feel confident about medical innovation, nervous about the durability of profits elsewhere and at ease about policy headwinds. All three variables are largely in place today.
Healthcare usually trades at a discount to the market, even though healthcare spending has outpaced the broader economy. That is because investors price in the sector's political risks. But there have been stretches when it sustained a premium, from 2003 to 2007 and from 2013 to 2015. The most recent episode was brief: In late 2022, when inflation surged, the Fed raised rates and the S&P 500 sold off.
At the most basic level, what those periods share is a bet that healthcare offers a more reliable source of long-term growth, often in an environment of tightening credit.
The mid-2000s are the most useful parallel to consider. Then, as now, energy prices were climbing amid war in the Middle East, and the Federal Reserve was steadily raising interest rates. And then, as now, one booming corner of the economy -- housing -- was powering profits. Yet the S&P 500's forward multiple slid from about 18 in 2004 to about 15 in 2007, according to FactSet. Healthcare, with steadier earnings, kept its premium.
Both eras featured nagging doubts that the boom can last forever amid the rising cost of debt.
As long as AI worries persist, investors will keep using healthcare as a hedge. And a higher multiple isn't necessarily cause for alarm, says Haider. He notes that Johnson & Johnson, the industry juggernaut, is forecasting double-digit sales growth by the end of the decade. Eli Lilly, meanwhile, is expected to grow sales this year by more than 30%, driven by its diabetes and obesity drugs Mounjaro and Zepbound. Together, the two companies make up about 25% of the XLV healthcare ETF.
The policy environment is another reason the premium could widen. More than a dozen drugmakers struck deals with the Trump administration last year, trading price concessions for tariff relief. And if Democrats win at least one chamber of Congress next month, a divided government would make major new legislation unlikely before the 2028 election.
That doesn't mean healthcare is free of political risk. Insurers in particular face more uncertainty. Talk of Medicare for All will likely grow louder heading into the 2028 primaries, which could weigh on companies like UnitedHealth Group and Humana, says Jared Holz, a healthcare strategist at Mizuho. But for drugmakers and medical-device makers, the policy outlook is arguably calmer than it has been in years.
For investors hunting for value within the sector, medical-device makers are trading well below their normal valuations. Stryker trades at about 18 times forward earnings, well under its 10-year average of 24. Investors recently soured amid problems and soft demand for its joint replacements, but those look like stumbles that can be overcome. Other device makers, from Abbott to Zimmer Biomet , also trade well below their historical valuations.
There is no knowing when the music will stop for the stock market and the AI trade. Investors who hid out in healthcare in early 2006 lagged behind the market for nearly two years afterward. But during the financial crisis, the sector fell far less, and it kept outperforming for a decade. The industries that had led the boom took years to recover.
If AI turns out to be this cycle's housing, even an expensive insurance policy could look cheap in hindsight.
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