Goldman Sachs: US AI stocks' rally is exhausted, focus on defensive sectors in the second half of the year, optimistic about healthcare and European defense.

Goldman Sachs: US AI stocks' rally is exhausted, focus on defensive sectors in the second half of the year, optimistic about healthcare and European defense.

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In the first half of this year, geopolitics and artificial intelligence (AI) mania dominated global markets. But as the second half begins, the macro environment and market logic are undergoing profound changes.

On July 4, Louis Miller, head of Goldman Sachs Global Custom Equity Basket business, pointed out in the latest market strategy report that as global growth expectations rebound from lows and inflation and interest rate pressures ease, the macro environment in the second half will greatly favor "Selective Broadening" of market breadth, with funds flowing out from the extremely crowded tech giants to search for new undervalued opportunities.

Goldman Sachs warns that AI and momentum trading, which dominated the first half, are already showing signs of exhaustion. Historical seasonal trends indicate these hot trades may enter a "summer dormant period" in July.

In fact, the momentum factor just saw its largest drawdown since Q1 2023, AI concentration in the S&P 500 is now above 50%, and hedge funds' momentum exposure is at an extremely high 92 percentile over the past five years. This extreme crowding means markets are vulnerable to sharp short-term pullbacks and forced unwinding.

With capital shifting from highs to lows, Goldman Sachs strongly recommends investors turn to defensive sectors and “non-AI-related” compound return assets in the second half. Among them, the healthcare sector is Goldman’s top pick, especially bioprocessing and large European pharmaceutical companies with strong M&A potential. Also, the underperforming European defense sector in the first half is now an excellent entry point due to low valuations and reset earnings expectations.

Tactically, Goldman Sachs expects lagging cyclicals, software, consumer, and real estate sectors to see catch-up gains. To cope with volatility from momentum unwinding, Goldman suggests investors use their “ex-AI” basket indices for hedging, retaining broad market exposure while avoiding short-term crash risks from crowded trades.

AI and Momentum Trades Face "Summer Dormancy", Extreme Crowding Sparks Pullback Risks

Looking back at the first half, AI trades were undoubtedly the absolute main theme. U.S. memory chips, new cloud services, AI inference beneficiaries, optical networks, and data centers sectors all posted returns over 100% since the start of the year. Asian and European semiconductors and related industries also doubled.

However, Goldman points out that this mania is facing real challenges. As Q2 earnings season approaches, market focus will return to fundamentals, and individual performance divergence will intensify.

Recently, momentum trading (buying past winners, selling past losers) suffered its worst two-day sell-off since 2022, with consecutive unwinding waves over 5%. This momentum pullback is causing collateral damage to AI trades, with Goldman’s AI long-short hedging strategy hitting its worst single-day performance recently.

In the past two and a half years, the AI sector has seen several phase-wise pullbacks, and both historical trends and seasonal factors point to July as a "breathing space".

More worrying, momentum factor exposure in Goldman’s Prime Book is at the 92nd percentile in a five-year view. Extremely crowded positions mean that once unwinding occurs, the damage will be magnified.

AI concentration in the S&P 500 has exceeded 50%, and AI weighting in European markets has doubled from 2023. Systemic risks cannot be ignored.

In summary, given that summer usually sees weak U.S. stock performance, along with the need for broader market breadth and high factor volatility, Goldman sees the AI sector at risk of further short-term sell-offs.

While AI is surging ahead, many market sectors remain in "deep waters".

Goldman summarizes several underperforming asset types in the first half, such as those seen as “vulnerable to AI disruption” (traditional software stocks in the U.S., Asia, Europe), and secondly, consumer discretionary sectors (European luxury, U.S. low-income consumption, etc.).

Goldman believes the most likely outcome in the second half is: lagging cyclicals, software, consumer, or real estate stocks see a “catch-up rally”. This rotation will support overall index performance, but will cause pain for portfolios heavily concentrated in momentum tech stocks. Thus, finding sectors where earnings expectations have been sufficiently downgraded and valuations are attractive for “Selective Broadening” is the core strategy for H2.

Among the defensive sectors, Goldman is very optimistic about healthcare, calling it the "ultimate non-AI related compound growth machine". This logic is already playing out as the U.S. broad healthcare sector, European pharma, and global drug discovery data sectors have rebounded strongly from the year’s lows.

Goldman emphasizes that future excess returns in healthcare will be driven by two core catalysts:

First, structural growth areas like global bioprocessing, which is not only one of Goldman’s highest conviction healthcare trades but also a real beneficiary from productivity gains driven by AI.  

Second, the M&A cycle of large pharmaceutical companies. Currently, European pharma sector valuations are roughly 10% below their historical market premium. More importantly, large pharma companies have ample balance sheet capacity, and face an imminent “patent cliff”, which has triggered a strong M&A cycle, likely to significantly bolster sector earnings.

In addition to healthcare, Goldman has also sharply identified a turning point in the European defense sector. Defense stocks lagged in H1, but recent rebounds are attracting market attention. Goldman believes this rebound is sustainable, as positions in the sector are currently very light, earnings expectations have reset, and depressed valuations set a very low bar for Q2 earnings. The European defense sector is rebounding from its yearly lows and still has roughly 12% relative upside left to catch up with the broad market.

As for the AI-related theme, Goldman does not completely turn bearish, but advocates “buying the dip”. Especially for U.S. hyperscalers, Goldman suggests building positions ahead of earnings season. Recent announcements from Meta about cloud services have already triggered the first wave of gains for the sector, and Goldman expects strong Q2 EPS will drive further upside.

Facing possibly increased market volatility in the second half, Goldman advises investors to take short-term tactical hedges. With AI’s weight in S&P 500 too large, traditional short index tools may inadvertently hurt “structural winners” supported by long-term fundamentals.

Therefore, Goldman and S&P have launched SPXXAI (S&P index excluding AI), and recently rolled out the “ex-AI Europe market basket” (GSXEXXAI) for the European market, as AI concentration there is also soaring (now at twice the 2023 index weight).

These tools provide investors with highly liquid, low-volatility hedging alternatives, allowing them to safely capture the benefits of broadening markets while avoiding the risks of crowded tech stock pullbacks.

Risk Reminder and DisclaimerThe market has risks, investment needs caution. This article does not constitute personal investment advice, nor does it take into account the individual investment objectives, financial situation, or needs of any particular user. Users should consider whether any opinion, viewpoint, or conclusion in this article suits their specific circumstances. Invest on this basis at your own risk. ```