Home AI If You’re Looking for AI, Look Beyond Tech, Vanguard Economist Says

If You’re Looking for AI, Look Beyond Tech, Vanguard Economist Says

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Key Points

  • In a recent Q&A, Vanguard economist Joe Davis talked about investing in AI.
  • Davis said investors should not be overweight in technology stocks.
  • Davis said AI's influence will be moving beyond tech into a broad cross section of sectors.

The AI transformation is moving beyond the overvalued tech sector.

Artificial intelligence, or AI, has exploded in recent years, driving huge market gains for many stocks. Most of these AI-driven stocks are in the technology sector, which has led investors to flock to Magnificent Seven, as well as technology ETFs and stocks to capitalize on the boom.

But as we enter the next phase of AI, that may start to change. In a recent Q&A posted on Vanguard’s website, Vanguard Global Chief Economist Joe Davis said investors should start to look beyond tech for AI opportunities.

Tech stocks are overvalued

To date, AI technology has mostly boosted tech stocks, as they have been at the center of the AI revolution. But now is the time for investors to broaden their horizons for a couple of reasons, said Davis.

One, tech stocks have become wildly overvalued. The current P/E of the Nasdaq 100 is about 36, according to Guru Focus. That is nearing the all-time high of 38 and well above the historical average of 23. Many of the high-flying tech stocks that have been buoyed by AI, like NVIDIA, Broadcom, and Palantir, have P/E ratios well above 36.  

Two, Davis said that the tech sector does not historically outperform during these periods of technological transformation.

“We’d expect some future stars to emerge, but there will be a larger percentage of those in the sector that flop,” Davis said. “For every Amazon that emerged from the internet bubble, there were dozens of start-ups that failed.”

So, Davis recommends, citing Vanguard research, that investors pull back from tech, but not entirely. However, he says investors should not be overweight in tech; rather, they should be overweight in the broader equity market.

“If our thesis is correct, and AI is a transformative technology with positive economic outcomes, we’d expect to see AI’s influence emerge in sectors outside of tech—health care, finance, manufacturing, etc.—driving increases in growth and productivity across the economy broadly,” Davis said. “For example, electricity was a transformational technology, and it influenced sectors of our economy well beyond energy. For that reason, we’d suggest that if you want to bet on this outcome, the preferred way to do so is by increasing your equity exposure, not by overweighting the tech sector.”

The next Magnificent Seven?

By overweighting the broader market, Davis is essentially saying that investors should have a broadly diversified portfolio. That could be done as simply as owning a total stock market ETF that invests in the total market. It could also be done by diversifying with a variety of different sectors and styles, including value stocks, which Davis said are poised to outperform growth stocks in this environment.

That’s because, he said, “growth firms will be up against a major headwind of a secularly low-growth environment—historically, growth stocks that can’t grow earnings, for whatever reasons, generally end up with a significantly lower valuation. Value stocks, on the other hand, may come into favor, after a very long underperformance, and outperform the broader equity market.”

Davis added that it may be a good time to seek out actively managed funds, as this should be more of a stock pickers market. With an actively managed ETF, portfolio managers may have a better chance of finding the winners.

At the same time, Davis cautioned investors to avoid concentration in just a handful of similar stocks, like the Magnificent Seven, or a particular sector, like tech – because things change.  

“When it comes to the stock market, two seemingly contradictory statements can both be true,” he said. “On one hand, large-cap, generally growth, stocks have a lot of staying power for longer than some might think—so the concentration could continue. On the other hand, these enterprises generally do not hold onto their position and growth mode for more than a few decades. Look at a list of the largest S&P 500 members from a few decades ago and compare that to today. Similarly, where were most of the Magnificent 7 stocks just 20 years ago?”

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