The first half of the year saw global markets dominated by geopolitical tensions and an artificial intelligence (AI) frenzy, but as the second half begins, the macro environment and market dynamics are undergoing a profound shift.

On July 4th, Louis Miller, head of Goldman Sachs's Global Custom Stock Baskets business, noted in a latest market strategy report that with global growth expectations rebounding from lows and inflation and interest rate pressures easing, the H2 macro environment will greatly favor a "Selective Broadening" of market breadth. Capital is expected to flow out of the extremely crowded mega-cap tech stocks in search of new opportunities.

Goldman Sachs issued a warning that the AI and momentum trades which dominated H1 are showing signs of exhaustion. Historical seasonal patterns suggest these hot trades may experience a "summer lull" in July.

In fact, the momentum factor just recorded its largest drawdown since Q1 2023. AI concentration within the S&P 500 has surpassed 50%, and hedge fund exposure to momentum is at an extremely high 92nd percentile level over the past five years. This extreme crowding implies a high susceptibility to sharp pullbacks and forced liquidations in the near term.

Against this backdrop of capital rotation from high-flyers to laggards, Goldman Sachs strongly advises investors to pivot towards defensive sectors and "non-AI related" compounders in the second half. The healthcare sector is viewed as a top pick, particularly bioprocessing and large European pharmaceutical companies with strong merger and acquisition potential. Additionally, the underperforming European defense sector, due to depressed valuations and reset earnings expectations, presents an excellent tactical entry point.

Strategic Recommendations for a Shifting Market

From a tactical perspective, Goldman Sachs expects lagging cyclical stocks, software, consumer, and real estate sectors to play catch-up. To hedge against market volatility stemming from momentum trade unwinding, the firm recommends using its proprietary "ex-AI" index baskets. This allows investors to maintain broad market exposure while mitigating short-term downside risks from crowded trades.

AI and Momentum Face a 'Summer Lull' as Extreme Crowding Poses Risks

Looking back at H1, AI trades were undoubtedly the market's dominant theme. Sectors like US memory chips, new cloud services, AI inference beneficiaries, optical networking, and data centers have delivered returns exceeding 100% since the start of the year. Semiconductor and related supply chain stocks in Asia and Europe have also seen significant gains.

However, Goldman Sachs points out this fervor is facing a reality check. As the Q2 earnings season approaches, the market focus will shift back to fundamentals, leading to increased stock dispersion.

Recently, momentum trades (buying past winners, selling past losers) suffered their worst two-day sell-off since 2022, with consecutive liquidation waves exceeding 5%. This momentum reversal is causing collateral damage to AI trades, with Goldman's AI long-short hedge strategy also recording its worst single-day performance recently.

Over the past two and a half years, the AI sector has experienced multiple periodic pullbacks. Both historical patterns and seasonal factors point to July being a potential "breather" period.

More concerning is the fact that momentum factor exposure within Goldman's Prime Book remains at the 92nd percentile from a five-year perspective. Such extremely crowded positioning means any unwinding could be amplified in its negative impact.

With AI concentration in the S&P 500 exceeding 50% and its weight in European markets doubling from 2023 levels, systemic risks cannot be ignored.

In summary, considering that summer is typically a weak season for US stocks, coupled with the need for broader market participation and high factor volatility, Goldman Sachs believes the AI sector faces risks of further selling pressure in the near term.

While AI surged ahead, many other market segments have languished.

Goldman Sachs identified several underperforming asset classes from H1, such as stocks deemed "vulnerable to AI disruption" (e.g., traditional software stocks in the US, Asia, Japan, and Europe) and the discretionary consumer sector (e.g., European luxury goods, US low-income consumption).

The firm believes the most likely outcome for H2 is a "catch-up rally" in lagging cyclicals, software, consumer, or real estate stocks. This capital rotation would support overall index performance but could be painful for portfolios heavily weighted in momentum-driven tech stocks. Therefore, the core strategy for H2 involves "selective broadening" into sectors where earnings expectations have been sufficiently reset and valuations are attractive.

Healthcare: The Ultimate 'Non-AI' Compounding Machine with M&A Cycle Beginning

Among the various defensive sectors, Goldman Sachs holds high hopes for healthcare, calling it the "ultimate non-AI related compounding machine." This thesis is already materializing, with the broad US healthcare sector, European pharmaceuticals, and global drug discovery data sectors having rebounded significantly from their yearly lows.

Goldman Sachs emphasizes that future outperformance in healthcare will be driven by two core catalysts.

First, structurally growing areas like global bioprocessing, which is not only one of Goldman's highest-conviction healthcare trades but also a tangible beneficiary of AI-driven productivity gains.

Second, the merger and acquisition cycle among large pharmaceutical companies. European pharma valuations are currently trading at about a 10% discount to their historical premium relative to the market. More importantly, large pharma firms possess strong balance sheet capacity and face imminent "patent cliffs," which have already triggered a robust M&A cycle expected to significantly boost sector earnings.

Spotting Opportunity in European Defense

Beyond healthcare, Goldman Sachs has also identified an inflection point in the European defense sector. Defense stocks underperformed in H1, but a recent rebound has caught market attention. Goldman believes this recovery is sustainable because current market positioning in the sector is light, earnings expectations have been reset, and depressed valuations set a very low bar for Q2 earnings. The European defense sector is rebounding from yearly lows and still has about 12% relative upside to catch up with the broader market.

A Nuanced View on AI: Buying the Dips

Regarding AI-related themes, Goldman Sachs is not outright bearish but advocates a "buy the dip" approach. Particularly for US hyperscale cloud service providers, the firm suggests accumulating positions ahead of the earnings season. Recent announcements from Meta regarding its cloud business have already triggered a first wave of gains in the sector, and Goldman expects strong Q2 earnings per share to drive further upside.

Hedging Tools for Increased Volatility

Facing potentially heightened market volatility in H2, Goldman Sachs advises investors to consider short-term tactical hedges. Because AI carries such a heavy weight in the S&P 500, traditional index shorting tools might inadvertently harm "structural winners" with solid long-term fundamentals.

To address this, Goldman Sachs, in collaboration with S&P, launched the SPXXAI (S&P 500 Ex-AI) index and recently introduced a "Europe Ex-AI Basket" for European markets, where AI concentration is also soaring (now double its 2023 index weight).

These tools provide investors with a highly liquid, lower-volatility hedging alternative, enabling them to safely capture the benefits of broadening market breadth while avoiding the downside risks from a correction in crowded tech stocks.