S&P 500 echoes 2021 setup as AI adoption fuels quality pivot

The S&P 500 is mirroring its 2021 configuration as investors rotate into high-quality megacap stocks on accelerating AI adoption, Morgan Stanley said.

"The broadening we've been expecting is now underway, with capital rotating away from pure AI infrastructure plays into sectors where earnings revisions are strongest," Michael Wilson, chief equity strategist at Morgan Stanley, said in a note.

Consumer discretionary and transportation stocks have outpaced the S&P 500 by 12% over the past two months, Wilson wrote. The Invesco S&P 500 Equal Weight ETF has risen 11% year-to-date through July 20, surpassing the S&P 500's 9% gain over the same period.

Wilson maintained Morgan Stanley's year-end S&P 500 target of 8,000, implying about 7% upside from recent levels, though he said a pullback to 7,000 is possible if selling pressure in high-flying AI stocks broadens into other sectors.

The rotation comes as the momentum trade — buying recent winners — has unraveled sharply. The iShares MSCI USA Momentum Factor ETF declined 12% from the start of July through July 20, while the S&P 500 was roughly flat. Volatility in momentum stocks has surged to the highest level of its 45-year history outside recession years, according to Goldman Sachs.

"Painful volatility in popular AI infrastructure stocks has renewed investor interest in investment themes outside of AI," Goldman's Ben Snider wrote in a July 18 report.

The 2021 parallel is significant for positioning. That year, the S&P 500 rallied 27% as the economy reopened and earnings growth accelerated. The current setup shares similarities in broadening market participation and sector rotation, though the catalyst this time is AI adoption rather than post-pandemic recovery.

Momentum unwind creates opportunity

The selloff in trendy AI and chip stocks has raised concerns about a broader market correction. Goldman Sachs cautioned that "history, positioning, and lack of a favorable catalyst point to continued near-term challenges" for the AI infrastructure momentum trade.

But Morgan Stanley sees the rotation as healthy for the overall market. The equal-weight S&P 500's outperformance relative to the market-cap-weighted index signals that gains are spreading beyond the largest technology companies — a dynamic that historically supports sustained bull markets. Wilson said the firm's 8,000 target remains "very achievable" even if the index temporarily dips to 7,000.

The broadening trend is also visible in sector performance. Beyond consumer discretionary and transports, areas where Wall Street firms are raising earnings-per-share estimates most sharply have attracted renewed investor interest, Wilson noted. The shift suggests the bull market is entering a new phase where gains are driven by earnings growth across a wider range of industries rather than multiple expansion in a handful of AI-related names.

For investors, the key question is whether the rotation has further to run. The momentum factor has erased all gains since late April, according to Goldman Sachs, suggesting the unwind may be nearing completion. If capital continues to flow into lagging sectors, the S&P 500 could sustain its upward trajectory even as AI infrastructure stocks consolidate.

This article is for informational purposes only and does not constitute investment advice.