Five ways to navigate the AI revolution and market pullbacks

FEW trends have captured the imagination of investors as quickly and fully as artificial intelligence (AI).

ChatGPT’s launch in late 2022 fuelled an enthusiasm for AI like no other, driving an estimated US$4 trillion surge in the value of global equities, according to our estimates. That’s equivalent to roughly the annual output of Japan – the world’s third-largest economy.

The top beneficiaries of the AI trend are now trading at around 25 times the 12-month forward earnings estimates versus around 18 times for global stocks, while the overall tech sector is trading at a near 32 per cent premium to its 10-year average.

For example, chipmaker Nvidia rallied 80 per cent in the first three months of 2024 to become the first US$2 trillion AI company by market capitalisation. Stalwart tech giants, including Microsoft and Dell, have also gained fresh momentum.

Even after an April setback – which we expect to be short-lived – this has been a remarkable rally.

Despite this, few investors see this as a bubble or doubt the wisdom of ensuring a long-term exposure to AI-related stocks.

This confidence is justified, in my view, by the speed with which the technology is being commercialised and by its potential to accelerate earnings growth across a wide range of industries.

But, while the importance of having AI exposure is not disputed, many of our clients grapple with how to best position for AI’s next wave of developments. No single answer fits all, especially since investors are at different stages in their AI investment journey.

Early adopters have reaped substantial rewards from the AI rally, and now face the question of how to protect their gains while still maintaining exposure to future growth.

Meanwhile, many who watched from the sidelines – often with a mix of awe and envy – are now questioning whether it’s too late to buy.

Here are five strategies for investors looking to navigate the AI market today and the next stage of revolution:

Protect against market jitters

Even a megatrend as favourable as AI can suffer reversals and sudden changes in individual firms’ ability to capitalise on the trend.

This has been underlined by April’s tech pullback, which has taken the Nasdaq Composite about 7 per cent down from its all-time high in March and led to the Magnificent Seven’s dispersed performance, at the time of writing.

Such volatility underlines the potential appeal of capital-preservation strategies. These strategies can limit losses from any market retreats while allowing investors to continue benefiting from further share-price gains.

Moreover, such strategies are most attractive at times of high interest rates, such as now.

Capital-preservation strategies also allow investors who have benefited from the AI rally to secure some gains without selling out. They can help investors who remain underinvested to strengthen their foothold with less risk.

The US is not the only game in town

When it comes to AI, the Magnificent Seven – America’s top growth and tech firms – have gained much attention worldwide. However, AI’s wave is not confined to the United States alone.

Asia’s “Super Eight” – a group of Asia’s top tech firms including TSMC, Samsung Electronics, and Baidu – are also making substantial strides in AI.

While these eight Asian leaders have performed well, they have lagged the Magnificent Seven and trade on less-demanding valuations. Investing in the Super Eight helps investors to diversify away from the Magnificent Seven, lower their exposure to demanding valuations, and tap into AI’s growth on a global scale.

Buy when others sell

Investors bullish on AI’s long-term prospects but nervous about current valuations might plan to buy a stock if its price drops. However, “buying the dips” can be easier said than done.

Since dips often occur following negative news – whether this is a setback for a leading firm, a rise in interest rates, or souring sentiment – investors often lose their nerve and delay buying indefinitely.

That is where systematic approaches, which typically involve selling out-of-the-money put options on favoured long-term plays, can help. Such an approach can allow investors to get “paid to wait” to potentially buy long-term winners at lower prices than today.

Generate income from AI stocks

This approach can work for investors who have a high degree of confidence in the AI theme but want to reduce the volatility from owning individual stocks.

Investors can earn income by selling out-of-the-money call options on AI-related equities they hold. If the stock falls or fails to rally to the strike price, investors will earn the option premium. If the stock rises beyond the strike price, investors have given up only part of their gains.

The relatively high volatility of AI-related shares means that it is possible to earn generous premiums, and our research shows that employing a systematic approach to option selling can improve long-term portfolio risk-return characteristics.

Do not put too many eggs in one basket

Outside of the options and derivatives universe, many investors are also asking simpler questions around diversification.

AI gains have been highly concentrated. Around 75 per cent of the gains have so far been captured by the top 10 firms.

But investing in AI doesn’t have to be limited to the biggest names. Investors can gain exposure to a broader range of companies that stand to benefit from the AI revolution, including those in ancillary services or industries that AI is set to transform.

This approach is relevant for investors looking for growth opportunities beyond the most prominent AI players.

Ultimately, AI is a compelling trend that continues to hold great potential for investors. However, investors should start considering strategies that go beyond owning the Magnificent Seven outright to position themselves for the AI revolution’s next stage.

With careful planning and strategic execution, the AI wave can be a powerful driver of portfolio growth.

The writer is head of UBS Global Wealth Management Unified Global Markets