Author: Jim Paulsen
Compiled by Deep潮 TechFlow
DeepInsight Summary: The weight of defensive stocks in the S&P 500 has fallen to 17%, nearing historic lows—what does this mean? Veteran strategist Jim Paulsen, using over 60 years of data, reveals: whenever investors toss “risk aversion” out the window, the market is often approaching trouble. If your portfolio is heavily weighted in AI and tech stocks, this article is worth reading carefully.
Sometimes in the stock market, investors cluster around a common theme or simultaneously avoid a key sector. This “herd” behavior often provides important information that shouldn’t be ignored—but doesn’t necessarily mean you should follow it. This may be one of those moments.
For much of this bull market, investment “herds” have flooded into next-generation stocks and achieved tremendous success. This bull market has been consistently fueled by several standout sectors, including Mag7, quantum computing, hyperscale computing, artificial intelligence, microcaps, IPOs, and cryptocurrencies. Amid all this excitement, investors have increasingly let their portfolio’s risk aversion fade—understandably so.
Chart 1 shows that defensive stocks have underperformed throughout the current bull market and have consistently lagged behind the broader market for much of the past decade. Chart 2 indicates that risk aversion within the S&P 500 is gradually fading. The market capitalization weight of defensive stocks within the S&P 500 has now declined to approximately 17% of total market cap—near historical lows and roughly half the peak levels seen in the early 1990s and at the 2009 market bottom, when defensive stocks accounted for nearly 36% of the overall market. No one knows how long the current tech boom will last, or how much higher the market will rise under the leadership of these new-era stocks. No one knows!
Nevertheless, it is becoming increasingly clear that the S&P 500—and likely most portfolios—are becoming riskier. With “defensive” sectors now accounting for such a small share of market capitalization, market volatility is expected to intensify over the remainder of this bull cycle. Relying solely on high-octane growth without a defensive buffer may still succeed, but it will likely be far more nerve-wracking. Additionally, as risk aversion continues to fade, the likelihood of disappointing outcomes is increasing.
Stock market risk aversion
A good indicator of market risk aversion may be the relative performance of low-beta stocks versus high-beta stocks. Figure 3 shows the total return performance of the lowest quintile of price beta stocks relative to the highest quintile of price beta stocks since 1963. The data comes from the Kenneth R. French database and includes all U.S. stocks listed on the NYSE, NASDAQ, and the American Stock Exchange.
Over the past nearly 65 years, the performance gap between the most defensive and the most aggressive stocks has been substantial. The relative total return index between low-beta and high-beta stocks has ranged from approximately 0.4 to 2.7. Periods of extreme investor defensiveness are indicated by the highest relative values, while extreme bullishness (or lack of defensiveness) is signaled by the lowest relative readings.
The dates shown on the chart clearly indicate that the degree of defense is closely linked to future risks in the broader stock market. The primary peaks in relative performance of low-beta versus high-beta stocks (highlighted in green on the chart)—typically characterized by excessive pessimism and caution driving outperformance of the most defensive stocks—often represent excellent buying opportunities. For example, buying the market in July 1963 followed the sell-off during the Cuban Missile Crisis; from July 1963 to the 1968 peak of the S&P 500, the market rose nearly 60%! December 1974 marked the bottom for the Nifty Fifty, October 1990 signaled the “beginning” of the massive bull market of the 1990s, September 2002 marked the bottom of the dot-com bubble bear market, November 2008 was just months before the Great Recession bear market trough in early 2009, March 2020 was the pandemic bear market low, and finally, December 2022 was very close to the 2022 bear market low.
The major troughs of this relative total return index—when low-beta stocks significantly underperform high-beta stocks over a period—typically indicate widespread market optimism and very low defensiveness (as shown by the red dates in Chart 3). Historically, these periods have signaled times when investors should exercise caution when investing in the stock market. November 1968 preceded the start of the 1969–70 bear market; April 1972 was months before the beginning of the Nifty Fifty crash; April 1981 marked the start of the bear market following Volcker’s tightening; February 2000 precisely coincided with the peak of the dot-com bubble bull market; and October 2021 was just weeks before the start of the 2022 bear market.
Last October, this defensive indicator approached its lowest level since 1963. Although the S&P 500 did experience a nearly 10% correction earlier this year—touching a bottom in March—it has since rebounded to new all-time highs. Nevertheless, the relative performance of low versus high beta stocks in the U.S. market remains severely weak, continuing to signal potential challenges for the broader market in the coming months.
The red dashed line represents the fifth percentile of this indicator since 1963. As shown in the chart, when the low/high beta relative index is at its fifth percentile, the S&P 500’s average annualized total return over the following month is only 7% (below the average), compared to an average future annualized return of 13.4% at other times. In other words, historically, when defensive sentiment is at its fifth percentile, the S&P 500’s average annualized total return over the next month is roughly half of what the market typically delivers. When defensive sentiment fades, investors are best advised to proceed with caution.
Chart 4 illustrates this more clearly, showing the past three years’ growth of low/high price beta relative to the total return index (i.e., the past three years’ growth of the series shown in Chart 3). While the level of low/high beta relative performance is important for future stock market returns, the extent of sustained underperformance is also critical. Today, not only are the relative total returns of low/high beta stocks near historical lows, but low-beta stocks have significantly underperformed for at least the past three years. As shown in Chart 4, historically, whenever the past three years’ relative total return of low/high beta stocks fell within the lowest quintile since 1963 (i.e., below the red dashed line, indicating severe and persistent relative underperformance of low-beta stocks, as is currently the case), the subsequent one-month average annualized S&P 500 total return has been remarkably weak at just 3.62%, compared to an average annualized total return of 14.4% during all other periods. Although low-beta stocks have underperformed, the sheer magnitude and duration of their recent underperformance—suggesting investors have abandoned caution—implies that the S&P 500 may face a difficult path in the coming months. Historically, when this caution signal has flashed red, as it does today, the subsequent one-month average annualized S&P 500 total return has been nearly four times lower than during all other periods since 1963.
Consider overweighting broad market assets
Although overall market downturns may affect all stocks, I suspect any selling pressure will be concentrated in highly popular (high-beta) new-era stock sectors. Therefore, rebalancing your portfolio by reducing exposure to these overweighted sectors and increasing allocations to broader market assets—such as small-cap stocks, value stocks, defensive and cyclical sectors, and international equities—could outperform the broader S&P 500 for the remainder of this year.
Chart 5 shows the relative total return index of a broad stock market proxy since 1950. Several points are noteworthy. First, since around 2011, the broader market has largely underperformed the overall S&P 500 index—similar to its prolonged underperformance between 1983 and the late 1990s. In fact, since 2011, the relative total return of the broad market has declined from the top quintile to the bottom quintile. Using its relative total return index as a guide to attractiveness, it has shifted from being heavily overweight and overhyped in 2011 to being significantly underweight and undervalued today.
Second, historically, the relative performance of broad market assets has often experienced “long-term” cycles. It significantly outperformed from 1958 to 1969, underperformed from 1969 to 1975, then nearly decade-long outperformance from 1975 to nearly 1984, followed by nearly 15 years of underperformance from 1985 to 2000, another decade of outperformance before 2010, and mostly underperformance over the past 15 years. Long-lasting cycles of relative performance are not uncommon. Importantly, if the relative performance low reached last October holds, this current period of underperformance for broad market stocks would rank as one of the longest such periods since World War II. The recent era of broad market underperformance has been both lengthy and significant, and most importantly, a reversal appears long overdue.
Third, since October 2025, broad market indices have once again outperformed the overall stock market—the first time this has occurred during this bull market. Interestingly, while most investors still focus on AI and other “tech stocks” leading the market rally, broad market indices have quietly outperformed the broader market by one of the largest margins in the past 15 years.
Finally, as shown in Chart 5, since 1950, when the broad market total return index has been in the lowest two quintiles (as it is today), the broad market asset has on average outperformed the overall S&P 500 by 1.53% to 2.81% annualized over the subsequent one month. If the broad market asset has finally turned a corner, it may continue to outperform the overall S&P 500 for some time.
Final comment
I’m concerned that the “defensive” mindset in the U.S. stock market seems to have disappeared. Most investors remain more worried about missing the next phase of this new-era bull market—now allegedly led by AI stocks—than about facing any significant market downturn.
Investors may soon face a temporary “gut check,” led by New Era stocks but not necessarily limited to them. My guess is that even if New Era stocks do correct by more than 20%, a bear market will be avoided. I am not suggesting that investors should sell all technology stocks. I do not expect the upcoming potential volatility to replicate the dot-com bubble burst. However, I would tilt my overall portfolio toward an underweight position in New Era stocks and increase exposure to “broad market benchmarks.” Given that broad market benchmarks have outperformed the broader market since last October, even if New Era stocks and the overall market continue to rise over the coming months, reducing exposure to New Era stocks may still benefit your overall relative performance.
Thank you for reading! Jimp
Any financial instruments mentioned in this document are speculative in nature and may involve risks to both principal and interest. Any prices or levels presented are historical or purely indicative data. This material does not take into account the specific investment objectives, financial situation, goals, or needs of any particular investor and does not constitute a recommendation to buy, sell, or hold any specific security, investment product, or other financial instrument or strategy. The securities, investment products, other financial instruments, or strategies discussed herein may not be suitable for all investors. Recipients of this report must make independent decisions regarding any security, investment product, or other financial instrument.
Leave a comment