Rebalancing in a Post-AI Rally: Shifting Exposure to Undervalued Sectors as the Fed Meets in Jackson Hole

The S&P 500's Technology and Communication Services sectors have been the market's darlings in 2025, driven by AI-driven innovation and cloud infrastructure demand. However, as the Federal Reserve prepares for its Jackson Hole symposium and retail earnings season kicks off, investors must reassess their allocations. Overbought conditions in Tech and Communication Services, coupled with undervalued opportunities in Industrials and Energy, present a compelling case for strategic rebalancing.

The Overextended Tech and Communication Services Sectors

The Communication Services Select Sector SPDR Fund (XLC) and the Technology Select Sector SPDR Fund (XLK) have surged to all-time highs, with the XLC trading at a P/E of 19.31 as of August 18, 2025. While this valuation is within the 5-year fair range of [18.83, 23.00], it is -2.00σ below the 1-year average of 20.93, suggesting short-term undervaluation. However, technical indicators tell a different story. Key stocks like T-Mobile US (TMUS) and Verizon (VZ) show RSI levels above 70, signaling overbought conditions. For example, VZ's RSI of 78.225 and TMUS's RSI of 75 indicate potential near-term corrections.

The sector's momentum is also fueled by the “Magnificent Seven” (Mag Seven), whose combined capex is projected to reach $460 billion in 2026. While this drives earnings growth, it also creates a valuation gap with the rest of the S&P 500. The Mag Seven's earnings growth has outpaced the index by a widening margin, raising concerns about sustainability.

Undervalued Opportunities in Industrials and Energy

In contrast, the Energy sector, represented by the Energy Select Sector SPDR Fund (XLE), trades at a P/E of 16.12, which is overvalued compared to its 5-year average of [9.36, 15.82]. Yet, this metric masks deeper value. The sector's long-term trend is bearish, with the XLE trading -2.93% below its 200-day moving average and -1.57% below its 50-day moving average. However, forward return models suggest a 10.66% expected 1-year return with a wide prediction interval of [-32.88%, 54.20%], indicating high volatility but potential for recovery.

The Industrials sector offers even more compelling opportunities. Sub-sectors like Railroads (P/E of 17.86) and Integrated Freight & Logistics (P/E of 19) trade at moderate valuations, while Engineering & Construction (P/E of 33.22) reflects high-growth expectations. The broader Industrials sector benefits from the S&P 500's earnings concentration in large-cap firms, with the top 50 stocks contributing 69.2% of total index earnings growth. This suggests that industrials with significant market cap presence, such as Caterpillar (CAT) or Union Pacific (UNP), could outperform as infrastructure spending and supply chain normalization drive demand.

The Fed's Role and Retail Earnings Season

The Federal Reserve's Jackson Hole meeting in late August will be pivotal. With inflation at 2.7% and rate cuts expected in September, lower borrowing costs could stimulate industrial and energy projects. Energy firms, in particular, may benefit from reduced financing costs for exploration and production. Meanwhile, retail earnings season, which begins in late August, could introduce volatility in consumer discretionary sectors, further incentivizing a shift to defensive and cyclical plays like Industrials.

Strategic Rebalancing: A Data-Driven Approach

Investors should consider reducing exposure to overbought Tech and Communication Services stocks and increasing allocations to undervalued sectors. For example:
- Energy: Target XLE or individual names like Chevron (CVX) and ExxonMobil (XOM), which trade at P/E ratios below their 5-year averages.
- Industrials: Focus on sub-sectors with strong forward earnings growth, such as Railroads (UNP) and Freight & Logistics (CSCO).

Risk Management in a Volatile Environment

Diversification remains key. While shifting to Industrials and Energy, investors should maintain a portion of their portfolio in high-growth Tech stocks, hedging with short-term options or inverse ETFs to mitigate potential corrections. The overbought RSI levels in Tech suggest a consolidation phase, but AI-driven demand is unlikely to wane entirely.

Conclusion

The post-AI rally has left Tech and Communication Services sectors vulnerable to near-term corrections, while Industrials and Energy offer attractive entry points. As the Fed navigates rate cuts and retail earnings season unfolds, rebalancing toward undervalued sectors can enhance risk-adjusted returns. Investors who act now may position themselves to capitalize on the next phase of the market cycle.