Investors are dumping AI stocks as 'tech wreck' worsens. Here's where they're turning now.

By Isabel Wang and Joseph Adinolfi

A continued selloff in the AI trade is forcing investors to move from tech names to the relative safety of government bonds and defensive stock sectors

Defensive plays are picking up steam.

A sharp selloff in shares of companies closely tied to the AI trade is driving investors toward safety, sparking a rotation into defensive stocks and fueling a surprise rally in hard-hit Treasury notes and bonds.

Treasury yields were slumping across the curve early Thursday as bonds headed for their biggest one-day rally in at least a year. Bond yields move inversely to bond prices, falling as prices rise, and vice versa.

The yield on the 10-year Treasury bond BX:TMUBMUSD10Y at one point was off 14 basis points, to 5.064%, before giving back some losses. The benchmark Treasury yield was on pace for its largest one-day decline in over a year, while the 30-year Treasury rate BX:TMUBMUSD30Y was also sliding 13 basis points, at 5.394%, and on track for its biggest drop since November 2024, according to Dow Jones Market Data.

Bonds continued to rally even after another inflation report showed price pressures picked up last month by an even greater degree than economists had expected. The data boosted the perceived odds of another Federal Reserve interest-rate hike later this month, but bond investors didn't seem to care.

Instead, worries that a slowdown in the AI-investment boom could weigh on economic growth appeared to overshadow the latest inflation data, according to Mike Thompson, co-portfolio manager at Little Harbor Advisors.

"With the AI trade coming acutely under pressure, if your read-through is that slowing AI spending leads to reduced capital expenditure, you can paint a macroeconomic picture where GDP slows dramatically. That allows Treasurys to rally even against a hot CPI print," Thompson said.

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Skepticism about returns on investment on the massive spending on AI by some of the world's largest tech companies is sparking another "tech wreck," as stocks associated with the AI build-out were coming under pressure. Reports about stalled revenue growth at Anthropic have also stoked concerns about the health of the broader AI ecosystem.

"The issue being, if these [AI] models aren't growing revenues, how will they live up to capexcommitments? And will this slow AI adoption rates?" said Brian Mulberry, chief market strategist at Zacks Investment Management.

"The downstream impacts are seen in the semiconductor space immediately today, and the counterbalance is software names are up," Mulberry told MarketWatch on Thursday. The PHLX Semiconductor Index SOX was sliding 2.2%, while the iShares Expanded Tech-Software ETF IGV was rising nearly 1%, according to FactSet data.

In Mulberry's view, this is "clearly a big rotation," but it has not yet reached the level of curbing all bullish momentum.

In addition to buying up Treasurys and software names, investors also appeared to be shifting money into defensive stocks, like those belonging to the consumer staples XX:SP500.30 and healthcare XX:SP500.35 sectors. Both sectors have been among the best performers on the S&P 500 on Wednesday and Thursday.

Thompson pointed out that some bellwether healthcare names, like Eli Lilly (LLY), were trading near their highest levels in a year, a promising sign that healthcare stocks could continue to climb.

Meanwhile, the violence of this week's rally in Treasurys could be due in part to hedge funds and other investors' betting against bonds - something that had become a hot trade as of late.

Data released by the Commodity Futures Trading Commission recently showed that bets against Treasury futures had reached extreme levels relative to history. With sentiment so bearish, the magnitude of this recent snapback rally makes more sense, Thompson told MarketWatch.

How to play it

Back in July, when a powerful semiconductor-led momentum trade endured a major crash, investors rotating into other sectors away from the AI trade limited the damage at the index level.

For investors worried that the pain at the index level might be even more intense this time around, there is still one powerful silver lining: Defensive options bets still look relatively cheap. The Cboe Volatility Index VIX, better known as the VIX or Wall Street's "fear gauge," remained well below its long-term average on Thursday. It stood slightly above 17 in recent trade, compared with a long-term average closer to 20.

Investors can buy calls on the VIX, or put options on the S&P 500, Thompson said. Both would likely pay off if the S&P 500 takes a sudden sharp turn lower.

"Spot VIX sitting around 17.5 doesn't seem particularly high given the level of market turbulence, which means options protection isn't crazy expensive right now," he added.

U.S. stocks were mixed on Thursday afternoon. Strength in defensive stocks helped boost the Dow Jones Industrial Average DJIA, which was rising over 450 points, or 0.9%, as of 12:40 p.m. Eastern time. Meanwhile, the S&P 500 SPX was flat, and the tech-heavy Nasdaq Composite COMP were giving back most of its earlier losses to trade just 0.5% lower, according to FactSet.

-Isabel Wang -Joseph Adinolfi

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10-15-26 1253ET