By Lewis Braham

Like snowflakes, every stock market bubble is unique. But historically, there have been two kinds of crashes when a bubble pops. One hits a particular sector especially hard, as in the 2000-02 dot-com collapse. The other is systemic, where everything goes down, as in the 2008-09 financial crisis.

While artificial-intelligence stocks have recently taken some lumps, many are still highly priced, so much so that many investors still see a bubble. Other sectors are catching up, and some fear that the entire market is in treacherous territory.

Some $3 trillion is now invested in the three largest S&P 500 index funds, with trillions more in similarly run funds. The S&P 500 currently has a hefty 35% tech weighting, but even that understates the AI-related concentration, as the benchmark categorizes Google parent Alphabet and Facebook parent Meta Platforms as part of the "communication services" sector, and Tesla and Amazon.com as "consumer cyclicals." Meanwhile, the index's biggest stocks are almost all AI-related.

Brian Kersmanc, a portfolio manager at GQG Partners, co-wrote a recent report titled "Dotcom on Steroids," which explained why the firm thinks the market's AI frenzy is worse than the dot-com bubble. "The trifecta of rich valuations, increasing macro risk, and -- perhaps most importantly -- deteriorating company fundamentals is very dangerous," the authors wrote.

As recently as December 2023, Kersmanc and the rest of GQG team -- which oversees $167 billion -- were bullish on U.S. tech, with the sector's current darlings constituting some 38% of their popular $3 billion GQG Partners US Select Quality Equity fund. Today, the same fund holds 2.6% in tech and 23% in regulated utilities.

If the GQG team is right, investors need to find ways of diversifying their portfolios to protect themselves. But even if it isn't, investing in funds that aren't exposed to the AI trade can still be profitable as the rally continues.

Rebalancing

The concentration in index funds worries experts, but that doesn't mean investors should dump them. "If you look at anything exposed to AI, it's about half of the market, and the Magnificent Seven [stocks] are about 35% of the S&P," says Jurrien Timmer, director of global macro at Fidelity Investments. "That's one of the most concentrated [index portfolios] in history, although we've had periods, especially in the 1950s and '60s, when that concentration persisted for a very long time without an adverse outcome. So, it's very hard to time these things. You can't just say, 'I need to get out of this space,' because it can remain concentrated."

The Bonds Buffer

Yet even as the S&P 500 surged 96% in the past five years, the popular Bloomberg U.S. Aggregate Bond Index lost 2%. Normal rebalancing helps diversification. If you have a traditional 60% stock/40% bond portfolio, reducing some of your S&P 500 position to buy a fund like the iShares Core U.S. Aggregate Bond ETF could help protect you in a down stock market.

Bonds didn't work as diversifiers in 2022's inflationary downturn, but that was a different time. Interest rates at 2022's start were close to zero, as were bond yields. "The starting yields in actively managed diversified [bond] portfolios are about 6% now," says Mohit Mittal, Pimco's chief investment officer of core strategies and a manager of the Pimco Total Return fund. "The yield is a strong indicator of forward-looking returns."

Mittal points out that the S&P 500's Shiller price/earnings ratio -- a valuation based on inflation-adjusted earnings -- is now 40. "Historically, if you look at the data from the 1900s to now, there have been four episodes when we have had [valuations] this high," he says. "Then, when you look at the subsequent three- to five-year returns with these starting valuations, they've ranged from, at the very worst, a Depression-era type period of -15% to -17% annualized, to even in the best case, 4% to 5% annualized." Given Mittal's 6% starting point for bond yields, high-quality bonds look attractive.

There are caveats. Bonds don't do well when investors are worried about sudden inflation spikes, as they were this past April. Almost everything declined then, including bonds.

A 2008-style credit crisis would also mean trouble. One of the reasons Kersmanc fears that the AI bubble could cause a systemic crash is that previously high-quality tech companies are now issuing a lot of debt to finance their data centers. Worse, some are using opaque, off-balance-sheet "special purpose vehicles" to house the newly issued debt without affecting their credit ratings. Such SPVs were instrumental in causing the 2008 crash.

Given that index funds don't exclude bonds with such off-balance-sheet deals, it's safer to buy actively managed bond funds today.

Foreign Correlation

Timmer calls international stocks "the low-hanging fruit of diversification" because of overseas markets' lower valuations and correlations to U.S. stocks. But there can be risks of AI irrational

exuberance overseas, too, making sectors worldwide move in tandem.   In Kersmanc's largest charge, Goldman Sachs GQG Partners International Opportunities, he has been trying to sidestep those sector risks. 

One way to find good diversifiers is to look at a fund's correlation to the S&P 500, as measured by its R2 score, which calculates the percentage of an investment's movements that mirror changes in its benchmark index. Another is to look for lower-than-average weightings in the major AI sectors -- tech, communication services, and consumer cyclicals. Next, see how the fund has performed both in down markets and overall. The Portfolio Visualizer website allows you to enter funds' ticker symbols and see how correlated they are over different time periods.

Consider Moerus Worldwide Value. It has 0% invested in technology and communication services, a low average P/E ratio of 12, strong returns, and little correlation with the S&P 500. Over the past three years, the fund had an R2 of 0.64, indicating a 64% correlation with the iShares Core S&P 500 ETF, low for an equity fund. Moerus was up 6% in 2022 when the iShares ETF was down 18%.

Moerus manager Amit Wadhwaney looks for cheap companies that often have imminent payoffs via restructuring, dividends, or share buybacks. Such companies are typically the polar opposite of AI stocks, which are valued on "long-dated payoffs, which, in my mind, are largely conjectural," he says. "We look at very different stocks in different geographies from most people."

There are individual countries' markets that are less correlated to the U.S., and smaller companies tend to move less in step with global markets. The WisdomTree Japan SmallCap Dividend ETF has a 49% three-year correlation with the S&P 500 versus the large-cap iShares MSCI Japan ETF's 73%, and it has actually been a better performer in downturns like 2022's.

Historically, emerging markets have reacted more harshly to U.S. downturns than developed ones, but the risks may not be as great today. "I don't think anybody should kid themselves that emerging markets are a safe haven asset now, but I think that going forward, they are much less volatile than they used to be," says manager Paul Espinosa of the top-performing Seafarer Overseas Value fund. One reason he cites is that many countries' monetary and fiscal policies are more disciplined than they were in the past -- and low valuations also help. (For more on emerging markets, see the Funds column here.)

Value Stocks

Timmer says buying U.S. value stocks now is like shorting or betting against the Magnificent Seven. Lately, when the S&P 500 has declined, value stocks, and especially dividend-paying value stocks, have fallen less but then trailed when the market has rallied.

One example is the popular Schwab US Dividend Equity ETF, which was up a mere 4.5% in 2025. In the past 12 months, the Schwab ETF's correlation with the S&P 500 ETF has been a low 26%, when over the past three years, it's a much higher 66%.

Dividend-oriented managers have noticed this disparity. "When you start with a portfolio with a 3.5% or 4.5% dividend yield, and you're looking for sustainable, defensive dividend growth, you're going to end up with a portfolio that, from a sector perspective, almost looks like a photo negative of the S&P 500," says Jared Hoff, who manages the Federated Hermes Strategic Value Dividend fund. The fund requires such high dividend yields that it has 0% in tech, but double-digit-size holdings in utilities, healthcare, energy, financial services, and consumer defensive stocks.

Hoff's fund has paid the price for this divergence -- it lags behind the S&P 500 and other value funds. But it's an excellent diversifier, having gained 8.1% in the brutal 2022 market, and it was up 15.3% in 2025. It's also worth considering the Schwab ETF or the Federated Hermes U.S. Strategic Dividend ETF.

Alternatives

Gold bullion is a classic alternative investment, but isn't cheap after surging in 2025. A diversified commodity futures fund like AQR Risk-Balanced Commodities Strategy or USCF SummerHaven Dynamic Commodity Strategy No K-1 might be a better bet. "If you look at the commodity charts right now, and how low oil prices are and how strong copper prices are, I think there's a case to be made that the broader commodity complex is going to take the lead," Timmer says. "Commodities are negatively correlated, or uncorrelated, to both stocks and bonds," making a commodity fund a "perfect diversifier."

There are also funds designed to replicate hedge funds that are uncorrelated to the broad market. But the strategies can be opaque and often depend on leverage for their execution, so trust in management is essential. The two most well-known shops in the public alt-fund space are BlackRock and AQR.

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January 08, 2026 01:00 ET (06:00 GMT)

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