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The past few years have been a bonanza for stock market investors, with the benchmark S&P 500 index (SNPINDEX: ^GSPC) soaring by roughly 26% in 2023, 25% in 2024, and 18% in 2025. The final tally for 2026 remains to be seen, but it looks increasingly clear that market sentiment is cooling, and we could potentially be on track for a bear market in 2027.
The biggest challenge is uncertainty about the sustainability of generative AI-related capital spending in the economy. The changing US political climate could add new risks from more regulation on data center construction and new energy projects. Let's discuss three ways investors can protect their portfolios in this increasingly uncertain stock market.
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The stock market is more concentrated than ever before, with America's top five tech giants (Apple, Nvidia, Microsoft, Amazon, and Alphabet) representing an eye-popping 30% of the entire S&P 500. This situation is dangerous because it means the index no longer offers a high level of diversification, and any decline in these stocks will have a huge impact on the index's overall return. There are big reasons to be worried.
With the exception of Apple, all five of these companies have gone all-in on AI technology, developing their own large language models (LLMs) and spending hundreds of billions to acquire the hardware needed to run and train these algorithms for major clients like OpenAI and Anthropic.
A recent study published by the WSJ suggests that the level of spending is so high that American businesses and consumers will have to spend the equivalent of 8.8% of the country's annual gross domestic product (GDP) on AI-related products and services by 2032 to make it worth it. This seems extremely unlikely, considering that it's more than energy spending and almost as much as the amount spent on food.
Furthermore, open-source models and low-cost Chinese rivals are rapidly gaining ground on their expensive American rivals, introducing the risk of margin-eroding competition that limits revenue and profit potential.
Increasing portfolio diversification is key to coming out ahead if the potential AI bubble bursts. And thankfully, there are a lot of options investors can choose from. We can look at the example of Warren Buffett for some ideas. The investing legend's Berkshire Hathaway portfolio currently holds a record 'cash' position of $365.5 billion, mostly in highly liquid securities like short-term Treasury bonds.
These assets offer a compelling risk-free yield of over 4%, which can make them a good alternative to risky stocks. Plus, they allow investors to quickly respond to opportunities in the market if stocks get cheaper over the next few months.
Investors can also look at more 'boring' and recession-resistant areas in the market like tobacco and consumer-essentials-focused real estate investment trusts (REITs), which also tend to offer good yields while being far less exposed to a potential slowdown in AI-related spending.
The stock market has a long track record of booms and busts, but over the long term it always bounces back. That's why time spent in the market tends to beat trying to time the market. The influence of government stimulus packages and the Federal Reserve's countercyclical policies (such as lowering interest rates or quantitative easing) also help to ensure that downturns are less extreme and briefer than ever before.
We can look to the example of the recent COVID-19 crash, which sent the S&P 500 down by roughly 18% in 2022, only to be followed by a rebound of 26% in 2023. I don't expect a bursting of the AI bubble to be much different. Investors should keep a long-term perspective and be ready to quickly react to any deals that show up in the coming years.
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Will Ebiefung has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Berkshire Hathaway, Microsoft, and Nvidia. The Motley Fool has a disclosure policy.
Prediction: A Bear Market Is Coming: 3 Ways to Stay Ahead was originally published by The Motley Fool
