Worried About a Stock Market Bubble? Here Are 5 Ways to Stay Invested

Are you worried about a US stock market bubble? Join the club. Oceans of digital ink have been spilled, including by me, about a pricey, top-heavy, tech-heavy stock market. The bears can be convincing. Parallels between today’s artificial intelligence-dependent market and the technology, media, and telecom bubble of the late 1990s are undeniably striking.

At the same time, most investors know that market timing is a fool’s errand. Smart folks have been calling stocks “expensive” for years, but sitting out would have cost you big time. The market may continue defying doubters by posting spectacular gains. AI might live up to its hype. And even if there’s a bubble, what if we’re in 1996, not 1999?

One sensible response to uncertainty is to diversify. Owning bonds, international stocks, and other assets can mitigate portfolio losses if a US stock bubble bursts. But even within your US equity allocation, there are options. For nervous investors who still want to participate in the US stock market, here are five alternatives that—to varying degrees—decrease dependence on the pricey technology stocks that dominate the market. Granted, all of these strategies have underperformed in recent years. But they could look better if conditions change.

Strategy 1: Own the Total Market, Not Just the Top

Many investors get their US equity exposure through a fund tracking a popular 500-stock index maintained by a Morningstar competitor. More than $10 trillion globally sits in funds benchmarked to it, according to asset flows data. It’s so ubiquitous that some think there are only 500 US stocks.

The Morningstar US Target Market Exposure Index, which represents the top 85% of stock market value, is a very similar benchmark. Like its more well-known counterpart, it weights constituents by market capitalization, so in proportion to their value. It also adjusts by free float—or what’s investable. Neither index is confined to a single stock exchange.

Then there’s the Morningstar US Total Market Index, which targets the entire investable universe for US stocks. It currently includes 3,450 constituents, compared with 465 for the Morningstar US Target Market Exposure Index. Here’s how the two indexes compare on other parameters:

Owning the total stock market instead of just the higher end doesn’t dramatically change your exposures, but it has some effect. You get less concentration, less technology, and lower average prices when you add in small caps. The muted impact of adding thousands of smaller stocks speaks to just how large the largest stocks have become. To give you a sense, the combined market value of the two largest US stocks—Nvidia NVDA ($5.2 trillion) and Apple AAPL ($4.6 trillion)—exceeds the entire US small-cap universe.

Strategy 2: Tilt Toward Value Stocks

Now let’s transition from defining the market differently to taking bets against the market. Value investing is for the bargain-hunters out there. Its premise is that certain stocks underpromise but overdeliver.

Long popular with active managers, value investing is also backed by academic research. Historically, stocks trading at low multiples relative to fundamental measures like earnings or sales have outperformed. This could be compensation for risk, or because low expectations are an advantage.

The Morningstar US Large Cap Value Index includes reasonably priced stocks at the higher end of the US stock market. “Reasonably priced” is defined by comparing a range of fundamentals—like earnings and book value—relative to share price. Here’s how the value index, which currently includes 306 constituents, compares with the top of the market:

The value side of the market looks very different from the overall market. By definition, it’s much cheaper. Less exposure to technology stocks helps explain that. The value index also skews toward smaller stocks and is far less concentrated.

Strategy 3: Invest for Dividends

Always popular with income investors, dividends also represent a significant chunk of equities’ long-term total return. Plus, dividend payers boast a strong track record. The fact that they tend to land on the value side of the market may have provided a boost. Screening for dividend payers is also a way to weed out speculative stocks. Then there’s the theory that committing to a dividend instills discipline. Corporate managers must steward cash prudently to deliver regular payouts.

Let’s look at two indexes: Morningstar US High Dividend Yield and Morningstar US Dividend Growth. The former focuses on the higher-yielding half of the US stock market, the latter on companies increasing their payouts. Higher yielders tend to be more mature companies whose shares carry low prices. A growing dividend can signal improving fortunes.

Both dividend indexes have a smaller stock orientation than the broad US market and are lower priced. Both are less concentrated by stock and sector than the market. Notably, the technology sector is de-emphasized by dividend-focused portfolios.

Strategy 4: Equal Weight Your Stocks

There’s intuitive appeal in offering each portfolio holding the same opportunity to influence returns. Unlike with market-cap weighting, an equal-weighted basket prevents top stocks from dominating. Plus, the discipline of buying low and selling high is built into the strategy. Rebalancing back to equal weight ensures that winners are trimmed, with capital reallocated to underperformers.

The portfolio’s equal weighting also has the effect of tilting it not just toward value stocks but toward smaller ones as well. That same academic research cited above showed a performance advantage for smaller stocks. Here’s how the Morningstar US Target Market Exposure Equal Weight Index compares with its market-cap-weighted counterpart.

As you’d expect, the equal-weighted index skews toward much smaller stocks. It also reduces concentration, both by stock and sector. Finally, equal weighting brings down portfolio-level valuation.

Strategy 5: Go Active

In a different era, this would have been the obvious choice. Hiring a professional stock-picker to identify winners and sidestep losers is highly appealing in theory.

In practice, not so much. The vast majority of active managers fail to beat the market. According to the Morningstar Active/Passive Barometer report, over the past 15 years, only 3.2% of active fund mutual funds in the US large-blend

have survived and beaten their passive counterparts, most of which track the 500-stock index. Whether that’s because the market is efficient, competitive, or somehow distorted is a matter of much debate.

Morningstar’s manager research team does single out some active managers believed capable of adding value. Strategies rated Gold, Silver, and Bronze hold the potential to outperform on a risk-adjusted basis, in our analysts’ view. A long-term perspective is key, though. So too is understanding the investment approach. Some active strategies take on even more risk than their benchmarks.

Let’s Talk Performance

To be fair to active managers, none of the index-based approaches have outperformed the top end of the market lately either. The total market index comes closest to the Morningstar US Target Market Exposure Index; that’s not surprising given that it deviates the least. The high-dividend index has posted the worst returns over the past 15 years.

What conditions would turn the performance tides? Smaller stocks outperforming large, value beating growth, and a technology sector slump would all boost the strategies described above.

For a historical example of such a market environment, look to the first decade of this millennium. From 2000 through 2009, small caps and value stocks beat large-cap growth. It was a major departure from the late 1990s technology bubble.

Of course, the only guarantee when taking a bet against the market is that your performance will deviate. That could mean beating the market; it could mean lagging. What’s most important, history shows, is being in the market for the long term.