Worried About the Market? 5 Big Risks and How to Hedge Them.

(Illustration by Wesley Allsbrook)

As the market hits new highs, some investors are losing faith. What to do to ease your fears.

Sports fans know well the feeling of cautious exuberance. It’s the paradoxical sensation of cheering your beloved team as it pulls ahead of its rival, while growing increasingly worried that it might ultimately lose the match.

As the current market rally approaches its third anniversary this month, investors know this feeling, too. They’ve celebrated as the S&P 500 notched more than 30 record highs this year and added more than $11 trillion in value since its early April swoon, even as they grow increasingly concerned about a possible crash.

The rally is becoming more difficult to believe in. Some common laments: Yes, stocks are some 85% higher from their October 2022 lows, but that is only because the eye-watering gains of the biggest tech stocks are dragging the market along. Sure, the rally is heading into its fourth year, but that is only because the Federal Reserve is ignoring inflation risks and cutting interest rates. Yeah, the economy is remarkably resilient, but that is largely the result of massive tax cuts and government spending that is adding billions of dollars in new debt.

So far, bearish investors have lost out. But at this toppy moment, considering strategies that can protect against worst-case scenarios makes sense—in part because they can help you stay in the game. Here are five of the market’s biggest fears heading into the final months of the year, and tactics for each one that can protect your portfolio.

Fear No. 1: The U.S. Deficit Will Spark a Bond Market Blow-Up

With the overall U.S. debt level topping $37 trillion, the highest on record, and careening at a pace that will take it to $50 trillion by the middle of the next decade, investors are starting to question whether dictum meum pactum (“my word is my bond”) is truly the case when it comes to U.S. Treasury bonds.

If investors demand a higher return for holding longer-dated bonds, that will mean higher borrowing costs for the government and falling prices on already issued bonds, because bond prices move inversely to rates.

Foreign investors and central banks are attempting to wean themselves off their reliance on U.S. Treasuries. They’re buying gold and debt issued by other highly rated nations, and they are rerouting payments in the global trading system to avoid getting paid in dollars.

What to buy if you’re worried

Corporate debt, especially paper issued by the strongest U.S. companies, offers an interesting alternative to government bonds. Apple, for example, carries a triple-A credit rating from both Moody’s Investors Service and S&P Global. It generates nearly $100 billion in free cash flow each year and, unlike its megacap tech peers, isn’t spending like an inebriated sailor on artificial intelligence. Its five-year bonds pay a fatter yield than comparable U.S. Treasuries, while offering what is effectively a risk-free return that is around half a percentage point higher.

How to ease your fears

Keep in mind that a bond market collapse, while not impossible, isn’t likely. Cool heads would do everything possible to avert a U.S. government default, and it would take a lot for foreign borrowers to dump Treasuries en masse.

Recent political theater over the debt ceiling aside, there’s no reason the Treasury wouldn’t be able to make a payment. As Neil Shearing, group chief economist at Capital Economics, puts it: “There are no magic thresholds for either public debt or budget deficits beyond which fiscal crises become inevitable.”

Fear No. 2: AI Is the Mother of All Stock Market Bubbles

The promise of artificial intelligence—that it will change everything from the way we look at the universe to the way we order a hamburger—has been the primary driver of the S&P 500’s three-year bull market. This has led to fears that it could continue to propel equities higher, in an echo of the dot-com bubble of the late 1990s, only to culminate in a market implosion similar to the Nasdaq’s swoon in the early 2000s.

“I think we’re standing at the edge of a similar run today,” says Rational Equity Armor Fund portfolio manager Joe Tigay, who lived through the dot-com boom and bust as a floor trader. “Stocks could rally significantly, and when I say significantly, I mean the kind of rally that makes people feel like geniuses right up until the moment it doesn’t.”

AI appears to be running up against some immutable laws of common sense. First, we just don’t have the power. The Lawrence Berkeley National Laboratory predicts that by 2028, AI will require the same amount of energy it takes to power 22% of U.S. households.

Second, there is a circularity problem with all the investment in AI. Most of the money is changing hands among the largest tech companies. Nvidia, the world’s leading AI chip maker, generates about half of its revenue from Microsoft, Amazon.com, Google parent Alphabet, Facebook parent Meta Platforms, and Tesla.

Recent deals signed between OpenAI, Oracle, and Nvidia, all of which will play a key role in the government’s $500 billion AI project called Stargate, reveal even more circularity. Nvidia takes a stake in the ChatGPT creator, which then purchases computing capacity from Oracle, which then buys more Nvidia chips.

What’s at stake if the new technology fails to meet what are increasingly lofty ambitions? AI stocks are, beyond question, the key driver of the S&P 500’s current bull market. Eight of the market’s 10 biggest stocks are tied in part to the AI investment story, and represent around $23 trillion in total market value.

What to buy instead

One simple way for investors to reduce AI exposure is to buy an equal-weighted S&P 500 index fund that isn’t overweight the largest tech stocks. Or diversify your holdings by adding more value stocks and high-quality names in downtrodden sectors such as healthcare.

Another idea: Since the power question isn’t going to go away, but neither is AI, a good hedge against a stock market crash could be found in the mundane safety of energy companies such as Constellation Energy, NextEra Energy, or the next-generation nuclear alternatives like Oklo. The reasoning here is that AI will work; it just might not deliver the exaggerated profits baked into the market’s biggest stocks. A crash in share prices won’t change the need for energy demand, and buying the power providers is a lot cheaper than chasing the inflated values of AI giants.

How to ease your fears

The AI stock bubble could burst but it would likely be a temporary valuation reset. The trillions spent on semiconductors, processors, and data centers won’t be wasted—it might just take more time than currently expected to come back in the form of corporate efficiencies that would fuel even more spending and stock market gains.

It’s helpful to note that bear markets, typically defined as a 20% pullback in a major stock benchmark, are inevitable, but they don’t tend to last long. The 21 bear markets since 1928 have each lasted less than a year.

Fear No. 3: A China Crisis That Isn’t Just a Trade War

Confusion continues to grip investors around the world when it comes to Beijing’s longer-term ambitions. At times, China shows signs of evolving into a consumer-powered economy at the forefront of tech innovation. At others, it is arresting business leaders, conducting military exercises in the Taiwan Strait, and reaching out to American adversaries as it develops its global supply chain.

The continuing trade war between Washington and Beijing is stoking investor fears as members of the Trump administration discuss how Beijing’s growing technological capabilities, especially in AI, could be a threat to U.S. national security. Projects like Stargate suggest an immediate competitive threat.

What to buy if you’re worried

AI investments might be exactly the kind of play to mitigate the risks associated with the threat of Chinese military aggression toward Taiwan, a condition U.S. Defense Secretary Pete Hegseth described as “imminent” during a security conference speech in Singapore in May.

Companies such as Palantir Technologies, which works closely with the U.S. Department of Defense, use AI technologies to provide Western countries with battlefield intelligence. The group signed a $10 billion contract with the U.S. Army in August, and CEO Alex Karp has talked openly about “powering the West to its obvious, innate superiority.”

Other good buys could include drone manufacturers, as modern military tactics increasingly rely on autonomous weaponry. Analysts see AeroVironment and Kratos Defense & Security Solutions as likely participants in President Donald Trump’s $175 billion Golden Dome missile defense system.

Why you don’t need to worry

Washington and Beijing are, in some ways, like a pair of roommates in an expensive apartment, neither of which can afford to live by themselves. China needs the U.S. to drive its export engine, the largest in the world, and keep its economy from spiraling into a slowdown that would stoke civil unrest.

The U.S. needs China to supply both cheap consumer goods and recycle its trade surplus into the Treasury market, which helps keep in check everything from government borrowing to mortgage costs. The rhetoric might get testy, but the two nations know there’s a lot more to lose by going it alone.

Fear No. 4: The U.S. Economy Gets Mired in Stagflation

Stagflation, or slowing economic growth and rising inflation, is no laughing matter—and the U.S. economy is showing warning signs of it.

President Trump’s tariff policies have already sparked an uptick in consumer prices, with the Federal Reserve’s preferred inflation gauge, the PCE Price index, recently reaching its highest levels since February. Further increases are expected once companies either stop absorbing the added cost of tariffs or make products domestically and pass those added costs along instead.

U.S. economic growth is running at half the rate it was last year, and weakness in the job market is starting to revive fears of a mild recession in 2026. That could put the Federal Reserve in a tricky position. If it significantly lowers rates, as the Trump administration demands, it could add to inflationary pressures. A surge in unemployment would require lower interest rates that support business investment, including hiring. But those low rates could also add to inflation pressures, as cheaper money chases few goods and services and drives prices higher. The Fed would have to be creative and not just lower rates, as the Trump administration is calling for.

How to play it if you’re worried

In a stagflationary environment, look to businesses that generate steady cash flows, no matter how weak the economy is. American consumers are devoted to their communication and entertainment today. That makes the business models of companies such as Apple, Netflix, Spotify Technology, and to a lesser extent Walt Disney compelling investments in a downturn.

Those tech and media companies command massive subscriber bases that pay monthly subscription fees regardless of the broader macro environment. They can often pass on price increases quickly, and operate with solid profit margins.

If inflation is the concern, investors can consider buying real assets, such as real estate and commodities. Gold’s rally this year is partly because investors are doing just that.

Why you don’t need to worry

The Fed is probably better able to battle a stagflationary environment than most investors might expect. Even when current Fed Chair Jerome Powell’s term expires next year and he is swapped for a Trump-appointed replacement who is likely to be sympathetic to the president’s call for sharply lower interest rates, the central bank will need to maintain credibility in global financial markets. That could still lead it to take a more hawkish approach than President Trump demands. “A data-dependent Fed that is not influenced by political pressures is critical,” says Jeffery Roach, chief economist at LPL Financial.

It has a lot of tools in its toolbelt to affect monetary policy other than just moving interest rates. If the economy falls into recession while inflation is high, most Americans will see the economic weakness as the result of failed government policies, giving the Fed some space to fix it.

Fear No. 5: The Dollar Does a Nosedive

The dollar’s dominance in global commerce is starting to crack, and America’s role in the world is likely to change as a result. The U.S. dollar index measures the dollar against a basket of six major global currency peers. It shows that the dollar suffered its worst six-month performance since the early 1980s this year, slumping more than 10% over the six months ended in June.

It has been treading water ever since. But with U.S. debt levels soaring and the Federal Reserve set to embark on a series of interest-rate cuts that could further undermine the dollar’s value, the U.S. dollar isn’t at the top of anyone’s list as the currency of choice for the back half of this decade.

What to do if you’re worried

Gold has been the principal beneficiary of what’s known as dedollarization, or the decline of the dollar in global trade. The People’s Bank of China has added 21 metric tons of gold to its reserves this year, based on calculations from Reuters, bringing its overall total to just over 2,300 tons.

Crescat Capital’s macro strategist Otavio Costa notes that global central bank gold holdings represent 27% of overall reserves, the highest in nearly 30 years. Foreign holdings of U.S. Treasuries, meanwhile, have fallen to around 23%, the lowest since the 2008-09 financial crisis.

That has helped lift bullion prices nearly 50% this year, putting gold on pace for its best annual gain since 1979. Joining the gold rally might seem like an expensive proposition, but it remains the key hedge against the dollar’s demise.

Cryptocurrencies offer similar protections, but their price swings are more volatile. Still, J.P. Morgan analysts, led by Nikolaos Panigirtzoglou, see Bitcoin reaching around $165,000 by the end of the year. That would mark a 38% advance from current levels and a 2025 gain of nearly 80%—more than enough to offset the likely 12% slump for the dollar index.

Emerging markets are another option.

Why not to worry

Many economists argue that the dollar will hold up just fine. Global trade is still greenback-based, and that isn’t going to change soon, thanks to a lack of credible alternatives. The euro is tied to an economy with sclerotic growth and existential breakup risks. The yuan is valued at the whim of a communist government. The yen lacks the support of an independent central bank. Investors might not love the dollar, but it’s too deeply embedded in global finance to turn away from it.

Write to Martin Baccardax at martin.baccardax@barrons.com