History Suggests the Market Could Crash in 2026: Here's How You Can Protect Your Portfolio Right Now

The last five years have been a bonanza for growth stock investors, with the technology-heavy Nasdaq Composite index up by 96%. That amounts to a 14.4% compound annual growth rate, well exceeding its historical average of around 10%. The outperformance can be mostly credited to soaring data center spending and optimism about generative artificial intelligence (AI).

But can this rally stand the test of time? There are growing signs that the answer might be no. There are solid reasons to believe stocks are overvalued right now. With that in mind, investors will want to take this opportunity to consider strategies they could use to protect their portfolios in the event of a market correction.

Valuation metrics flash warning signs

There are many ways to gauge how expensive the stock market is. But the cyclically adjusted price-to-earnings (CAPE) ratio is arguably one of the most useful, because it is derived using the market's inflation-adjusted earnings over a 10-year period. That smooths out short-term fluctuations and gives investors a more reliable picture of long-term stock valuations.

At the time of writing, the broad-market S&P 500 index trades at a CAPE ratio of 41, which is significantly higher than its century-plus average of 17. Things get even more alarming when you consider that there are only two other times in history when the market has been in this range.

The first was in 1929, when the CAPE ratio hit 32.6. A few months later, stocks began a crash that would take them down 83% and start the Great Depression. The CAPE ratio didn't surpass that peak again until the late 1990s and early 2000s, when it achieved a new all-time high of 44.19 before crashing substantially as the dot-com bubble burst.

Is this time different?

Whenever stocks get pricey, there will be bullish voices arguing that "this time is different." To be fair, they actually have a good point. Generative AI could eventually help companies save on labor costs throughout the economy, potentially juicing long-term profitability.

Furthermore, the CAPE ratio's use of 10-year average earnings can obscure the performance of companies that have seen earnings rise dramatically in the last few years. These stocks often look quite affordable when analyzed with more traditional valuation metrics.

Micron Technology is a great example of this concept. It has a forward price-to-earnings (P/E) ratio of just 7.1, despite seeing net income surge by 163% year over year to $13.8 billion in its most recent quarter. That said, while the soaring growth of AI infrastructure companies can make them look like good values right now, there are questions about the sustainability of the demand powering their businesses.

Image source: Getty Images.

The consumer-focused large language model (LLM) companies that rely on AI infrastructure face significant challenges. Analysts at Deutsche Bank believe that industry leader OpenAI could lose a total of $140 billion from 2024 through 2029. Rising energy costs could lead to even steeper losses. It may only be a matter of time before investors decide the risks outweigh the rewards and stop pouring money into the space.

If the companies that are AI infrastructure consumers start running low on money, eventually the infrastructure providers could be left with slowing growth and expensive assets that will be more difficult to monetize.

See market corrections as opportunities instead of challenges

The market is at an elevated risk for a correction because of its relatively high CAPE ratio and investors' general uncertainty about the sustainability of AI-related spending in the economy. But this doesn't mean it's time to panic. Historically, the U.S. stock market as a whole has always bounced back from crashes, though not every company does. There is no reason to expect the next crash to be any different.

Investors can cushion their portfolios by rotating some money away from AI stocks toward more recession-resistant consumer defensive industries. It might also be a good idea to keep some cash on the sidelines so you can shop for deals if stocks become significantly cheaper at some point in the future.

Will Ebiefung has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Micron Technology. The Motley Fool has a disclosure policy.