Alarms are sounding over inflated valuations in US markets, prompting some leading fund managers to reallocate capital towards overlooked, undervalued assets.

Recent analysis shows the cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500, adjusted for elevated earnings trends, has soared to 68, surpassing all historical levels. This signals the US market is grappling with a dual bubble in both prices and corporate profits.

Concurrently, the South Korean Kospi index plunged 5.4% on July 9, entering a technical bear market with a roughly 20% retreat from its peak. This has accelerated a capital flight from Korean semiconductor stocks towards Hong Kong's tech sector, where the Hang Seng China Enterprises Index surged as much as 4.5% in a single day.

Navigating US Concentration and Crash Risks

Faced with the highly concentrated US artificial intelligence trade and mounting risks of a sharp correction, fund managers like Alexander Chartres of Ruffer LLP and Tomiko Evans, CIO of Crossing Point Investment Management, advise investors to achieve effective diversification by targeting Chinese tech stocks, UK high-dividend equities, and the global energy sector, rather than simply moving to cash.

US Valuations Hit Historic Extremes Amid AI Concentration

The issue of high US stock valuations has persisted for years, but the current situation may have entered a new extreme phase.

The current CAPE ratio for the S&P 500 nears the 44x level seen at the peak of the 2000 dot-com bubble. However, after further adjusting for the fact that current corporate earnings are also far above their long-term trend, the effective CAPE ratio jumps to 68, exceeding any recorded level in history. In essence, the market is paying a premium not just for high prices but also for abnormally high profits.

The core driver of this dynamic is artificial intelligence. A handful of tech giants dominate major index weightings, and a corporate race to invest in AI infrastructure has led to market concentration at historically rare levels. An investment portfolio manager notes that while AI-driven semiconductor demand is real and massive, it is "essentially underpinned by about $1 trillion in capital expenditure controlled by just a few large tech companies." A slowdown in this spending could rapidly materialise downside risks.

While the exact timing of a bubble's burst is difficult to predict, investors can mitigate one-sided exposure through sufficient diversification.

Turning to Chinese Tech: Value Depressions with AI Optionality

Chartres argues that the massive capital drawn into the US AI trade has made relative value in other sectors stand out, with large Chinese tech stocks being a prime example.

"If you think about who provides cloud computing services globally, it's basically the US and China, each with a handful of names," Chartres stated.

He points out that Chinese tech companies possess solid fundamentals with steady revenue growth and ample "optionality value" in the AI field. Their valuations, however, are suppressed far below their US peers due to political risks and sentiment over domestic economic softness.

This logic is gaining market validation. A thematic research team previously issued a report recommending clients shift exposure from the Korean AI trade to the "Chinese AI value chain." Capital subsequently flowed into Hong Kong's tech sector, with Alibaba Group Holding Ltd's Hong Kong shares soaring over 13% in a day.

UK High-Dividend Stocks: An Alternative Path Away from Tech

For investors looking to avoid the tech sector entirely, UK equities offer a distinctly different proposition.

Tomiko Evans, in discussions with a UK investment association, noted that the UK market's sector composition differs significantly from global equity indices. It has a higher weighting in cash-generative industries like financials, energy, healthcare, and consumer staples, making it a good hedge for portfolios overly concentrated in technology.

The Energy Sector: A New Hedge for an Inflationary Era

When searching for genuine portfolio hedging assets, Chartres highlights that bonds have become less effective hedges in an environment of heightened inflation volatility, a gap the energy sector can fill.

He stated that recent events in the Gulf region remind markets that spiking energy prices often hurt both stocks and bonds simultaneously, whereas fossil fuel sectors tend to benefit in such scenarios.

He further noted that the beneficiaries extend beyond just oil majors. Oilfield services companies could also see long-term gains as countries ramp up investment in energy infrastructure. "Of course, oil markets could remain weak for quite some time," he said, "but that's precisely the point of diversification."