The S&P 500 fell a modest 0.5% last week, its second down week in a row. These pauses for the market to catch its breath are normal. The index is down less than 2.5% from its October 6 closing all-time high. Remember, three to four mild corrections of at least 5% a year is normal. Volatility is the toll we pay to invest, but we continue to believe new all-time highs are quite likely by the end of the year.
As the market has climbed this year, everyone’s been complaining that the market lacks breadth (too few stocks driving the rally). Well, despite the decline, now we have more breadth. A whole lot more. On Thursday, October 22, 324 of 500 S&P 500 companies gained, with the median stock up 1.09% (177 gained over 2%). Yet the S&P 500 fell 1.36%, technology plunged 3.3%, and the Goldman Sachs Broad AI Index dropped 6.01%. Nine of 11 sectors beat the index, and six gained, led by defensives: staples, utilities, and healthcare.
That captures the problem. More breadth is great, except when it is led by defensives and comes with a steep selloff in AI stocks. Be careful what you wish for when you have a concentrated index and a bull market powered largely by AI.
The Tape Doesn’t Look Good
We’ve shared this chart before comparing AI stocks (Goldman Sachs Broad AI Index), the S&P 500, and non-AI stocks (Goldman Sachs S&P 500 Ex AI Enablers Index). AI trounced everything from 2023 through the first half of 2026. But that has flipped in the second half: through October 22, non-AI stocks outperformed AI by over 28 percentage points. There’s still an enormous gap to close. Since the end of 2022, AI is up 353%, versus 49% for non-AI stocks (a respectable 11.1% annualized). The S&P 500 is up 110%, powered by AI.
On June 22, AI was outperforming non-AI stocks by a whopping 49 percentage points for the year. That lead has collapsed to just 4.8 points.
It’s one thing for non-AI stocks to lead for a week or month, but this reversal has lasted longer. The chart below shows AI’s rolling six-month excess return over non-AI stocks since 2023. It’s now at its worst level of this four-year bull market. Something seems to have shifted.
Back in June, we pointed out that AI stocks were far outpacing everything else, lifting momentum stocks with them. At the end of June, momentum looked really stretched:
- The S&P 500 Momentum Index’s one-year excess return was in the 96th percentile of the last 40 years.
- It’s now fallen to the 47th percentile.
But longer-term momentum is still pretty stretched:
- In June, momentum’s three-year excess return was in the 100th percentile of the last 40 years.
- It’s still in the 95th percentile.
In other words, there’s a long way to go before three-year excess performance gets back to the median, let alone below that.
The strength of AI stocks has partially hidden a less robust return profile across the rest of the index. The S&P 500 hasn’t had a 10% correction this year, yet the median stock has suffered a drawdown exceeding 24%. Concentration helped on the way up as AI surged, and boosted index performance. It can hurt just as much in reverse.
Technology alone is 38% of the S&P 500. Add in some of the tech-adjacent megacap stocks that aren’t officially part of the tech sector, and that rises to 51%. And that doesn’t include AI-linked industrials and utilities.
Let’s put some numbers here. From January 1, 2024 to September 30, 2026, the S&P 500 gained about 66%. We’re excluding 2023, since that was arguably a recovery from the 2022 bear market. Here’s the breakdown:
- A basket of 47 AI stocks contributed 40 percentage points (60% of the return). Their average index weight was just 33%.
- The remaining 67% of the index contributed 26 points (40% of the return).
- The Magnificent 7 (the seven major tech-oriented megacap stocks), making up 32% of the index, contributed 30 points (46% of the return). (Note: Five of the Magnificent 7 are also in the AI basket.
The concentration was even more stark in the first half of 2026, when the S&P 500 returned 10.2%:
- The AI basket contributed 7.6 points, or 75% of the return. Its average index weight was 37%.
- The other 63% contributed just 2.6 points, or 25% of the return.
- The Magnificent 7 were 33% of the index but contributed almost nothing.
Then things reversed big time in the second half. Of the S&P 500’s 2.5% gain through October 22:
- The AI basket, now 39% of the index, subtracted 1.7 percentage points.
- Non-AI stocks contributed 4.2 points, more than offsetting the AI drag.
The trouble is that years of outperformance have made AI stocks an increasingly large share of the index. A significant reversal would therefore hit the S&P 500 disproportionately hard.
Rotation and Breadth: Be Careful What You Wish For
At the end of June we wrote about getting comfortable with a “bubble,” arguing that diversification may be the secret to investing through it. That’s played out faster than we expected. The current selloff may not last, but if this rotation persists, it could signal the beginning of the end of the AI wave and the bull market.
Rotation is also how the late 1990s tech bubble ended, along with an 18-year bull market. We looked at sector returns, momentum, and low volatility factors (both long-only) across three periods:
- January 1998 – March 2000 (the bubble)
- April 2000 – December 2000 (rotation)
- January 2001 – March 2003 (the crash)
A few things stand out:
- Technology and momentum soared during the bubble, alongside tech-adjacent communications and consumer discretionary, then collapsed afterward.
- But there was breadth during the bubble. Most other sectors generated solid returns; only staples and low volatility were negative.
- From April 2000 through December 2000 there was a lot of rotation, as tech-adjacent sectors and momentum sank while most other sectors and low volatility gained.
- During the 2001–03 crash, every sector took a beating, especially tech and momentum.
- Across the full period, healthcare, energy, financials, and even consumer discretionary posted positive returns. Momentum finished positive despite brutal drawdowns, but low volatility did better, as did an equal-weighted mix of healthcare, financials, and energy.
All this to say, things could get a lot uglier. We’ve barely scratched the surface of a tech selloff. There’s a solid macro case for AI to keep running, driven by more capex and profit growth. But in this business, you have to weigh that against the message from the market, and right now, the tape for AI doesn’t look great. If this continues, it could mean the end of the bull market as well (despite some areas of the market holding up well). It’s still AI or bust. Perhaps now more than ever, it’s important to keep an eye on the tape.
A Case of the Bond Jitters
In the third quarter, the Bloomberg US Aggregate Bond Index (“Agg”), the most widely used bond benchmark, fell 3.5%, its worst quarter since Q3 of 2022 (-4.8%). Suddenly, the trauma of 2022 was back for bond investors, and they once again forgot how yields are the main driver of returns but require some patience. We’ve anecdotally heard so much fear of bonds lately that we can fairly call this a fresh case of the bond jitters.
We are not particular fans of bonds. We prefer stocks for the short and long run. But we are fans of smart investing decisions. If aggressive equity positioning is not appropriate for your risk tolerance or doesn’t fit your financial plan (which is true for many investors), bonds are still an attractive way to diversify portfolio risk.
But they are not the only way. We are still strong advocates of “diversifying diversifiers.” But bonds still legitimately can be a primary portfolio volatility buffer and source of diversification. If the 60/40 portfolio (an allocation of 60% stocks, 40% bonds) is dead, it’s only because it shouldn’t have been a thing in the first place. We were blinded by an extended period of extraordinary bond strength and low stock/bond correlations. But if you call it the 60/40* portfolio, with the asterisk signaling a 40% allocation to bonds but also other diversifiers, such as Treasury bills or trend following strategies that can provide exposure to commodities, then the 60/40* is very much alive and well.
Many of the same arguments we make to help investors avoid the worst behavioral biases in stock investing apply to the bond world too. It’s not as important a message on the bond side, since stocks are both a more significant driver of returns and more volatile. But the bond jitters can lead to mistakes on the bond side similar to the mistakes investors make with stocks.
5 Signs You Have the Bond Jitters
- Do you understand that stock declines are normal but treat any moderate bond decline as a reason to abandon ship?
- Are you steadfast that we should not treat every threat to stock markets as the reincarnation of the Great Financial Crisis, but take your bearings for bond markets from 2022?
- Do you focus on earnings for stocks and mostly look past valuations because earnings are the main driver of stock returns, but focus on interest rate changes for bonds and ignore yields, which play an even stronger role for bond returns than earnings do for stocks?
- Have you ever said or thought, “I just don’t want to own any bonds in my moderate portfolio; they’re just too risky,” when the worst year for bonds on record is about the same as the average intra-year decline for stocks?
- Has someone presented you with an investment vehicle that supposedly can replace your bond allocation, with recent bond returns as evidence, and you embraced it without looking at the longer-term history, the forward-looking expectations, or costs?
If you answered yes to one or more of the above, you may have a case of the bond jitters.
All of the above is a little tongue-in-cheek. Bonds have their risks. And it is always important to keep in mind that very short maturity Treasury bills, which investment professionals often refer to as “cash” (they don’t usually mean literal cash), are an alternative to bonds to consider. Bills usually (not always) have a lower yield than bonds and have had a lower long-term return, but they also have basically no default risk and no volatility. Since 1992 (first shared history available), the Agg has had a 4.6% return, while “cash” has returned 2.6%. But keep in mind that the lookback includes an extended period of ultra-low short-term interest rates.
Don’t Take Your Bearings From the Worst Bond Year On Record
Yes, 2022 was a very bad year for bonds, by most accounts the worst on record dating back to the early 20th century. The Agg fell 13% in 2022. But that’s just a typical intra-year drawdown for stocks (the S&P 500 average intra-year drawdown is about 14.3%). Over the next three years, the Agg returned 5.5%, 1.3%, and 7.3%, an average annual growth rate of 4.7%. That’s 14.7% over the three years, just a little better than offsetting 2022’s decline.
But rates were low at the end of 2021, so if bonds are supposed to get you your yield over the long run, they more or less did their job over an even shorter time span. (And yields aren’t low anymore—a good thing for bond investors.) Treasury bills did a little better over those three years of gains (4.9%), and much better if you include 2022. But if you asked most investors how bonds did from 2023–2025, we don’t think you would get many estimates near 5%.
Lessons from History
Let’s caution right away that prior performance is no guarantee of future returns. But rather than focus on 2022, let’s focus on the longer track record. The Agg has been around since 1976. From 1976 to 2020 (45 years of returns), it had only three years of negative returns. Then came 2021 and 2022, with their -1.5% and -13.0% declines. That was followed by three years of gains (discussed above). And now we may get our sixth negative return for the Agg in 2026. (The Agg was down 1.1% year to date as of Friday’s close.)
Despite relatively rare negative years, bonds are risky assets. You can see it in the pattern of intra-year drawdowns. We often share the chart of yearly stock declines to help make the point that declines are normal and to avoid panicking with every drawdown. Here are bond intra-year declines, which have averaged 3.5% historically top to bottom. This year has been a little worse at -4.6%. As with stocks, volatility is the price we pay to invest in bonds, and there is a decline at some point every year. The average decline for the Agg is about ¼ the decline for the S&P 500, but the risk premium you historically get above Treasury bills is also much smaller than for stocks. The mistaken belief that bonds never go down is an important contributor to the bond jitters. Correcting that to thinking of bonds as risky assets, lower risk but still risky, may help.
2022 Was an Unusual Year, and Chances Of A Repeat Are Quite Low
You can also see on that chart what an outlier 2022 was. 2022 was a perfect storm of three different factors:
- Starting yields were extremely low.
- Since rates were very low, they were more vulnerable to a large move higher.
- There was an unusually strong catalyst for just that kind of move.
Below is the annual percentage point change in the 10-year Treasury yield based on year-end values. 2022 is the largest move on record. There are other years that were close, but those years also had higher starting yields, so you didn’t get declines approaching the same scale as 2022. The three down years before 2021 (1994, 1999, and 2013) all had higher starting yields, which buffered some of the impact of rising rates. The worst of them (1994) saw the Agg decline 2.9%.
Bond Prices Don’t Go Down When Rates Go Up
Well, they do. You weren’t misinformed by the finance articles you have read or the finance course you might have taken. But there’s an important sense in which they actually don’t. No matter what interest rates do, the price you get for a bond at maturity (assuming no default) is unchanged by the path of interest rates getting there. If rates were at 2% when you bought a bond and 4% when it matures, the price you get at maturity is still exactly the same. How can that be? If bond prices fall when rates rise, how can rates go up a full 2 percentage points and the price at maturity still be par? It had to be falling at some point, right?
The main reason is there’s another force that impacts bond prices. It is very small, almost meaningless on a day-to-day basis, but like a river that carves out a canyon, over the life of a bond it is practically all that matters, and it is ultimately indifferent to rate changes. It’s just the pull of par, the process of accretion or amortization to par in bond lingo. While almost invisible on a day-to-day basis, the pull of par together with the impact of coupon payments ultimately determines almost all of a bond’s return, and both are indifferent to rates (for fixed rate coupons). Also, since they’re slower, steady forces, you could say that the parts of a bond’s returns they represent are uncorrelated to stocks, which gives risk a different meaning for bonds. The true driver of a bond’s (or bond portfolio’s) return over its lifetime is uncorrelated with stocks.
It’s a little like taking your dog out for a walk on a very long leash. You steadily progress through your walk, which is your bond slowly realizing its yield. Your dog runs back and forth, sniffing this, barking at that. Your pup’s movements are volatile and make up all the action in short time frames. But ultimately you finish your walk. Throw in that you slowly shorten the leash as the walk proceeds until your dog is just heeling as you head up your walkway, and you get some sense of how bond volatility works. You taking your walk—that’s the work a bond’s yield is doing. Your dog wandering here and there—that’s the short-term effect of interest rates. But at the end you both get home at the same time. Yields do all the work. That’s why the yield when you purchase a bond determines its expected return over its maturity. It’s just in the bond math. The bond jitters give all the attention to the dog.
What does that mean for bond investors now? The yield on the Agg is currently 5.45%. That means over the next eight years, you’ll very likely get something close to a 5.45% return for an Agg-like bond portfolio, even if in the short term there may be uncomfortable fluctuations. For a bond portfolio, you won’t get exactly that number, but constrained by the bond math, the difference doesn’t get very large. Historically you’re within +/- 1 percentage point of the predicted value 75% of the time, and you’re never way off.
The yield for a Treasury bill right now is about 4.2%. That more than 1% of extra return annually is large enough to be meaningful, especially when compounded. The eight-year return for the Agg, if realized, would be 53% versus 39% if short-term rates stayed where they are and you stayed in bills. That’s not a life-changing difference, but it’s meaningful, especially if bonds make up a large portion of your portfolio.
Investment Takeaways
The aim here wasn’t to revive the 60/40 or even argue for bonds over bills. And we wouldn’t ignore other ways of diversifying the 40 in the 60/40, both by going outside of bonds (managed futures, natural resources) and in how the remaining bonds are managed. The point really is don’t avoid bonds just because of the bond jitters, which the financial press sometimes seems to spread like a bad cold.
S&P 500 — A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly traded companies from most sectors in the global economy, the major exception being financial services.
The views stated in this letter are not necessarily the opinion of Cetera Wealth Services LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. This information is from sources believed to be reliable, but Cetera Wealth Services, LLC cannot guarantee or represent that it is accurate or complete.
9200306.1-1026-C
