The AI Stock Rally Has More Room To Run, Says BofA. Here's How To Play a Possible Bubble

Bank of America strategists indicate that the Magnificent Seven stocks, despite a 225% rally since March 2023 and a 60% surge since early April, have not yet reached historical 'peak bubble' metrics, with their current P/E of 39 significantly below the average peak of 58. Driven by AI optimism, robust earnings, and recent interest rate cuts, the strategists suggest the rally has further upside. For investors seeking to hedge against a potential bubble, BofA recommends a 'barbell strategy' by going long on cheap, distressed equities and shorting the debt of richly priced tech companies, anticipating credit markets will signal deterioration before equities.

Analysis

According to Bank of America (BofA) strategists, the Magnificent Seven stocks have not yet reached historical 'peak bubble' valuations despite a significant 225% rally since March 2023. The analysis, led by Michael Hartnett, contrasts the group's current metrics against historical bubble peaks, noting the current price-to-earnings (P/E) ratio of 39 is well below the 58 average seen at past peaks, and the stock group's position 20% above its 200-day moving average is shy of the typical 29% premium. This suggests further upside potential for the rally, which has been fueled by AI optimism, resilient earnings, and the recent Federal Reserve interest rate cut, contributing to a 60% surge since early April. Acknowledging the high valuations, BofA recommends hedging strategies, including a barbell approach that pairs long positions in big tech with long positions in cheap, distressed equities such as Brazilian and British stocks or global energy plays. This is based on the premise that asset bubbles boost broader economic growth. Additionally, the strategists suggest shorting the corporate debt of richly priced tech companies, citing historical precedent from the Dotcom era where credit markets priced in balance sheet deterioration before the equity bubble burst.

Key Decisions for Investors

• Given that key metrics are below historical bubble peaks, investors might consider maintaining exposure to the Magnificent Seven to capture potential further upside, while acknowledging the rally is in a mature phase.
• To hedge against concentration risk and a potential tech downturn, consider implementing a barbell strategy by allocating capital to undervalued assets like Brazilian or British equities and global energy stocks, which may offer non-correlated returns.
• Monitor the corporate bond performance of high-valuation tech companies, as widening credit spreads could serve as a leading indicator of a potential equity correction, providing an early signal to de-risk.