• Bank of America warns of a bubble in US growth stocks echoing the “Nifty Fifty” and “dot-com” eras.
• Concentration in US stocks is significantly above historical norms, BofA said.
• Investors should consider diversifying and focusing on quality stocks to mitigate risks, BofA said.

If you listen closely enough, amid all the investors cheering on AI, echoes of some of the great bubbles in history are starting to reverberate through the narrow canyon of skyscrapers on Wall Street.

That’s the warning Bank of America strategists issued to clients in a note earlier this week.

As investors continue to pile into growth stocks, sometimes passively, the market has started to resemble the so-called “Nifty Fifty” and “dot-com” bubbles in the 1960s and late 1990s, respectively, the bank said. And while stocks could still rise in the near-term, outcomes after those famous bubble periods suggest trouble could be coming.

The argument was based on concentration levels in the market. The market cap of US stocks compared to the rest of the world is 3.3 standard deviations away from the historical norm.

Within the US, the S&P 500’s largest five stocks are now 26.4% of the index.

And the market cap of “new economy” stocks in the S&P 500 also make up more than half of the index’s total value, a record high.

Part of the reason the market has gotten so concentrated is because of passive investing, where investors shovel money into indexes indiscriminately, Woodard said.

“Passive funds dominate with 54% market share,” he wrote.

“Passive disregard for valuations & fundamentals means big upside from innovations,” Woodard continued, “but big risk in a bust cycle.”

These concentration levels could mean a long period of pain ahead for investors — like it did after the “Nifty Fifty” and “dot-com” bubbles.

“Momentum reversals are becoming unusually sharp. A 50%+ ‘new economy’ drawdown (smaller than dot com) could drag the entire index down 40%,” wrote Jared Woodard, and investment & ETF strategist at Bank of America, in the February 11 note.

“If the eight sectors outside ‘new economy’ darlings were to rally 10% and the handful of mega cap tech stocks fell 10%, the index overall would still just be flat,” he continued. “Not very healthy or diversified.”

Woodard’s warning of a difficult decade ahead for investors aligns with views of strategists at other major Wall Street banks in recent months. Morgan Stanley’s Mike Wilson said in December that the S&P 500 would see a decade of “flat-ish” returns ahead, and Goldman Sachs’ David Kostin said the index would return 3% annually, on average, over the next 10 years.

How to avoid a potential drawdown

The bank did lay out a playbook for how to avoid a potential bear market and “lost decade” ahead.

First, Woodard said to watch when the S&P 500 equal-weight index starts to beat the cap-weighted index.

“The equally weighted S&P 500 index has outperformed the market cap-weighted index by 1ppt/year since 1958. There have been five periods when the cap-weighted index outperformed; those typically lasted 16 quarters,” Woodard wrote. “Today, the cap-weighted index is 2.5 standard deviations overbought relative to the long-term trend.”

Second, consider investing in baskets of quality stocks with lower exposure to the Magnificent Seven stocks, Woodard said. Some examples of funds that offer exposure to quality stocks, the bank said, include: the Pacer US Large Cap Cash Cows Growth Leaders ETF (COWG); the iShares MSCI USA Quality GARP ETF (GARP); and the WisdomTree US Quality Growth Fund (QGRW).

And third, diversify. Woodard said Derek Harris, Bank of America’s head of global wealth and investment management portfolio strategy, recommends keeping each holding in a portfolio under a 15% weighting.