Strategists from the Wall Street financial giant Bank of America are urging investors to step away from the overly crowded theme of AI computing trades.

In the face of a deleveraging storm in the AI theme, a forced unwinding of extreme crowded positions, and inflation risks challenging traditional portfolios, the institution sees compelling opportunities in value stocks, biotechnology, regional banks, select credit instruments, and commodities. BofA's latest positioning highlights a shift in investment focus toward high-cash-flow compounding assets, accelerating the dispersion from the historically leveraged AI computing theme and the crowded high-beta momentum trades into "high-quality cash flow compounding plus valuation-misplaced alpha."

In a recent heavyweight research report, the BofA strategy team stated that, beyond the above attractive investment themes, international small-cap value stocks have become far more appealing than U.S. large-cap growth stocks, while Japanese corporate profitability has climbed to a record high. The firm also views listed private equity management companies as a contrarian investment opportunity and prefers high-quality high-yield bonds over investment-grade bonds.

For investors, this report clearly points to the need for broader asset diversification after years of U.S. tech stocks dominating global equity markets. Bank of America believes there are significant investment opportunities in profitable cyclical companies with strong fundamentals and in real assets, while questioning whether the record-breaking scale of AI investment has generated sufficient economic benefits to justify its high costs. Meanwhile, the firm remains technically bullish on the S&P 500 Index.

Bank of America is not bearish on the AI theme but rather emphasizes a very clear upgrade in asset allocation: shifting from a highly concentrated AI/U.S. large-cap growth trade to a portfolio mix of "maintaining a structural AI long position while increasing exposure to low-correlation, high-cash-flow, and low-valuation assets." As AI transitions from a scarcity narrative to a trillion-dollar capital expenditure payoff period, the determinant of excess returns will shift from "whether there is AI exposure" to "whether valuation, free cash flow, ROIC, and crowding are aligned."

Therefore, as the AI bull market enters a phase of "high valuation, high crowding, and high capital consumption," BofA advocates rotating marginal funds from the most expensive AI computing beta into "cheaper earnings growth, genuine cash flow, and inflation-resistant assets." This is a rebalancing aimed at dispersing from a single tech theme into broader market profitability and high-quality cash flow sectors, rather than signaling the end of the AI bull market.

Massive AI Spending Has Yet to Deliver a Productivity Boom

Within S&P 500 components, excluding the financial sector, capital expenditure as a percentage of sales has reached a new all-time high. However, according to BofA's report, productivity growth in the overall U.S. economy remains modest. U.S. productivity is currently growing at a rate of 2.2%, only slightly above the 2% average since 1987. BofA economists estimate that AI currently contributes only about 0.1 percentage points to annual productivity growth, due to slow adoption rates, skill shortages, and organizational barriers that limit its impact.

This sharply contrasts with the internet boom from 1996 to 2004, when tech investment was accompanied by a more pronounced acceleration in productivity growth. BofA strategists acknowledge that AI is improving economic output efficiency in areas like software development. However, the bank warns that over the long term, the largest incremental gains may ultimately flow to consumers and the broader global economy, rather than to the tech companies supporting the massive buildout of AI computing infrastructure.

Among respondents to the bank's latest fund manager survey, semiconductors remain the most crowded trade, and semiconductor ETFs attracted approximately $17 billion in inflows in July.

Biotech, Bank Stocks, and Value Stocks Offer Alternative Options

BofA strategists point out that biotechnology, insurance, regional banks, and revenue-weighted small-cap stocks are important investment directions that are less dependent on the expectations of AI boom and AI computing-related volatility. The report notes that since June, returns for these sectors have all reached approximately 10% or more. Bank of America recommends rotating capital into profitable cyclical value companies in the fourth quarter, particularly those closely tied to sectors of the economy capable of generating substantial cash flow.

International small-cap value stocks have also stood out. Over the past five years, this asset class has achieved a cumulative return of 98%, compared to an 85% gain for U.S. large-cap growth stocks over the same period. International small-cap value stocks currently trade at a forward P/E of about 12x, versus roughly 30x for U.S. large-cap growth stocks, while their tech sector exposure is only about 6%. Year-to-date, U.S. value stocks have outperformed growth stocks by a full 10 percentage points, the strongest relative performance since 2022.

Japanese Reforms Driving Higher Corporate Returns

Japanese companies' return on equity (ROE) has risen to a record 12%. Bank of America attributes this, in part, to corporate governance reforms and other policies aimed at promoting economic growth. This improvement has occurred against a backdrop of largely flat global manufacturing indicators, suggesting the driving force is not merely a cyclical rebound. Over the past year, the benchmark valuation of Japan's blue-chip stock market has surged nearly 40%. BofA strategists unanimously state that expansionary fiscal policy, corporate reforms, and measures to support the yen could further encourage domestic investment in Japan.

Private Equity Management Companies as a Contrarian Trade Opportunity

Bank of America says that listed alternative asset managers may offer one of the most attractive recovery trades in the market. With improving financial conditions and a rebound in software stocks, shares of listed private equity management firms have risen 17% in about a month. The firm lists Ares Management (ARES.US), KKR (KKR.US), and Blue Owl Capital (OWL.US) as its most preferred listed private equity stocks, noting that these three companies are still 25% to 35% below their historical highs. Related risks include potential AI disruption, high-valuation investments formed during the previous market boom, and investor reluctance to reallocate capital. However, signs of recovery are emerging in the market. IPO volume increased fourfold from the first quarter to the second quarter, which could make it easier for private equity firms to exit investments and return cash to clients. BofA also expects redemption requests for private credit funds to decline significantly in the third quarter, after peaking earlier this year.

S&P 500 Bull Market Trajectory and Uptrend Remain Intact

The firm's technical strategists unanimously state that the S&P 500's breakout from a months-long trading range supports their year-end bullish target of 8,000 to 8,540 points, implying a potential upside of roughly 3% to 10% from the index level at the time of the report. This bullish outlook is predicated on the index holding above the 7,504 level. A break below this support level would warrant increased caution. Seasonal volatility remains a key risk factor. Since 1928, the S&P 500 has risen only 55% of the time during the August to October period. During August of the second year of a U.S. presidential term, historical data shows the S&P 500 has averaged a decline of 0.46%.

Preference for High-Quality Junk Bonds

In the fixed-income market, Bank of America prefers BB-rated high-yield bonds and so-called "fallen angels," which are bonds downgraded from investment grade to high yield. Over the past 40 years, these securities have generated some of the best risk-adjusted returns in the corporate bond market. BofA's strategy team states that BB-rated bonds of various maturities have an average annual return of about 8%. In contrast, CCC-rated bonds, despite their high headline yields, often see their returns offset by default losses. BofA expects a total return of 6% for high-yield bonds over the next 12 months, a historically optimistic level. The bank also warns that major bond indices may expose investors excessively to inflation and interest rate risk. For example, the Bloomberg U.S. Aggregate Bond Index has approximately 88% of its assets allocated to securities rated A or higher, while excluding or underweighting emerging market bonds, senior loans, and other higher-yielding categories.

Commodities May Offer Greater Diversification Value Than Bonds

The traditional 60% stock and 40% bond portfolio has returned 8% year-to-date, but according to the report, its inflation-adjusted annualized return since 2022 has been essentially zero. Meanwhile, the correlation between bonds and stocks has been increasing. Over the past four years, the monthly correlation coefficient between the U.S. Aggregate Bond Index and the S&P 500 has been 0.58, diminishing the effectiveness of bonds as a hedge. Consequently, Bank of America is turning bullish on commodities and other real assets. Since 1945, a hypothetical portfolio of 60% stocks and 40% commodities has yielded an average annual return of 10.8%, compared to 9.2% for a portfolio of 60% stocks and 40% U.S. Treasuries. Over the past five years, the correlation between commodities and stocks has been -0.12, while the correlation between bonds and stocks has been +0.20. This historical performance supports the view of the firm's investment committee experts that in an era of persistent inflation, supply shocks, and geopolitical instability, real assets like gold, silver, and copper may offer more effective protection than bonds.

Searching for the Next Wave of Excess Returns: Non-Consensus Alpha

BofA strategists believe that AI capital expenditure has reached an unprecedented level, yet U.S. productivity growth remains only around 2.2%, estimating that AI currently contributes a mere 0.1 percentage points to annual productivity growth. Simultaneously, global semiconductors have become the market's most crowded trade, with a record 82% of respondents in the July BofA Fund Manager Survey identifying it as the most crowded long position. Therefore, Bank of America is not bearish on the AI theme, but rather emphasizes a very clear upgrade in asset allocation: shifting from a highly concentrated AI/U.S. large-cap growth trade to a portfolio mix of "maintaining a structural AI long position while increasing exposure to low-correlation, high-cash-flow, and low-valuation assets."

The most solid fundamentals behind this rotation are the "broadening of earnings dispersion, compression of valuation gaps, and excessively high AI crowding premiums." AI infrastructure still boasts strong order books and earnings growth, but BofA strategists note that hyperscale cloud providers have already invested approximately $234 billion in capital expenditure this year. The market is beginning to worry about the massive cash flow migrating from the hyperscalers to the AI computing supply chain and whether the ultimate return on investment will match the cost of capital. Meanwhile, other heavyweight sectors like healthcare are showing real capital and earnings inflection points. Over the past three months, the S&P 500 Healthcare Index has risen 11.2%, outperforming the broader U.S. market by about 5 percentage points. In July, U.S. healthcare funds attracted $2.44 billion in net inflows, and BofA fund managers' net overweight position in the healthcare sector jumped from 14% in June to 32%. The market expects this sector to re-enter double-digit earnings growth from the fourth quarter of 2026 through 2027.

In the view of BofA strategists, the common characteristic of assets like biotechnology, regional banks, insurance, international small-cap value, and Japanese reform beneficiaries is not simply "defensive assets." Instead, it is that their valuations have not yet been fully re-priced, earnings are improving, and they have a lower correlation with the AI CapEx (AI infrastructure capital expenditure) cycle. This makes them a source of asymmetric and non-crowded alpha investment returns beyond the crowded AI trade. The so-called "alpha" is defined as the actual investment return significantly exceeding the "beta return," which refers to the synchronous investment return achieved by tracking a benchmark index.

On a cross-asset alpha level, BofA strategists suggest that the optimal portfolio for the coming years may no longer be the traditional "60/40," but rather a new barbell closer to "growth tech plus cash flow value plus real assets plus high-quality credit." Persistent inflation, fiscal deficits, and energy and supply chain shocks are weakening the ability of long-duration government bonds to act as a natural hedge for stocks. The increasing frequency of stocks and bonds falling in tandem in recent years is prompting institutions to seek alternative diversification tools such as commodities, infrastructure, and inflation-protected assets. Meanwhile, massive financing needs from AI companies and governments are pushing long-term real interest rates higher, further increasing the price of capital scarcity.