Bank of America recommends buying the Nasdaq relative to the S&P 500 in the AI era, considering the upside potential and volatility.

Investing.com - U.S. bank analysts recommend investors hold the upside potential and volatility of the Nasdaq 100 index relative to the S&P 500 index, citing the expected impact of tech and AI initial public offerings (IPOs) and proposed changes to index construction methods.

The bank estimates that since the launch of ChatGPT at the end of 2022, the survivor bias effect in the AI era has been twice as large in the Nasdaq 100 index compared to the S&P 500. In market-cap benchmarks, passive investors can benefit from this characteristic because winners have a larger weight in the index, while underperformers are removed.

The bank states that the proposed changes to Nasdaq’s index construction method could lead to faster inclusion of IPO stocks listed on Nasdaq. These changes may also make passive tracking funds a key buying force for newly listed Nasdaq stocks, even if the initial free float is below 10%. If the IPO pipeline proceeds smoothly, future Nasdaq components may become more concentrated in tech and AI sectors, with underperformers exiting more quickly.

Using comparable peer data, valuation dynamics of perpetual futures, secondary market trading, and public funds holding large pre-IPO allocations, the bank predicts that volatility for a large, potentially newly listed Nasdaq component could range from 100% to 120%. This estimate is about three times the average stock volatility in the Nasdaq and may be conservative, as newly added stocks could have lower initial free float.

The bank expects this to initially have a mild impact of 0.1 volatility points on the Nasdaq’s volatility, but if there are large listings or free float increases over time, the impact could grow to 1.1 volatility points.

The bank notes that the Nasdaq is more concentrated in tech and AI than the S&P 500, and with Nasdaq’s proposals and strong IPO pipeline, this gap could widen. It points out that if AI-driven asset bubbles occur, history shows that concentration tends to outperform diversification before the bubble peaks, and volatility tends to rise with prices as the bubble inflates.

The bank recommends long positions on the relative performance and volatility of the Nasdaq versus the S&P 500, including a conditional excess return of the Nasdaq relative to the S&P 500 expiring in December 2027, which has historically averaged a 3x return, potentially reaching 13x in bubble scenarios. It also suggests using a variance swap on the Nasdaq minus S&P 500 index with a December 2027 expiry, offering a risk-reward ratio greater than 5:1.

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