UBS: The 2 biggest stock market fears are completely overblown

Reuters / Brendan McDermid

• Even though the stock market keeps hitting new record highs, investors are continuously finding new reasons to be worried.
• UBS tries to dispel these concerns, calling for the S&P 500 to climb as much as 9% from current levels by the end of 2018.

Investors seem awfully scared, considering the stock market has been routinely hitting new record highs.

Some are fearful that the factors that have catalyzed one of history’s strongest bull markets are bound to overheat. Others think that the ongoing rally is too good to be true, and that any disruption to current conditions could send stocks tumbling.

UBS doesn’t agree. It sees the S&P 500 climbing as much a 9% by the end of 2018, hitting any number of new all-time highs along the way. And it wants to dispel two of the biggest concerns they hear voiced by investors.

Stocks are overvalued, and global equities are in a bubble

This is a popular argument, and its disciples cite measures such as the price-earnings ratio (P/E) for various indexes and the so-called Shiller CAPE ratio — both of which are historically stretched. Some have even gone as far as to call it a bubble.

UBS rationalizes the levels seen in these measures, arguing that the slow global growth environment causes gradually-growing corporate earnings to be discounted at low risk-free yields. And you get higher average valuation multiples as a result.

“Adjusting P/Es for the decline in risk-free yields, we find that despite ongoing multiple expansion, on an interest rate adjusted basis, valuations are within the post-crisis ranges in the US and slightly higher than those in Europe and Japan.”

Central bank tightening will suck the life out of stocks

UBS readily admits that yields will feel some upward pressure as central banks remove accommodation — but it doesn’t see it happening to an extreme degree. To them, the stock market will be fine as long as tightening measures are done with a soft touch.

Assuming economic growth continues to churn gradually higher, and inflation doesn’t spike suddenly, central banks should have plenty of room to hike interest rates gradually and on a predetermined schedule. UBS even foresees a situation where stocks continue rising in tandem with yields.

Overall, while 9% is the firm’s most optimistic forecast, it actually has six different models for the S&P 500 in 2018. As shown in the chart below, equity appreciation has four key components: CPI inflation, income (dividends, buybacks, reinvestment), real equity risk premium and the real risk-free rate.

Regardless of which mix you think is most accurate, UBS’ stance is undeniable: stocks are going to continue higher, and the market’s fears are overblown.

UBS