LIVE MARKETS-Equity bubble risk alive and justifiable, but we're not in one - UBS

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EQUITY BUBBLE RISK ALIVE AND JUSTIFIABLE, BUT WE'RE NOT IN ONE - UBS

The risk of a stock market bubble is very much alive and it can be justified, say UBS strategists, but we're not in one.

"Our view remains that there are 7 preconditions for a bubble, and we could have all 7 if we get more benign liquidity conditions, ie the Fed reduce rates to 3.5-3.75% by year-end, QT ends mid-year and the PBOC print - all of which seem feasible," they write, adding they see a 35% chance of a bubble.

The six preconditions already met are: the end of a structural bull market, profits under pressure, loss of breadth, gap of 25 years from the previous bubble, a 'this time is different' mentality, and retail participation. The seventh is loose monetary policy.

For UBS the two most vital predictions for a bubble is the timing at the end of a structural bull market, and when either ‘dominance’ or technological change allows investors to say ‘it is different this time around’.

"...with Mag 7 we have both dominance and Gen AI," they write.

Historically bubbles get to a P/E ratio of 45x to 72x for up to 43% of market cap on a bond yield of at least 5.5%, according to UBS.

"But critically when bubbles burst, typically prices fall 70% to 80%; hence investors want to avoid the last 6 months of a bubble," says UBS.

"Currently the Mag 6 (ie the Mag 7 minus Tesla) have a P/E of 33X 12 month trailing (P/E of 29x 12 month forward)."

So how could one be justified?

"One possibility is Gen AI is perceived to push up productivity as much as TMT did temporarily (which was 2%) - this was a rise in productivity that ended up being illusionary," write the UBS strategists. They say the anecdotes on the impact of AI are increasingly impressive.

If Gen AI immediately improves productivity by 1%, then equities have 17% upside on UBS's equity risk premium (ERP) model. If Gen AI pushes up productivity by 2% from 2028, they can justify a 30% upside for equities.

They flag abnormally high government bond volatility relative to that of equities for their case for structurally lower ERP.

UBS says if governments are to de-lever by printing then the ERP should be lower, but if they choose to de-lever by taxing the corporate sector, then the ERP should be structurally higher, with the former looking more likely

(Lucy Raitano)

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