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We have reached an interesting but alarming stage in the stock market rally: motivated reasoning and rationalization.
Not only is the famous bear surrendering, but Banks is publishing a research note about how this time is actually different, which we hear is always a good sign. Here’s a note from UBS’s equity strategists this week:
While it’s easy to portray high multiples as a bearish harbinger, we think it’s more useful for investors to explore the reasons for such elevated levels.
The bank argues that the S&P 500 index should trade at 22 times next year’s earnings, well above its long-term average of 17 times.
He then cites four reasons why this state of bullish denial should continue.
Reason 1: Tech stocks now make up a larger portion of the S&P 500 index, and these businesses are inherently better and growing more.
Thirty years ago, before the commercialization of the Internet and long before smartphones, tech companies accounted for just 10% of the S&P 500’s market capitalization. Now they account for 40%. Over this period, TECH+ companies have grown sales faster with higher profit margins. As a result, of course, overall market valuations are shorted to the upside.
Still, there’s no reason to worry about the margin pressures and government oversight that come with any maturing tech industry.
UBS is also not concerned that the rise in big tech stocks may be driven solely by optimism about AI, given the real-world questions about the technology’s fundamental attractiveness and utility. .
The current premium is not about the potential of AI. Rather, this is a response to strong fundamentals: rapid revenue growth and sustainably high EBIT margins.
What’s driving sales and EBIT profit growth for big tech companies? I couldn’t say.
Reason 2: The company’s cash flow is currently increasing, so it deserves a higher valuation.
UBS points out that when you compare the S&P 500’s price to its free cash flow, it doesn’t look that expensive.
Banks is right that over the past two decades, large-cap stocks have become more technology-focused, more “capital-light,” and generate more cash per dollar of sales.
Will this trend ever change? It’s difficult to say what will happen in the future. This is especially true when it comes to external pressure on American companies to spend more on heavy industry and domestic manufacturing.
Reason 3: Corporate cost of capital remains low.
This is very interesting. UBS argues that corporate bonds trade at very narrow spreads to Treasuries, which keeps the total cost of borrowing low for companies, despite the recent rise in Treasury yields. There is.
In other words, widespread optimism about risky markets – essentially what keeps stock prices high – also keeps borrowing prices low.
And that’s why stock prices remain high. What an argument!
Reason 4: There is no recession in sight.
From UBS:
Many investors believe that a stock’s valuation, or equity risk premium, means a return to fair value. Our research shows that valuations have an upward bias during non-recession periods, but undergo sharp corrections during periods of economic contraction. Multiples are most likely to rise in 2025 as current recession risks are contained.
The bank also includes a handy chart that shows the stock price will continue to rise until it stops rising. And when it stops rising, it will fall significantly.
So, at least for now, the message is:
