Since the beginning of the year, the S&P 500 index has performed remarkably well, rising by about 23% cumulatively. However, UBS strategists point out that the U.S. stock market has not yet formed a bubble, and its further upside potential is closely related to the Federal Reserve's monetary policy. UBS believes that seven conditions are required for the formation of a bubble, and currently, six of these conditions have been met, with only loose monetary policy not yet in place.
Conditions for Bubble Formation
UBS analyst Andrew Garthwaite and his team pointed out in a report that six conditions have been met: the end of a structural bull market, corporate profit pressure, reduced market breadth, 25 years since the last bubble, increased participation by retail investors, and the widespread belief among investors that "this time is different." However, the critical condition of loose monetary policy has not yet been realized.
The report states that the Federal Reserve's current policy rates remain relatively restrictive. This week, the Fed lowered the federal funds rate by 25 basis points to 4.25%-4.50%, but this level is still not sufficiently accommodative. Garthwaite suggests that the federal funds rate needs to drop to around 3.2% to create a monetary environment conducive to bubble formation. This implies that the Fed needs to cut rates by at least another 100 basis points.
He further notes that if the Fed achieves this level of accommodation, a portion of the $6.6 trillion in money market funds might flow into the stock market. Such an inflow could fuel the continued rise of high-momentum stocks, potentially leading to a bubble.
Potential 20% Further Rise in US Stocks
UBS estimates a 35% chance of a bubble forming in the US stock market by 2025. If a bubble does indeed form, the S&P 500 index could see an additional increase of at least 20%. This potential rise would match the returns of 2023 and 2024, reminiscent of the late 1990s internet bubble, which ultimately ended in a market crash.
Investment Strategy and Advice
To hedge against potential bubble risks, Garthwaite advises investors to focus on "reasonably priced AI and electrification stocks." These include companies like TSMC, Meta, PG&E, National Grid, and Vistra.
UBS analysts emphasize that the Federal Reserve's policy trajectory will be key in determining the future market trends. If monetary policy is insufficiently accommodative, the market may remain stable, but if policy becomes too loose, the market could face a significant rise and the risk of bubble formation.
Conclusion
Although the S&P 500 index has shown strong performance in 2023, UBS's analysis indicates that future upside potential for US stocks still depends on the Fed's policy direction. Investors need to respond cautiously to market changes, paying attention to monetary policy and related industry investment opportunities, to manage risks and asset allocation effectively.
