UBS Reveals The Stunning Reason Behind The 2017 Stock Market Rally

It's 2018 forecast time for the big banks. With Goldman unveiling its seven Top Trades for 2018 earlier, overnight it was also UBS' turn to reveal its price targets for the S&P in the coming year, and not surprisingly, the largest Swiss bank was extremely bullish, so much so in fact that its base case is roughly where Goldman expects the S&P to be some time in the 2020s (at least until David Kostin revises his price forecast shortly).

So what does UBS expect? The bank's S&P "base case" is 2900, and notes that its upside target of 3,300 assumes a tax cut is passed, while its downside forecast of 2,200 assumes Fed hikes in the face of slowing growth:

We target 2900 for the S&P 500 at 2018 YE, based on EPS of $141 (+8%) and modest P/E expansion to 20.6x.

 

Our upside case of S&P 500 at 3300 assumes EPS gets a further 10% boost driven by a 25% tax rate (+6.5%), repatriation (+2%) and a GDP lift (+1.6%), while the P/E rises by 1.0x. Downside of 2200 assumes the Fed hikes as growth slows, the P/E contracts by 3x and EPS falls 3%. Congress is motivated to act before midterm elections while the Fed usually reacts to slower growth; so we think our upside case is more likely.

Why is UBS' base case so much higher than what most other banks forecast? According to strategist Keith Parker, the reason is a "Valuation disconnect": Higher rates are priced in, while higher expected growth is not. He explains:

We model the S&P 500 P/E based on select macro drivers. The S&P P/E is 5x below the model implied level, which points to solid returns. More specifically, the 2.8% Fed rate target is priced in (worth 1.3x) but higher analyst expected 3-5yr growth is not (worth 3.7x). The P/E has been 2-4x above the implied level at the end of each bull market and the model has been a good signal for forward S&P returns (20-25% correlation). High-growth (most expensive) and deep-value (cheapest) stocks are cheap on a relative basis; the price for perceived safety is high. We focus on risk-adjusted growth + yield.

On the earnings side, this is how UBS bridges its 2018 rise to 141:

Following the 2014-16 earnings recession, S&P 500 EPS returned to growth in 2017 on the back of improved economic momentum globally, a commodity recovery, and rising margins. While a tax plan would significantly impact our growth assumptions, our base case EPS forecast excludes any tax upside given the degree of legislative uncertainty.

 

For 2018, we expect the earnings recovery to continue and forecast 8.3% EPS growth, driven by solid economic growth, offsetting margin drivers and higher interest rates. To control for the volatility and different drivers for certain sectors, we model financials and energy separately, with a buyback tailwind applied at the index level (1% assumed in 2018). 

 

We forecast S&P ex Financials & Energy earnings to grow 7% in 2018. Top-line growth is a function of 2.2% US real GDP and 3.8% RoW GDP growth, a relatively stable USD, and slightly higher growth in intellectual property products ("IPP" or tech) plus business equipment spending (less structures spending). Margins are adversely impacted by rising unit labor costs of 1.9% and boosted by a 1% improvement in productivity, with a negative net effect. Finally, flat US GDP growth means that earnings do not benefit much from operating leverage.

 

We expect Financials earnings to grow 7%, with return on assets improving on the back of a rising 3m Libor rate to 2.2% by YE 2018, two Fed hikes in 2018, a stable financing spread (delta between total bond market and Financials OAS spreads) and no rise in delinquencies (modelled using change in unemployment).  Asset growth is estimated using a beta of 1.35 to US real GDP growth.

 

We expect Energy sector earnings to continue to rebound, growing 28%. Energy accounts for less than 4% of total projected S&P 500 net income. Given the inherent volatility in earnings over recent years, we model sales growth as a function of oil and natural gas, which explains 97% of the sector's top-line growth. We assume that margins recover as D&A and other overhead is leveraged

Here we have some bad news for UBS: none of the above will happen, for one simple reason - the driver of earnings growth in 2017, China's record credit injections, has slammed shut, and if anything is now in reverse. This is bad news not only for China of course, but for fungible global markets, all of which are reliant on the world's biggest marginal creator of crerdit in the financial system, Beijing. And, as we discussed yesterday, starting, well, two weeks ago, China is in active deleveraging mode. 

The implications for corporate profits will be adverse.

* * *

Yet as we stated at the beginning, none of the above is surprising, or even remotely remarkable: it's just another bank's forecast, and with the benefit of hindsight one year from today, we will have some laughs at its morbid, late cycle optimism.

What is very striking, however, is an little noticed analysis from UBS inside the projection, which seeks to explain where virtually all the market upside in 2017 has come from. In a statement that one would never hear on CNBC, or any other financial medium, as it destroys the narrative of new money entering the market, UBS argues that the entire 2017 rally was just one giant short squeeze! In its own words:

Short covering fuelled the YTD rally; retail and foreign should continue to buy. YTD US equity ETF+MF flows have been -$17bn as short covering in stocks and ETFs of $83bn has supported the rally.

 

 

And as the shorts get decimated, the final buyer emerges before the whole house of cards comes crashing down: the retail investor. Some more details:

US equity demand model: short covering has fuelled the 2017 rally

 

We have developed a simple model of US equity demand, from the major sources of potential buying using higher frequency data. Figure 101 shows the cumulative "demand" since 2010, and the broad US equity market has tracked the measure well. Since the beginning of the year, US equity ETF+MF flows have been -$17bn as short covering in stocks and ETFs of $83bn has supported the rally (Figure 102). We see the rally transitioning to the next phase where inflows into MFs and ETFs need to take over with short interest as a % of market cap near the lows.

 

 

Retail and foreign buyers drive the last phase of a bull market. Following on the point above that flows to MFs and ETFs need to take over, we find that the retail and foreign buyer are typically the marginal buyer during the last phases of a bull market (Figure 103). Indeed, we see that US households have been increasing their ownership of US equities (ex MFs, ETFs, pensions), which has happened at the end of prior cycles. Additionally, the foreign buyer stopped selling and could start becoming a net buyer, with Asia money flow the key with ~$40tr sitting in M2.

 

In UBS' most bizarre admission, the Swiss bank also notes that "the last part of a bull market is typically fuelled by retail and foreign money, which has been the case of late." And yet, even more inexplicably, UBS believes that there is enough "dry powder" behind the short squeeze to push the market to not just 2,900 but potentially 3,300.

Which, if UBS is right, means that there will be a lot of suicidal shorts in the coming months as the world's biggest short squeeze proceeds to its inevitable conclusion. But the worst news is for the last bagholder left: Joe and Jane Sixpack, aka US retail investors, as institutions dump all their equity holdings to the last bid remaining, something JPM first warned about in February when it wrote that "Institutions, Hedge Funds Are Using The Rally To Sell To Retail" and which everyone appears to have forgotten.