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We’ve reached an alarming, albeit entertaining, stage of any stock market rally: Motivated reasoning and justification.
Not only are well-known bears capitulating, but banks are publishing research notes about how this time is really really different, which we’ve heard is always a good sign. Like this note from UBS’s equity strategists this week:
While it is easy to portray lofty multiples as a bearish harbinger, we believe investors would be better served by exploring the reasons for these elevated levels.
The bank argues the S&P 500 should be trading at a price that’s 22 times next year’s earnings, well above the long-term average of 17:
And it lists four reasons that this state of denial bullishness should continue.
Reason 1: A greater share of the S&P 500 is tech stocks now, and those businesses are inherently better and growthier.
30 years ago, before the commercialization of the internet, and eons before the smartphone, tech-related companies made up just 10% of S&P 500 market cap. Today, they make up 40%. Over this period, TECH+ companies have grown their top lines faster, with higher margins. The result — not surprisingly — is an upward short in valuations for the market broadly.
Not that there’s any reason to worry about the maturing of the tech industry, with the margin pressure and governmental scrutiny that usually entails.
Nor is UBS worried about the possibility the big-tech rally is fuelled only by optimism about AI, given real problems with the technology’s fundamental appeal and usefulness:
The current premium is less about the potential of AI. Rather, it is a response to superior fundamentals, namely rapid sales growth and sustainably high EBIT margins.
What’s fuelling big tech’s sales growth and EBIT margins? Couldn’t say.
Reason 2: Companies have higher cash flows now, so they deserve higher valuations.
If you compare the S&P 500’s price to its free cash flows, it doesn’t look quite so expensive, UBS points out:
The bank is correct in arguing that large-cap companies have become more tech-heavy and “capital light” over the past two decades, meaning they generate more cash per dollar of sales:
Could this trend ever change? It’s tough to say what the future may bring, especially when it comes to external pressure on US companies to spend more on heavier industry and domestic manufacturing.
Reason 3: Companies still have a low cost of capital.
This one is so funny. UBS argues that despite recent years’ climb in Treasury yields, corporate bonds are trading at very narrow spreads to Treasuries, which is keeping companies’ overall cost of borrowing low.
That means broad optimism about riskier markets — basically, what’s keeping stock prices high — is also keeping their borrowing prices low.
And that’s a reason stock prices will stay high. What an argument!
Reason 4: There’s no recession in sight.
From UBS:
Many investors assume that stock valuations—or equity risk premia—mean revert toward fair value. Our work indicates that valuations have an upward bias in non-recessionary periods, but correct sharply around economic contractions. With current recession risks contained, multiples are most likely to drift higher in 2025.
The bank even includes a handy chart that says stocks keep rising until they stop rising. And when they stop rising, they fall by a lot.
So for now, at least, the message is: F*ck it we ball?