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.

(Click on image to enlarge)

 

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.

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