Key Ratio Points To 15% S&P Upside, One Bank Says

January’s stock swoon isn’t out of sync with fundamentals and played out largely as expected considering the tightening impulse in financial conditions, signs of slowing growth and the read-through from the Omicron wave.

That was one takeaway from a strategy update out of UBS, whose Keith Parker and Alastair Pinder assessed the situation in US equities after the worst start to a year in history.

By now, most readers have seen the chart (below), but it’ll surely come up again over the next several months, when the benefit of hindsight allows everyone to determine whether this was a buying opportunity or the beginning of something entirely sinister.

That was the state of affairs on Monday at noon, just before a “biblical” turnaround that found stocks erasing a ~4% decline to close green. Equities attempted another Houdini on Tuesday, but fell short.

Parker and Pinder cited an elevated equity/ bond vol ratio in the course of suggesting stocks can rebound to post outsized gains over the next six months, consistent with the bank’s 5,000+ target for the S&P in the second quarter.

“Spikes in the equity to bond volatility ratio often lead market bottoms and eventual S&P 500 rallies,” they wrote. The figures (below) illustrate the point.

In addition to that, UBS walked through a series of “circuit breakers and catalysts,” the first of which was simply that the market has aggressively priced the Fed.

For weeks, I’ve argued that barring some manner of macro “shocker” and/or smoke signals from Fed officials, there’s just not much room left for additional hawkish pricing. If 50bps were to get fully priced for March and traders didn’t fund those expectations by removing one of the other three hikes priced for 2022, that would be 125bps this year. Plus whatever balance sheet rundown equates to.

“The 9% S&P selloff is the same as in 1994 and 2004 when the Fed hiked >200bps in the next one year, and even worse when normalizing to six-months prior to Fed liftoff,” UBS said.

COVID cases, meanwhile, are pretty much destined to fall from here. If Omicron weighed on growth in Q4 (and likely in Q1), then the opposite should be true as the current (and, perhaps, last) virus wave recedes. As Parker and Pinder put it, “the hits from Omicron [and] slower growth have been priced, but plummeting cases and a sizable recovery could be the positive surprise.”

They also expect Q4 earnings to ultimately turn out decent, although they emphasized that margin guidance is key. Additionally, they cited cheaper valuations after the selloff (the S&P has de-rated two turns already this year) and, crucially, the return of buybacks.

“The pace of weekly corporate flow from buybacks and dividends is set to jump fivefold [in] the next two to three weeks, as earnings blackouts end,” they wrote, adding that “end-of-January rebalance buying should be supportive” as well, “particularly with active fund positioning 0.7 standard deviations below average, led by asset allocation and macro/CTA funds.”

The Ukraine situation, they conceded, is “difficult to price.” Tensions with Russia, the bank remarked, are an “added downside risk.” Needless to say, any kind of energy shock on top of what’s already played out over the past six months would likely undermine sentiment.

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