With US stock valuations remaining high, discussions about whether the market has entered a bubble phase are intensifying. Despite strong corporate earnings, Wall Street executives have begun warning of potential pullback risks.
According to TrendFocus, a recent report by UBS has proposed a framework comprising seven indicators and concluded that the current market is in the early stages of a potential bubble, but has not yet reached its dangerous peak.
They pointed out that technology stocks have price-to-earnings ratios that are close to normal relative to the overall market, with better earnings revisions and growth prospects, and their capital expenditure cycle is in its early stages. Most importantly, the current market is far from exhibiting the signs of oversupply seen at the peak of historical bubbles.
UBS concluded that if a market bubble exists, it may be reflected in the high profit margins of tech giants. As capital intensity increases and competition intensifies in the industry, these high profit margins may face downward pressure in the future. However, for now, the market is still far from a truly dangerous moment.
Seven prerequisites for bubble formation
In a report, UBS equity strategist Andrew Garthwaite and his team proposed that seven preconditions are typically required for market bubbles to form. They believe that if the Federal Reserve's interest rate cut path aligns with UBS's forecasts, all seven conditions will be triggered.
- Buy-the-dips mentality: Over the past decade, stocks have outperformed bonds by 14% annualized, far exceeding the 5% threshold required to develop this mentality.
- The narrative of "This time it's different": The rise of generative artificial intelligence (Gen AI) provides a powerful new technological narrative.
- Intergenerational memory gap: It has been about 25 years since the last tech stock bubble (1998), and the new generation of investors is more likely to believe that "this time is different".
- Overall profits are under pressure: In the United States, if the top 10 companies by market capitalization are excluded, the 12-month forward earnings per share (EPS) growth of the remaining companies is close to zero, which is similar to the profit situation during the dot-com bubble.
- High concentration: The concentration of both market capitalization and revenue in the US stock market is currently at a historical high.
- Retail investors are actively entering the market: Retail trading activity has increased significantly in many regions, including the United States, India, and South Korea.
- Loose monetary environment: Financial conditions are already loose, and if the Federal Reserve cuts interest rates as expected, the monetary environment will be further eased.
Three signals at the top of a bubble
Although conditions for a bubble are gradually forming, UBS believes the market is still quite far from its true peak. The report analyzes key signals indicating a market top from three dimensions: valuation, long-term catalysts, and short-term catalysts.
1. Clear overvaluation: Historically, bubble peaks are often accompanied by extreme valuations. For example, in previous bubbles, at least 30% of companies by market capitalization saw their price-to-earnings ratios rise to 45 to 73 times, while the current forward P/E ratio of the "Big Seven" (Mag 6) is 35 times. Meanwhile, the equity risk premium (ERP) has not fallen to the extreme lows of around 1% seen in 2000 or 1929.
2. Catalysts for a Long-Term Peak: The report points out that several long-term indicators also show no signs of peaking. First, the share of information and communication technology (ICT) investment in GDP is far lower than the level in 2000, indicating no obvious overinvestment.
Secondly, the leverage ratios of tech giants are far better than during the dot-com bubble. Furthermore, market breadth has not deteriorated as severely as it did in 1999, when the Nasdaq nearly doubled, but the number of declining stocks was almost twice that of rising stocks.
3. Short-term topping catalysts: In the short term, the market lacks urgent signals of a market top. For example, there haven't been extreme mergers like Vodafone/Mannesman or AOL/Time Warner in 2000. Meanwhile, the Federal Reserve's policy stance is far from tightening to the point of triggering a market crash. Historical experience shows that the market will only peak when interest rates rise close to nominal GDP growth (projected at 5.2% in 2026).
Lessons from the Post-TMT Era
UBS reviewed the lessons learned from the bursting of the technology, media, and telecommunications (TMT) bubble in 2000, offering several insights for investors. First, after a bubble bursts, value may flow to non-bubble sectors; in the initial sell-off, non-TMT stocks initially rose. Second, the market may exhibit an "echo effect" or a Double Top pattern. Most importantly, the "concept was right, but the price was wrong," with companies like Microsoft, Amazon, and Apple seeing their share prices plummet by 65% to 94% from their peaks, taking 5 to 17 years to recover.
The report also emphasizes that the ultimate winners in the value chain may not be the builders of the infrastructure, but rather the users who can leverage new technologies to create disruptive applications or critical software.
