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Bubble trouble

If Treasury yields climb above 5%, investors may be in trouble.

A bubble lifting the NYSE

Emily Parsons

3 min read

You may have heard the B-word thrown around to describe how concentrated the market has become in a few key AI stocks. But how do we know if we’re actually in a highly-feared stock market bubble?

According to UBS Global Equity Strategist Andrew Garthwaite, the market meets six out of the seven preconditions for a bubble—not exactly reassuring math.

Here’s UBS’ checklist for a stock market bubble:

✅ End of a structural bull market: “Bubbles happen at the end of a structural bull market (when equities outperform bonds over a 10-year period by at least 5% per annum),” he wrote in the note.

✅25 years since last bubble: It’s been a long time since the dot-com bubble burst, and many of today’s investors have never experienced the growth and subsequent implosion of a market bubble. “This allows a new generation to believe 'It really is different,'” Garthwaite wrote.

✅ “This time is different” narrative: New technology or a trendy new way of investing can dominate the market during a given period of time, so much so that investors forget that even newer tech or trends will eventually replace the old. “And now we have both with the 'Magnificent 7,'” he wrote. “The bubble risk has been reinforced by the narrative of Trump deregulation and 'MAGA'.”

✅Pressure on corporate profits: “Happens when overall profits come under pressure (often when margins peak) – this was certainty the case in Japan in the late 1980s (when stock prices were driven by real estate values, not earnings),” Garthwaite explained.

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✅Narrowing breadth: A few key tech stocks have driven much of the S&P 500’s growth over the past year, to the point that the top 10 stocks by market cap now account for about 37% of the S&P 500. Compare that to a decade ago, when the top ten accounted for 14% of the index.

✅ Retail investors getting in on the fun: Retail investing has surged since 2020, accounting for a larger percentage of market volume over the last few years than it has throughout history. “Both anecdotal and ETF flows data show this to be the case,” he explained.

❌ Loose monetary policy: “What we are missing are benign monetary conditions, but if the Fed reduces rates to 3.2%, then some of the $6.6 trillion in money market funds could easily switch into equities,” he wrote.

Keep your eyes peeled: We’re not in a bubble yet, but Garthwaite says that if the 10-year Treasury yield rises above 5%, it will signal to investors the equity-risk premium is no longer worth it.

The hedge? “Just in case there is a bubble (35% chance) that we are not yet in, we would favour investing in the areas that are different this time around but where you can justify the valuation without a bubble – namely the Gen AI and electrification names above,” he wrote. A few of those names include TSMC, Meta, Amazon, Microsoft, Nvidia, and Vistra. He also advises underweighting non-financial cyclical stocks, and argues financial stocks are a hedge against rising inflation.—LB

Making sense of market moves

Stay up to date on the latest market news with daily analysis of the investing landscape, served up Brew-style.