UBS: 12% Overheating Probability to Boost Cyclical Stocks

UBS analysts have indicated that the market is beginning to price in the possibility of economic overheating, with the probability of this scenario currently standing at 12% and rising. This trend is expected to drive cyclical stocks higher and broaden market participation across various sectors.

According to UBS equity strategist, the sensitivity of certain sectors to the probability of overheating is a key factor in this trend. The strategist noted that sectors such as automobiles and auto parts, durable consumer goods and apparel, and diversified financials are particularly responsive to the overheating probability. These sectors are likely to outperform the broader market as a result.

Currently, the best-performing sectors in the S&P 500 include software, media and entertainment, semiconductors, and equipment and banking. Conversely, sectors such as household and personal care products, chemicals, and packaging containers are among the worst performers. This ranking is based on the "R.E.V.S. scoring system," which evaluates economic cycles, corporate earnings, valuation levels, and market sentiment.

The scoring system suggests that the market is showing signs of broadening, with 26 out of 27 sectors receiving positive scores. This indicates that market breadth is likely to expand further, and lagging sectors may see a catch-up rally.

The strategist also pointed out that the earnings growth gap between the "tech+" sector and the rest of the S&P 500 is expected to narrow by 2026. By that year, the earnings gap between the "six tech giants"—NVIDIA, Microsoft, Apple, Google, Amazon, and Meta—and the rest of the S&P 500 is expected to return to normal levels, reducing overall market earnings disparity. The strategist also noted that the semiconductor, pharmaceutical, and media sectors are expected to achieve strong growth of over 15%.

Currently, the forward price-to-earnings ratio of the S&P 500 is above 22 times. Excluding the "tech+" sector, this valuation stands at 18.6 times, which is considered high. However, the strategist argued that factors such as stock buybacks and stable inflows from global pension savings plans have created a momentum effect that supports current valuations. While valuation concerns are valid, they will only have a significant impact if corporate earnings expectations begin to decline. In the short term, continued earnings improvements and their broadening scope should offset the pressure from high valuations.

In terms of market sentiment, the communication services, technology, and financial sectors remain particularly popular. The strategist's "portfolio beta coefficient analysis" showed that the scale of balanced fund holdings has increased again, driving the comprehensive beta holding index back to the average level. Meanwhile, hedge fund holdings data indicated that funds are exiting the banking, food and beverage, and tobacco, and medical equipment sectors, and flowing into the pharmaceutical sector.

Finally, the strategist noted that UBS's "theme heat meter" showed that the market crowding of the "seven giants" and artificial intelligence-related investment themes is at an extremely high level. However, this phenomenon is still rational due to their relative resilience and market leadership in earnings expectations adjustments.

The stocks with the highest scores in the "R.E.V.S. scoring system" include Hasbro, Dayforce, Qurate Retail, Steris, and MongoDB.