The Fed is the only thing standing between investors and a full-blown stock bubble, UBS says

A laid back US central bank is the missing ingredient for a stock market bubble, according to analysts at UBS.

Strategists led by Andrew Garthwaite of UBS Investment Bank said that of the seven conditions required for a stock market bubble to form, six have already been met.

Those six thing include the end of a structural bull market, profits that are under pressure, a loss of market breadth, a gap of 25 years from the previous bubble, participation among retail investors, and a prevailing sentiment among investors that “this time is different.”

The last remaining condition for a bubble is loose monetary policy, according to the note, and with the Federal Reserve keeping interest rates at restrictive levels after Wednesday’s 25-basis point interest rate cut, that requirement doesn’t look likely to be met soon.

“What we are missing are benign monetary conditions,” Garthwaite said, adding that a Fed funds rate of around 3.2% would qualify.

“Then some of the $6.6 trillion in money market funds could easily switch into equities,” Garthwaite said, adding that the cash on the sidelines would likely pile into high-flying momentum stocks, bidding a potential bubble even that much higher.

The Fed lowered interest rates to 4.25%-4.50% on Wednesday, so at least another 100 basis points of interest rate cuts would be necessary for what UBS says is the final bubble ingredient to be added to the mix.

UBS ultimately sees a 35% chance of a bubble forming in the stock market in 2025, and believes that the Fed will eventually lower rates enough to spark such a risk-on mentality.

If a bubble does form in the stock market next year, expect the S&P 500 to surge at least 20%. Such a gain would be on par with its returns in 2023 and 2024, and would be reminiscent of the late 1990’s rally that eventually ended with the bursting of the dot-com bubble.

To hedge risks of a bubble, Garthwaite recommends investors buy “reasonably priced Gen AI and electrification names.”

Those stocks include TSMC, Meta, National Grid, PG&E, and Vistra.