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De-rating vs. key themes/drivers: what's priced?

The key question in our mind going into 2019 is whether the de-rating in the market multiple and across most industries is justified, given the fundamental backdrop. We evaluate how sectors, industries, styles and factors stack up as it relates to the key themes discussed below, and compare those forward-looking drivers of performance against the 2018 returns and valuation changes.

De-rating in 2018 could see a ~40% reversal of relative returns in 2019. As we discussed above, sectors/IGs have reversed ~40% of relative underperformance in the year after a P/E de-rating. To assess the potential for a re-rating higher, we score sectors, industries and companies based on YTD performance, change in NTM P/E since March (after tax priced out) and NTM P/E vs. average since 2010; we calculate a cross-sectional z-score for each and take the average across the three.

Composite scores for 2019 based on key themes and fundamental drivers.

To better assess relative impacts of the key drivers for 2019, we standardize different data results by calculating a z-score for each of the themes across sectors and industries, as well as styles and factors for some of the themes. We discuss our approach for each of the themes starting on page 33. We take an average of the relative z-scores for the below to get a composite score for 2019.

ISM cycle implied relative returns, assuming midpoint of 52.5 hit in Oct-19.

Tariff-related potential impacts using UBS Evidence Lab mapping.

Margin risk score amid decelerating sales growth and rising wages.

Dividend growth upside amid rising payouts.

Momentum tends to persist, look for sustainable growth.

C-Speak: corporate net sentiment can provide a leading signal.

Quality tends to outperform at this stage, look for FCF too.

Cyclicals de-rated by much more in 2018. There has been a big relative rerating since March as P/Es for Financials, Industrials, Materials and Energy declined by ~2x while P/Es increased by ~1x for Utilities, Health Care and Staples. Tech and Comm Svcs P/Es have been flat.

Figure 14: S&P 500 sector and industry change in NTM P/E since March

We include the historical context because some industries and stocks are trading close to historical lows on a relative basis.

We position to capitalize on underappreciated later cycle upside and leadership/ momentum that we think is still relatively cheap while still accounting for the key risks as it relates to tariffs, decelerating growth, rising wages and margin sustainability.

We see the ~2.5x relative rerating between domestic/defensive sectors and more cyclical sectors as likely pricing in more risks.

4				Change in NTM P/E since March	Sales revision, 3m (rhs)		16%
2							8%
0								0%
-2							-8%
-4							-16%
-6							-24%

Source: FactSet, UBS

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We find that the relative de-ratings have been ~50% correlated to our 2019 composite scores for sectors and IGs. For sectors and IGs, we compare the de-rating in 2018 to the 2019 composite score based on the key themes/ drivers. The fairly high correlation suggests that some of the relative risks/upside have been priced, but not all of it.

The line in Figure 15 represents the theoretical one-to-one trade-off between the relative re-rating/performance in 2018 on the X-axis and relative fundamentals on the Y-axis. In the bottom left quadrant, we find that certain sectors and IGs have de-rated by more than the deterioration in relative fundamentals. For instance, Energy and Capital Goods stand out as having better potential for relative upside in 2019 on this basis. On the flip side, the weaker fundamentals have not necessarily been fully priced for Materials, Autos & Comp and REITs.

On the upside, we find that Pharm/Biotech, Consumer Svcs, Media & Enter and Transports are not fully pricing their relatively better fundamental backdrops. On the other hand, Food & Staples Retail stands out as having one of the largest reratings higher despite average fundamentals. Healthcare Equip & Svcs, Tech Hdwr and Software & IT Svcs have solid fundamentals but seem to be pricing more of it.

In the middle, on the dashed line, Semis, Banks, Div Fins and Staples have re-rated in line with relative fundamentals on our measures.

We would tilt toward those sectors and IGs that are above the dashed line, given the trade-off between relative valuation support and fundamentals:

-Healthcare, Pharma/Biotech

-Consumer Services, Retail

-Comm Svcs, Media& Enter

-Industrials, Cap Goods,

-Transportation

-Energy

-Insurance

Figure 15: Relative de-rating in 2018 (x-axis) versus relative fundamental score (y-axis)

	0.8
		Green = attractive			Pharma Biotech & LS		Health Care
	0.6	Red = avoid		Consumer Svcs			Retailing
risk)	0.4							HC Equip & Svcs
vs.				Food Bev & Tob
reward				Media & Entertain		Cons Staples
	0.2				Transportation		Cons Disc	Tech Hdwr & Equip
(relative								Software & Svcs
				Comm Svcs			Technology
								Food & Stap Retail
				Insurance
	0.0
							Utilities
Score				Telecom
				Industrials
		Capital Goods
Composite				Financials
	-0.2
				Banks
		Div Financials
					Real Estate
2019		Energy
	-0.4				HH & Personal Prod
			Cons Dur & App		Com & Prof Svcs
		Semis & Equip
	-0.6
				Materials
		Autos & Comp
	-0.8
		-1.0		-0.5	0.0			0.5	1.0
				2018 De-Rating Score (negative score can catch up)

Source: UBS

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At a style/factor level: quality, momentum and growth should lead at this stage, but they are not cheap

Quality is the best performing factor from an ISM peak to a trough, but higher quality stocks are relatively expensive versus history, and lower quality stocks are relatively cheap.

Momentum also tends to work through the last half of a cycle, performing best in the current phase when the ISM is high/falling. The recent unwind of high momentum stocks has made the relative valuation gap less extreme, but valuation is by no means a tailwind.

Growth has outperformed value on average at this stage, though FCF yield has worked best through an ISM peak to trough cycle on average. When the ISM falls below the midpoint, growth tends to lag as a factor. In particular, high growth stocks tend to significantly underperform. On the flip side, value actually has outperformed on average when the ISM fell below 52.5, with FCF yield and dividend yield standing out.

Large has outperformed small when the ISM fell from a peak. We see a number of factors as supporting large cap outperformance versus small at this stage including relative margins, rate sensitivity, pricing power and labor costs.

Similar to sectors and industries, we find that the styles and factors that should lead at this stage of the cycle when the ISM is high/falling and through the later stage when ISM is low/falling are relatively expensive.

Figure 16: Factor performance when ISM high/falling vs. low/falling, and relative factor valuations

Perf during Low and Falling ISM cycle

25%

Bubble size = relative valuation of high vs. low

Quality perf best from

Red bubble = expensive vs. history

ISM peak to trough, but

Comp Quality

it is relatively expensive

20%

Green bubble = cheap vs. history

FCF Yield (trailing)

15%

EY (trailing)

Comp Value

Dividend Yield (trailing)

ROE

ROIC

10%

EY (NTM)

OCF margin

Price Mom (12m ex 1m)

5%

Gross Profit margin

Comp Momentum

EBITDA margin

Earnings Revision 3m

Net Debt

to EBITDA

Market Cap

Earnings growth 1Y fwd

0%

Book to Price (trailing)

Earnings growth 1Y trailing

Sales growth 1Y fwd

-5%

Total

Debt to EV

Sales Revision 3m

Short Interest Ratio

Comp Growth

Sales growth 1Y trailing

-10%

Growth does well when ISM

-15%

is high/falling, but lags later

Beta 12m

cycle

-20%

-25%

Volatility 12m

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Perf during High and Falling ISM cycle

Source: S&P, Compustat, IBES, UBS Note: Bubble size is based on NTM P/E and z-score since 2010; average performance during ISM cycles, high vs. low quintile within the S&P 500, non sector neutral.

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