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These 6 trades can help investors beat the market as torrid earnings growth pushes the S&P 500 to 5,000 in 2022 — even with near-term upside limited

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Summary List Placement

The stock market's remarkable rally from March 2020 lows has further upside but is bound to slow down, even after companies blew Q2 earnings expectations out of the water.

That's according to UBS, which recently bumped its S&P 500 2021 price target up from 4,500 to 4,600 and raised its 2022 price target to 5,000. The firm's new price targets imply stocks have about 2.5% upside through the end of the year and will run 11.5% higher in the next 16 months.

Q2 earnings beatsEarnings rose by an eye-popping 90% year-over-year in Q2 and topped expectations for the fifth straight quarter. That was the main driver for UBS's upward S&P 500 price target revisions, as the firm had expected earnings to rise 80%. Revenue also jumped 25% in Q2 while S&P 500 profit margins hit a multi-decade high, according to UBS.

UBS profits

UBS projects S&P 500 earnings to expand 45% in 2021 and for the 500-component index to log a 22.5% gain this year. Last year, the S&P 500 advanced 16.3%, even as earnings fell 11.2%.

UBS earnings pre-pandemic

Stock market valuations are historically high, but equities still look appealing relative to bonds, wrote David Lefkowitz, UBS's head of equities in the Americas, in an August 22 note.

"While valuations are higher than average, we remind investors that valuations have no correlation with market returns over time horizons less than three years," Lefkowitz wrote. "And valuations typically don't contract meaningfully unless investors are concerned about a sharp growth slowdown or a policy error by central banks."

Investors can credit the outsized stock gains to robust economic growth and the easy monetary policy from the Federal Reserve that fueled it, Lefkowitz wrote. 

Fed officials are debating whether or not to walk back their emergency-era policies, like near-zero interest rates and $120 billion in monthly bond purchases, and will share their decision at this week's August meeting. Wall Street expects the Fed to announce tapering of bond purchases later this year but doesn't see rate hikes until early 2023, the UBS note read.

"The Fed should be in no hurry to move to tight monetary policy any time soon," Lefkowitz wrote. "The recent rise in COVID-19 cases only bolsters this outlook. That means the Fed can remove accommodation at a slow and deliberate pace."

Fears of rampant inflation gripped the market in the spring as commodity prices quickly rose and stimulus-induced demand overwhelmed businesses, many of which dealt with intermittent supply and worker shortages. The Fed would be forced to tighten monetary policy early, investors thought, so bonds sold off. Yields, which move inversely to bond prices, shot up.

Inflation concerns then evaporated over the summer as quickly as they came. Commodity prices plunged as supply caught up with demand, evidence of wage growth was lacking, and unemployment remained persistently high, the note read. These were tell-tale signs of weaker growth, not hotter inflation, especially as the COVID-19 Delta variant surged.

UBS expects optimism about the economy to return as unemployment numbers fall and decade-high household savings rates, boosted by generous fiscal stimulus, support healthy corporate profit growth, the note read.

"Even though consumer spending was subsidized by government stimulus during the height of the pandemic, continued job growth should propel consumer spending higher," Lefkowitz wrote. "On the production front, businesses are struggling to keep up with demand, suggesting a long pipeline of investment projects and a need to rebuild inventories — both of which are supportive for the growth outlook."

6 trades to make now

A steadily healing economy and peaking COVID-19 case count will lift economically sensitive cyclical stocks, according to UBS. The group has "meaningfully underperformed" in recent months as investors feared the pandemic and a hawkish Fed would slow growth, Lefkowitz wrote.

But not all cyclical sectors are equally safe. UBS downgraded the Industrials sector to neutral from moderately preferred, and is less bullish on the Consumer Staples and Utilities sectors.

"Despite our view that cyclicals will rebound in the coming months, we acknowledge that the business cycle is maturing, and it therefore makes sense to scale back the size of our cyclical exposure," Lefkowitz wrote.

Below are six sectors and trades that UBS prefers, along with analysis of its bullish rationale for value stocks, mid-cap stocks, and the healthcare sector. No analysis was given for the latter three investing ideas, though each are cyclical sectors that should benefit from a healing economy. Note that the screenshots of ETFs below are for illustrative purposes and are not UBS recommendations.

1. Value over growthS&P Global

Analysis: "We believe cyclicals (and value) underperformed in June and July as fears around COVID-19 and the Fed accelerated. If those fears begin to wane, as we expect, value stocks should enjoy a nice recovery. This is in line with our fixed income team's views for higher long-term interest rates. In addition, valuations continue to be very attractive with value stocks trading near post-dotcom valuation lows relative to growth stocks."

2. Mid-caps over large-capsS&P Global

Analysis: "Smaller size segments should benefit from the economic reopening, but we think the opportunity for mid-caps to outperform large-caps is greater than small-caps. As we transition to more of a midcycle environment, investors tend to move up in quality. Mid-caps are higher quality than small-caps, but more cyclical than large-caps. This balance seems appropriate from a risk-reward perspective. … Finally, both earnings growth and relative valuations remain attractive for mid-caps."

3. Healthcare SectorMarkets Insider

Analysis: "Our upgrade of healthcare [to moderately preferred from neutral] reflects its improving growth prospects relative to the market. ... In addition, valuations remain attractive and risks around drug pricing reform are likely already reflected in share prices. While the prospects for drug price reform are uncertain, we think an aggressive cut to drug prices is unlikely due to the powerful position that centrist Democrats currently hold in the Senate. … Relative to other defensive sectors — consumer staples and utilities — healthcare has generated faster earnings growth, and forward-looking growth prospects remain favorable."

4. Consumer Discretionary SectorMarkets Insider

5. Financials SectorMarkets Insider

See the rest of the story at Business Insider

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