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UBS: Risk of bear market, and maybe crash, rising

Ilya Naymushin | Reuters

UBS sees chances rising for a 20 percent decline in major global stock market prices because of the end of the credit cycle, lackluster earnings and rising macroeconomic risks. The possibility that this decline could include a stock market crash driven by a lack of liquidity are increasing as well, according to the investment bank.

Paul Winter, head of quantitative research, Asia-Pacific, was the lead analyst on the dense 38-page report sent to clients late Monday which featured a number of different academic models used to gauge the current state of equity risk premiums, market liquidity and earnings growth.

"We think of valuation as a function of growth and risk premia," the Winter-led team wrote. "Overall, we find that the equity market is pricing in a world of low growth and low inflation, but surprisingly also low risk. Given the significant increase in macro risk and the apparent end of the credit cycle we believe that an overall repricing of risk is likely."

The analysts go on to explain that stocks are receiving a premium that is too large relative to bonds given that earnings are actually declining right now.

"How does this correct itself?" asks the report. "Either earnings need to pick up to around 4 percent, which would suggest a decline in equity market volatility and justify a 4 percent risk premium. Or alternately, equities would need to correct by around 20 percent to bring the equation back into equilibrium."

And market declines such as these can lead to a sudden crash if liquidity is not there. And right now, liquidity conditions are not strong, according to a UBS variation on academic Pete Kyle's "market impact" model.

"The Kyle model is highlighting that whilst we have not suffered a significant drawdown in the market, the market impact has certainly increased, in our view increasing the risk of a stock market 'crash,'" the report says. The model looks at the cost of making trades over time to show large price moves would be hard for this current market to handle.

And the report shows that just because the market does not have the frothy characteristics of past stock bubbles, that does not make it immune to a correction or bear market:

"We show that contrary to conventional wisdom, the market does not need to be overvalued in order to correct. In fact, it's more likely that the market suffers a drawdown when earnings growth rates and valuations are low. ... We examine drawdowns of worse than -10 percent in a calendar month. Overall, we find that 41 percent of drawdowns occur in the bottom 10 percent of earnings growth rates (largely when earnings growth rates are negative)."

So what's an investor to do? Buy quality stocks the report says: