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Market Preview: Holding Out for a 'Grand Bargain'

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NEW YORK ( TheStreet) -- Enjoy the spotlight while you can fiscal cliff because talk of the need for a grand bargain on Capitol Hill is already leaping into Wall Street's lexicon.

Most market observers expect the Democrats and Republicans will show they learned their lesson about playing chicken with the nation's finances during the debt ceiling debacle and come to some compromise in a timely manner in order to avoid the fiscal cliff, which refers to a bevy of tax increases and spending cuts that will go into effect on Jan. 1 unless the parties can hammer out a deal.

There is a fear though that U.S. legislators will simply borrow a page from their procastinating counterparts across the pond and find a way to delay, rather than solve, the country's financial problems. What's needed instead is a ... wait for it ... grand bargain that will be more than a band-aid.

UBS used the term in commentary on Monday as it introduced a year-end 2013 target of 1425 for the S&P 500 . That view implies potential upside of just 2.7%, or 38 points, from Monday's close at 1387, and 4.8%, or 65 points, from Friday's finish at 1360.

"Our cautious stance is predicated upon a belief that a number of macro uncertainties -- the most important of which stem from long-term U.S. fiscal imbalances --will hamper earnings growth and constrain valuations in 2013," the firm said. "While not our base case, we believe that stocks could rise substantially if U.S. policymakers can negotiate a 'grand bargain' that credibly addresses long-term tax, spending, and entitlement reforms. Unfortunately, our sense is that the most important structural issues will be pushed off into the future, leaving significant uncertainty about the long-term direction of the economy and corporate profits."

UBS reset its year-end 2012 target for the S&P 500 at 1375 and said it expects "mid-single digit earnings growth over the next two years on the back of moderate economic growth, flattish margins, and buyback activity."

From a sector standpoint, the firm said it's now overweight on discretionary, Staples and Health Care, and that it's staying underweight on financials, telecom and utilities, stating that: "We believe stocks exhibiting a combination of high earnings growth and payout ratios will continue to outperform."

One observation that UBS offered up was that while the S&P 500 has doubled off its financial crisis low in March 2009, the forward price-to-earnings ratio that the index has been afforded has actually contracted, going from a peak of more than 15x early in the recovery to a multiple of 12x right now, a decline of roughly 20%.

"In our view, stock investors have been unwilling to 'pay up' for earnings results due to an exceptionally high level of uncertainty about the future direction of the economy and corporate profits," the firm said.