The last 2 times stocks entered the 'Grey Zone' was before the tech bubble and the global financial crisis. Here's why UBS thinks equities are on a similar path - and why the Fed will be powerless to stop it.

• UBS strategists Francis Trahan and Samuel Blackman lean on historical data and correlations to paint a bleak picture for the S&P 500's future.
• The strategists see a slowdown in Institute for Supply Management new order data signaling meek S&P 500 earnings, which they think will translate into a decline.
• Trahan and Blackman also think the Federal Reserve will be powerless in its attempts to rescue equity markets, since a key correlation that was prevalent in the 1990's is no longer existent.
• Click here for more BI Prime stories.

It's never a welcome sign when one of the world's top banking institutions starts to compare today's market environment to past periods marred by epic crashes.

But that's just what the strategists at UBS have done - and their warnings could coincide with the beginning of the end for the stock market's historic run.

"The ISM New Orders Index, the PMI that correlates best with S&P 500 earnings, dipped into contraction territory on September 1st with a reading of 47.2," UBS strategists Francis Trahan and Samuel Blackman wrote in a recent client note.

They added: "This move is an important signal because across the decades, the ISM crossing below 50 has been synonymous with S&P 500 earnings growth turning negative."

Considering profit growth has been the foremost driver of the more than 10-year bull market, any such contraction likely spells a rough road ahead for stocks.

The chart below depicts the highly-correlated relationship between the ISM New Orders Index (dark blue line, left scale) and S&P 500 forward earnings growth (light blue line, right scale). Their ominous relationship is undeniable.

"Most importantly, perhaps, is that this has been the point where the equity market moves into what we call the Risk-Aversion phase of the equity cycle," the UBS strategists said.

Trahan and Blackman refer to this transition as the "Grey Zone" - otherwise known as a soft spot for equities when sentiment changes from a moderate risk-off to full-blown risk aversion. The last two times stocks dipped into "grey" territory was in 2000-2001 and 2007-2008. Those were two periods - the tech bubble and the financial crisis - that saw stocks get slaughtered.

However, if there's a silver lining to the situation, it's that there's still time.

"Looking back at the last two times the equity market transitioned from Risk-Off to Risk-Aversion (i.e., the ISM crossed below 50) it is clear that it's not an "on and off" switch for equities," Trahan and Blackman said.

Before the Great Recession, it took around 5 months for S&P 500 to start its decline once ISM New Orders fell below 50.

The chart below depicts the lag between an ISM New Orders reading below 50 and a corresponding drop in the S&P 500.

The S&P 500 fell even quicker in the midst of the tech bubble when the ISM broke below 50. Same scenario, quicker unwind.

The chart below depicts the 2 month span between a fall in ISM and a dramatic undoing of the S&P 500.

The Fed's futility

Many financial pundits have been comparing today's era to that of the 1990s - an age in which the Federal Reserve side-stepped a potential recession with timely interest rate cuts. In that time period, there was a strong inverse correlation between rate cuts and stock pricing. In other words, if the Fed moved rates lower, stocks would go higher.

However, that relationship no longer exists today.

In today's market environment, following Fed rate cuts, stocks have moved lower in lockstep, leaving the US central bank powerless in the midst of a decline.

The charts below shows the correlation between Fed rate cuts and stocks in 1995 - a clearly inverse relationship - against today's highly-correlated connection.

Against this backdrop, Trahan and Blackman are skeptical at best in their equity outlook.

"Indeed, there are now 157 companies in the S&P 500 with negative forward earnings versus just 68 at the beginning of the year," they said. "Moreover, the weakness of LEIs [leading economic indicators] in recent months suggests that the deterioration in earnings breadth will get worse from these levels."