After a phenomenal 2015, in which JPM's head quant Marko Kolanovic as if by magic managed to correctly call every major market inflection point ahead of time, he found 2016 far more challenging, although toward the end of the year, he did get a second wind, and his key predictions since the Trump election have panned out, as he himself note in his latest note:
One day after the US election, we set a January 2017 S&P 500 price target of 2300. Now that this target was achieved a week ago, we want to assess the prospects for stocks and market volatility. We maintain that in 2017 we will likely see further equity gains (our 2017 YE target is 2400).
Of course, there are 11 months until the end of the year, and what happens inbetween could have a major impact on the final December 31 S&P500 print. So what does Kolanovic think will happen next? As he says, "we believe the market will be more volatile and note that two-thirds of our projected target have already realized. This means that the market risk-reward has deteriorated." And, in taking the opposite view of Goldman which predicts markets will keep rising until the end of the first half only to turn lower into the second half, Kolanovic expects the most likely downside scenario "would be a short lived ~5% pullback on the back of a hawkish Fed and deleveraging of systematic investors during the first half of this year."
So only a 5% move?
Considering the market hasn't had a 1% down day since October 11, a 5 % drop may end up as a shock to the latest generation of hedge fund managers and robots, who increasingly are exposed to a market that no longer has any drawdowns or down days.
Kolanovic continues why a market drop is overdue: "Following the recent rally, a level of risk complacency has started to set in. The ratio of S&P 500 Puts to Calls has dropped to a ~3 year low, and the VIX reached near-record lows of ~10. Option (gamma) positioning was heavily tilted towards the calls. This has historically led to a suppression of realized volatility (e.g. long gamma exposure likely softened/reverted the first meaningful pullback of the year on Monday and Tuesday). Equity exposure of various systematic strategies is also quite high as a result of positive price momentum, and record-low levels of volatility for bond-equity portfolios."
And the rest of his take:
CTA investors currently have high equity exposure, and their assets continue to grow . Volatility targeting funds likely have record high equity exposure given that the volatility of bond-equity portfolios reached record lows. Similarly, elevated equity exposure is likely true for Risk Parity strategies (although this may vary between hedge funds, asset managers, pension funds, structured products and other investors that employ different implementations of this simple allocation method). In addition to systematic strategies, there are indications that discretionary investors are long as well: mutual fund cash balances are near cycle lows, and the beta of equity long-short hedge funds is in its 95th percentile (all hedge funds beta is in its 98th percentile). While the risks of systematic selling have substantially increased, this may not cause a market selloff on its own. For instance, momentum would turn substantially negative with a greater than 5% drop in equities. There is however more sensitivity to an increase in realized volatility in relation to volatility targeting strategies, and option gamma hedging will likely start adding to market volatility if the market drops by only ~1%.
Despite the complacency and risks around high leverage, a potential pullback would likely be relatively shallow, e.g. ~5%. There are still good reasons for investors to stay constructive – in particular, the pro-business agenda of the new administration (de-regulation, tax reform, repatriation, infrastructure, domestic manufacturing, etc.). In our view, this bullish argument can only be derailed by a stronger USD and higher interest rates – both of which are largely influenced by the Fed. The goal of the new administration – bringing back manufacturing, and shifting the trade balance towards the US – can also be achieved with a weaker USD, and the administration will likely try to engineer a lower USD. A more hawkish Fed could easily derail these goals.
A likely outcome of this tug of war is a lower USD and higher equity prices by the end of this year. The most likely downside scenario would be a short lived ~5% pullback on the back of a hawkish Fed and deleveraging of systematic investors during the first half of this year. An upside surprise to our view would be a powerful combination of a dovish fed, fiscal reforms and pro-growth policies that could result in the market surpassing our target.
In other words, should the BAT pass, which would send the dollar soaring, stocks would be poised to drop providing yet more ammo for those US retail producers who are against the border tax adjustment. It also means that jawboning in which foreign currencies are slammed for being "devalued" will likely continue, resulting in even more volatility in FX markets, where if Kolanovic is right and the stocks are poised for mostly smooth sailling for the rest of the year, is where the bulk of vol is to be found.