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Economy  | January 7, 2021

The stock market is vulnerable to a drawdown to begin in 2021 after a fierce performance last year, according to Morgan Stanley's chief investment officer, Mike Wilson.

Optimism is high in the market right now as investors can see the vaccine-led economic recovery in their front view, and a 2020 that closed at record highs in their rear view. While this optimism alone won't spark a sell-off, there's three catalysts that could lead to a drawdown, Wilson said in a Monday note to clients.

"Extreme optimism and/or high valuations are necessary but insufficient conditions for a meaningful equity market correction," Wilson said. "Nevertheless, we must acknowledge that the 'risk reward' of the US equity market has deteriorated materially and the market is ripe for a drawdown." 

The first catalyst could be the two Georgia Senate run-off elections, taking place on Tuesday, Wilson said. The outcome of the races will determine which party takes control of the US Senate. If just one Republican wins, the GOP will have 51 votes in the Senate and the Congress will be split. While some investors say the market has largely priced in a Republican win, an unexpected outcome could rattle investor confidence. 

Wilson also said softer guidance than expected during the fourth quarter earnings season could trigger a stock drawdown. While investors are confident in the economic recovery in 2021 and anticipate a return to normal for companies hit hardest by the pandemic, they may lose faith if major companies signal a later-than-expected recovery during the upcoming earnings season. 

The third potential catalyst could be "some kind of intervention by regulators and or the Fed to quash the exuberance in crypto-currencies," said Wilson.

In December, the Financial Crimes Enforcement Network (FinCEN) proposed regulation that would require companies to collect the names and addresses of people if they make cryptocurrency transactions over $3,000. Bitcoin's sky-high price demonstrates exuberance hasn't been squashed just yet, but Wilson is watching for what further government intervention could mean for cryptocurrencies and the broader equity market.

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