Barely two months after JPMorgan’s Marko Kolanovic previewed the next financial crisis, which he dubbed the “Great Liquidity Crisis”, and which would be catalyzed by the following liquidity disrupting elements:
- Decreased AUM of strategies that buy value assets
- Tail risk of private assets
- Increased AUM of strategies that sell on “autopilot”
- Liquidity-provision trends
- Miscalculation of portfolio risk
- Valuation excesses
… the quant wizard is back in a more conventional form, this time summarizing JPM’s 2018 outlook for equities, volatility and tail risk.
Starting at the top, it may seem otherwise paradoxical – although in the new normal nothing surprises any more – that JPM which holds a near apocalyptic long-term forecast for the world in a derivative context, is also the bank with the highest 2018 S&P target among its bank peers. Here’s Kolanovic:
Our price target for S&P 500 at the end of 2018 is 3,000 and our earnings forecast (including tax reform) is $153. Half of the earnings upside (~$10) is due to tax reform, and the other half due to top line growth (~$7), margin expansion (~$1.50) and buybacks (~$2.50). To reach the price target, bond yields should not rise too much as that would destabilize the equity multiple. Yesterday’s Fed announcement did not indicate an increased pace of tightening. Opinions differ on the number of hikes in 2018, level of long term rates and impact of G4 central bank normalization. We think that risks for equities will start rising significantly mid-next year as the monetary accommodation is reduced and the level of interest rates increases. This will also be the main driver of an uptick in market volatility in our view.
In other words, the second half is when one can expect fireworks. Meanwhile, and speaking of tax reform, the immediate future will – after numerous false starts – be marked by a “great rotation” into the Trump Tax Trade…
The upcoming reduction of US corporate tax rates may be one of the biggest positive catalysts for US equities this cycle. It will likely result in a rotation from bonds to equities, from international to US equities, and from Growth to Value stocks. We have extensively analyzed the impact of this reform, and the degree to which its impact is reflected in prices. We think that little is priced into the market and hence there is potential for market upside and significant style and sector rotation to be realized. Discussions with most of our clients support this thesis – clients are not repositioning portfolios until they see the reform passed. Sell-side analysts are also not revising earnings estimates until there is certainty on all of its details. As the reform passes, we expect hedge funds will reposition first, then real money fundamental investors, and finally quant models that will pick up revised earnings estimates, quality metrics or change in price momentum over several subsequent months. We are very early in this rotation.
… unless of course the deal once again fall aparts in the final stretch.
* * *
What about Kolanovic’s bread and butter: volatility?
Market volatility collapsed in 2017, and our view is that it will gradually increase next year. The average VIX level of ~11 in 2017 may increase to an average level of ~13-14 in 2018. Volatility will likely be contained in the first half of the year, and then increase in the second half. In 2017, the VIX was ~10 points below its historical average. Out of those 10 points, our analysis shows that ~1/3 can be attributed to a temporary decline of stock correlations, ~1/3 to supply of volatility and temporary effects of daily gamma hedging, and ~1/3 to positive macro fundamentals and stability. Record low correlations between stocks are very likely to increase after the tax reform is fully priced in by the second half of 2018. This will likely push index volatility up by ~3 points. Perhaps the best example of the impact of correlation on reducing S&P 500 volatility was the market move on Nov 29th, when financials and technology stocks moved ~4% relative to each other (a ~5 sigma move), leaving the S&P 500 index price unchanged. The impact of volatility sellers and gamma hedging should also moderate as realized volatility increases and investors start to hedge gains later in the year. Higher interest rates are expected to put pressure on leverage and various volatility-reducing arbitrage strategies.
We find it somewhat surprising that unlike BofA’s Michael Hartnett, Kolanovic does not see a violent, “Black Monday”-type flash crash in the beginning of 2018. In fact, his view is flipped with the bulk of volatility saved for the latter part of the year when the impact of receding central bank liquidity will finally be felt. How will that translate to equities?
Tail risk for equities and other risky asset classes will increase in 2018. Our analyses point to significant impact of monetary stimulus removal on levels of risk premia across asset classes, levels of leverage, and valuations.
And here is some practical advice from the quant: “asset classes may not react immediately, and like a ‘frog being boiled’ tail risks may be realized with a significant delay and triggered by an unrelated catalyst.” However, once the tail risk does manifest itself, it could be a violent event: “with forced deleveraging of systematic strategies (options hedging/dynamical delta hedging, volatility targeting, risk parity, trend following), disruptions to market liquidity, and failure of bonds to offset equity risk. We believe that starting in Q2 of 2018, equity investors should start hedging tail risk.”
Finally, we catch a glimpse of the “old Marko” in the following concluding hedge regarding JPM’s – and anyone else’s – year end price target:
Can equities, volatility and tail risk all go higher, and how much conviction should one have in any ‘year-end’ price target? Annual price targets may be remnants of times when markets were less efficient, market reaction times slower and investors less sophisticated. In the age where quantitative/derivative investors and technology (e.g. big data and AI) compress the time horizon of market reactions, it is likely impossible to predict price levels 1 year out. Price target also cannot be cast in isolation to other asset classes.
Marko’s conclusion: take everything he – and his colleagues – just told you about JPM’s price target, and throw it out:
… the level of an equity index is dependent on the level of interest rates (which in turn may be impacted by actions of a central bank in a foreign country), levels of market volatility (that determine leverage), impact of FX, etc. Can all of those be forecasted on a year-long horizon? Likely not. We do think short term predictions are possible where one can isolate specific catalysts, positioning and flows against an otherwise stable macro backdrop. Given that most of the notional volumes nowadays are also traded via derivatives, more useful forecasts would be those of a price distribution and correlations (rather than one price level at a particular point in time).
Which, of course, is the most political way possible for the Croat to say that while it is impossible to predict where stocks end 2018, the one place where they will not be, is JPM’s price target. As for everything else, we can only hope that volatility finally does rise high enough to make the opinions of volatility experts great – or even just relevant – again.