JP Morgan’s US Equity Strategy Team has declined to come up with anything as eye-catching as Bank of America’s “Icarus trade”, it but the team still believes that the short term downside risk for a sell-off is increasing despite an improving fundamental backdrop.
The bank’s analysts are sticking to their price target of 2,400 for 2017 even though recent gains have taken the index up to and slightly above this level. It seems the equity strategy team is expecting more volatility going forward and just like Bank of Ame; it seems JP Morgan believes the bulk of this volatility will come during the second half of the year as the Trump rally runs out of steam.
“Over the medium-term, pro-growth policy reforms and solid fundamentals should likely result in higher equity values. However, in the near-term we see increasing risk of a sell-off due to more hawkish Fed rhetoric at a time when investor positioning is stretched and equity volatility is likely to rise from low levels.”
Chances Of A Sell-Off Are Growing
JP Morgan’s key concern from market strength is the current market structure. Hedge Fund exposure to equities is approaching record levels as Macro and Long/Short Equity funds each exhibit ~95th percentile beta to equities while short positions across stocks, ETFs, and equity futures remain near 10-year lows. Add in the fact that low sector and equity correlations, as well as option dynamics, have suppressed equity volatility in recent weeks, and you get a nice cocktail for volatility.
A sudden change in equity correlations or option dynamics would result in higher equity volatility, leading systematic strategies to reduce their elevated equity exposures.
That being said, market fundamentals remain strong. In the report JP Morgan’s analysts they came away from the first quarter earnings season “incrementally more constructive on growth based on guidance.” Fourth quarter earnings figures delivered a record high S&P 500 EPS figure of $31.37, up 6.3% year-on-year versus an estimated 4.6%.
Despite these positive figures, unless there is a substantial increase in EPS growth estimates for the rest of 2017, recent hawkish comments (and a hawkish shift) by the Federal Reserve could pressure the already high S&P 500 equity multiple of 18.6 x (based on house EPS figures of $128) JP Morgan’s analysts conclude.
JP Morgan’s analysts are most positive on the Financial and Energy sectors going forward, based on recent guidance and rhetoric from management as well as Washington:
“Financials remain our highest conviction OW due to rising rates, regulatory pullback, largest beneficiary of corporate tax reform, and potentially higher ROE/multiples as companies return excess shareholder capital. While the positive guidance helped push 2017E earnings growth rate to 12.6% (strongest growth of all sectors) from 11.3% at start of the reporting season, we continue to believe Washington more than fundamentals will drive sector performance for the foreseeable period.”
“Energy (OW) companies were mostly optimistic and expect to boost capex by 14% this year. Higher volume (US expected to gain market share relative to international producers), rising oil prices, and lower expenses support our view for stronger than expected margin and earnings recovery for the sector. Energy companies are expected to boost capex double-digit.”
