Limited upside to US equities. Equity upside will be closely linked to earnings growth delivery. We expect S&P 500 to reach 2,200 by year-end 2016, with an EPS target of $123. This implies 4-5% upside in price and 3-4% upside in earnings. Negative earnings effect from energy is likely to fade away, but strong USD will continue to exert some drag
causing further negative revisions to current 2016 earnings growth estimates of 8.5%. Equity multiple will be limited from re-rating much higher, in our view. The market is of age and already trading at close to 18x (NTM) P/E.Expect a volatile path—VIX to rise from current level of ~15 to an average of 16-18 in 2016. Higher volatility forecast is based on the rates cycle and uncertainty around central bank policy and extremely low levels of market liquidity. While equity volumes look robust, market depth has declined by more than 60% over the last 2 years, limiting market capacity to absorb large shocks. We forecast higher level of tail risk—a measure of volatility of volatility—with both quiet periods and periods of volatile sell-offs such as August this year as likely. High levels of geopolitical risk will also add to market volatility.Macro crowding—change in market leadership is warranted. Central bank policy divergence and related macro trends have fueled one of the strongest momentum trades across equities since early 1980s. These macro trends—strengthening USD, weakening commodities and EM assets, falling bond yields—are closely intertwined across markets and asset classes. They’ve had a strong impact on equities. Even though S&P 500 has been range-bound for most of 2015, at the stock level winners have continued to win and losers continued to lose driven by macro forces. In many areas of the market this momentum trade has persisted for several consecutive years. Consumer Disc, for instance, has outpaced Energy in each of the last 7 years, cumulatively outperforming by more than 260%.This equity trend can also be viewed across style performance. Momentum—closely resembling Low Volatility, but also Growth and Quality styles—outperformed Value by 31% from mid-2013. Momentum is extremely expensive and crowded—valuation spread between Momentum and Value is at historical extremes and dispersion among high momentum stocks is low and falling. Also, the much anticipated Dec. rate hike is a risk to Momentum and a boost to Value, which is seasonally strong around the turn of the year. See Figure 211 for detailed screens of Momentum related “Stocks to Avoid”.How much further can the current macro divergence persist for and have market expectations already run too far ahead? Several of these equity trends are relying on anticipated central bank actions that would boost the USD and further weaken commodities and EM assets. The risk of this increasingly one dimensional positioning, not just by equityinvestors, but also by macro funds, CTAs and risk parity portfolios, is that these trends don’t materialize and trades simply become too crowded and bound to sharp reversals. An example of such crowded and complacent macro positioning was 12/3 post-ECB reaction, where EUR/USD shot up by ~4% intraday (4.9 std. deviation event) and had the 2nd biggest daily move since its inception. While it’s hard to pin-point the exact timing of this rotation, we suggest investors start rotating from expensive, crowded and macro-driven equity Momentum plays towards Value, both across and within sectors. See page 99 for screens of “Stocks to Favor” with more reasonable valuation as part of this rotation.In line with the above views, at the sector level we continue to favor Financials and Technology, and are upgrading Energy to OW from Neutral. We are downgrading Healthcare from OW to Neutral, and maintain a Neutral stance on Materials, Cons. Staples and Cons Disc (recently downgraded). We stay UW Utilities, Telecom and Industrials.