Things are looking pretty good in the U.S. stock market. After a bit of a hiccup with the Brexit vote result, both the S&P 500 Index and the NASDAQ Composite managed to bounce back, even surpassing their all-time highs. However, a leading expert in the industry just said that things could turn sour very quickly.
On Wednesday, September 7, JPMorgan Chase & Co.’s (NYSE:JPM) global head of derivative and quantitative strategies, Marko Kolanovic, warned about the consequences of an uptick in volatility. (Source: Dieterich, C., “JP Morgan’s Top Quant: Even a Tiny Bit of Volatility Could Unleash $100B Cascade of Selling,” Barron’s, September 7, 2016.)
Kolanovic noted the relative lack of volatility in the U.S. stock market. Major indices have steadily moved higher without any sizable swings since the Brexit referendum. This period of placidity, according to the analyst, has led to “near record levels of equity exposure” at managed future funds.
This is because there are systematic investment strategies that make asset allocation decisions based on volatility levels. These strategies, such as “risk parity,” have led to investors loading up on stocks to “near all-time highs.”
“Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility,” said Kolanovic.
“In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October.” (Source: Ibid.)
The analyst warns that this typical seasonal volatility could lead to a sell-off in the U.S. stock market. This is because “when it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of around $100 billion.” (Ibid.)
Note that investors are not just faced with potential September and October seasonal volatility. Another trigger for a potential sell-off would be a rate hike from the U.S. Federal Reserve. There are quite a few signs pointing towards an expanding U.S. economy, and several Fed officials have made hawkish comments. But whether the U.S. stock market can handle another rate hike remains to be seen.