The end of the Federal Reserve's grip on markets, a maturing economic expansion and the coming policies (and tweeting) of President Donald Trump will send us back into a highly volatile trading environment like the late 1990s, according to Jim Strugger, derivatives strategist at MKM Partners.
"Late-cycle dynamics suggest a healthy environment for U.S. equities and risk assets broadly, but an inflection in monetary policy could remove a significant force that has acted to suppress equity volatility and bring it in line with more elevated cross-asset volatility," wrote Strugger in a note to clients Friday.
"This would result in the baseline for VIX shifting moderately higher and an increased frequency of higher-magnitude shocks more akin to August 2015 and January 2016 than the presidential election-related event."
"The late 1990s are our favorite analog, during which time elevated equity volatility coexisted with upward-trending equity markets," Strugger added.
The graphic below illustrates the environment the analyst is describing. It's the CBOE Volaility Index (orange) versus the during the 1990s and early 2000s.
Source: MKM Partners, Bloomberg
The end of the Fed "backstop," more political turmoil in Europe and rising tensions with China are the likely causes of volatility spikes in 2017, according to Strugger.
Also making his list of sources of risk next year is the president-elect. Here's one of Strugger's bullet points:
Strugger, who guides clients on how to trade volatility and other derivatives, notes that this new environment really started in August 2015 and since that time these so-called volatility shocks have occurred every five months. The analyst believes the frequency may increase, but for now clients should brace for March or April containing the next volatility spike.
Adding to the volatility risk next year is the fact that the current economic expansion is five months short of reaching the 95-month average of the last three cycles, noted his report.
To be sure, Strugger is not predicting the equity market gains during this coming volatile period will match that of the dot-com bubble. But some similar strategies, like buying high-beta stocks, could work, he wrote.
Writes Strugger: "Though it would be silly to anticipate the late-1990s animal spirits that drove the S&P 500 index to a 22x forward P/E (and almost 50x for the NDX), exuberance since the presidential election may be representative of sustained late-cycle psychology."