A significantly increased likelihood of volatility in the stock markets in 2014 is the major thesis of the Citi Equity Research report published on January 14 titled “Equity Strategy: Beware the Bronco Busting Raging Bull Phase”. The report is appropriately titled as authors Tobias M. Levkovich, Lorraine M. Schmitt and Christina Wood argue that their two-year-old bull thesis on the equity markets remains intact, but that they expect to see some major downdrafts in the stock indices at some point during the year, followed by another leg up.

Interest rate headwinds

The Citi analysts highlight uncertainty regarding interest rates and a high probability of at least a step in that direction by the end of ’14 as headwinds for U.S. equities indices. They also suggest that concern over interest rates will be a significant factor related to the volatility they expect to see in the stock markets over the next 12 months.

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Earnings main driver for stocks

The report also advances the argument that earnings are going to be the primary driver for stock prices over the coming year, especially in larger cap stocks. They argue that it is unlikely we will see significant expansion of P/E multiples this year, although it is likely that a few sectors will merge as exceptions to the rule.

Five to ten percent pullback in equities

Levkovich et al argue that a 5 to 10% haircut in the major stock indices is likely at some point in 2014. “Stocks outpaced underlying earnings by a factor of five in 2013 and it is likely that such gains are not going to be repeated. Indeed, the shape of the yield curve is quite effective as a two-year lead on market volatility and thus one should expect more choppiness in 2014 and probably 2015 than the fairly smooth experience of the past year. In this context, considering a 5%-10% pullback seems not only plausible but fairly rational.”

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New money coming to stock markets

The Citi report also suggests there is a good chance that the growing public appetite for equities will lead to new money flowing into the bull market. “While much has been said of a rotation out of bonds into stocks being a necessary ingredient for further gains, it seems more possible that people will just take down some of their $9 trillion in household deposits and move a portion of that into equities. As noted in the past, the baby boom echo is just entering its savings years and has limited if any recollection of stock market performance over the past 10-15 years. Thus, new money flow is probable and provides another support for appreciation potential.”