BUCKLE UP: The stock market could get crazy

UBS sees a perfect storm of factors converging that will end this unusually long period of subdued volatility, according to a note circulated to clients.

UBS that the Federal Reserve's likely rate hike on March 15 and expected weak economic data in the first quarter of 2017 will drive the market down at least 10%.

The bank said:

"While we do not expect the current bull market to expire imminently, valuations consistent with prior tops, a more aggressive Fed likely to hike on 3/15 even as the economic data and growth proxies such as oil and high yield bonds are softening, and the potential for fund flows to slow down nearer to the US tax deadline of April 15th could cause a convergence of Realized volatility toward Implied, resulting in a broad market pullback consistent with other such corrections of the past several years, toward the 200 Day moving average near 2,192."

UBS is also wary of falling oil prices and softening credit conditions, a similar scenario to market turbulence in the early months of 2016

One of the indicators that has UBS on alert is the growth of the "VIX premium," or the between the volatility index and realized S&P 500 volatility. The VIX is around 11 while actual recent moves in the S&P 500 represent a volatility less than 7%. UBS noted that these periods of elevated VIX premiums usually don't last long.

UBS argues that one of the reasons that this risk premium has developed is a lack of correlation between stocks in the S&P 500. When this occurs in a bull market, valuations tend to become stretched, and the US equity market is currently trading above 20x earnings on a trailing 12 month basis.

Based on similar periods, UBS predicts that the most likely event to bring down stocks, realign the correlation, and drive up volatility, would be a large macro event.

Specifically, UBS said:

"What are the macro catalysts that could cause a correlation and volatility spike and a market sell off of 10% or more, consistent with the macro scares of the past six years? The current setup would appear to most closely resemble 2016's "Recession That Wasn't" in that the Fed seems intent on tightening on March 15th just as the economy appears to be hitting a 1Q2017 soft patch."

The bank added:

If 1Q2017 GDP were to print at the current forecast 1.2%, it would represent one of the weakest quarters in which the Fed has raised rates in any hiking cycle dating back to 1987.

Fed rate hikes during such weak quarters have generally been accompanied with or followed by market instability.