The market’s shift into value stocks will continue and stocks should move higher in October, especially if the trade talks between the U.S. and China go well at the beginning of next month.
That’s according to JPMorgan’s (NYSE: JPM) global head of macro quantitative and derivatives strategy, Marko Kolanovic, who says his view is based on how he sees investor positioning, the underperformance of value names, and the unwinding of technical flows in equities and bonds last month, which drove yields to multi-year and record lows.
The quant guru says stocks can move higher even beyond October, spurred along by central bank easing and fiscal stimulus.
According to Kolanovic, the rotation out of momentum and into value has been setting up for a while, and pointed out that the market has traded virtually flat since January 2018 and most of the gains seen in the S&P 500 in that time have come from defensive sectors, those with bond-like features and “secular growth” tech names.
Many of those names are now being sold and “incorrectly in our view, are deemed to be impermeable to economic woes,” Kolanovic wrote in a note.
“Given that the S&P 500 is heavy in bond proxies and secular growth, we would expect higher upside potential in small caps, cyclicals, value, and Emerging Market stocks than the broad S&P 500,” Kolanovic wrote.
In July, Kolanovic alerted investors to the “largest divergence ever” between growth and value stocks, which at the time were performing even more poorly than they had been in the throes of the dotcom bubble.
At the time, Kolanovic wrote “we think that the unprecedented divergence between various market segments offers a once in a decade opportunity to position for convergence.”
Now, Kolanovic says there’s another extreme divergence, this time with the record performance gap between large cap and small cap companies. The quant strategist says his small cap momentum indicator—which is based on weighted 1-, 3-, 6-, and 12-month price momentum—reached its maximum negative reading last Friday. At the same time, the momentum indicator for the S&P 500 was at its maximum positive reading.
According to Kolanovic, the only other time this has happened was in February 1999.
“Many similar indicators suggest the gap is not sustainable between value, cyclicals, SMid and high beta stocks on one side, and momentum, low volatility, and growth on the other side,” Kolanovic said.
“While manufacturing lags both, we see that in the coming months one could expect manufacturing activity to pick up given the increased monetary stimulus, providing support for the market and value stocks,” Kolanovic continued. “We think October negotiations will be the key for future performance of equity markets and more broadly the global economy.”
Kolanovic is “cautiously optimistic” heading into next month’s trade talks, and said that polls indicate that the majority of American voters blame the Trump administration’s trade policies and the president himself for market volatility, and more than half would blame Trump if the economy fell into a recession.
“If the October negotiations fail, these moves could be unwound, but given the extreme low positioning and style tilt, we think the downside is limited,” Kolanovic concluded.