Many investors have been buying defensive stocks on worries that the market and economy are peaking, but JPMorgan strategists are going in the opposite direction. They advise investors to rotate out of some of their defensive holdings and into cyclical stocks that can ride the wave of an accelerating economy. In particular, they recommend the capital goods, financial, auto and semiconductor sectors, Barron's reports. Screening for low valuations and high growth prospects in these sectors, Barron's found 5 stocks they find especially attractive: Caterpillar Inc. (CAT), KeyCorp (KEY), Parker-Hannifin Corp. (PH), BorgWarner Inc. (BWA) and Applied Materials Inc. (AMAT).

JPMorgan Moves From Defense To Offense: Sectors It Likes

Capital goods
Financial
Auto
Semiconductor

Source: Barron's

What Matters for Investors

The S&P 500 Index (SPX) rose by 7.2% in the third quarter, its best quarterly performance since the final quarter of 2013, putting the total year-to-date (YTD) gain through the end of September at 9%, The Wall Street Journal reports. This recent spurt in stock prices has had conflicting effects, inducing increased optimism about more gains ahead for some, and provoking worries in others that a market top is near, if not already here. Data on wage growth, inflation, manufacturing output and consumer confidence are indicating continued economic strength, and they are prompting similarly mixed responses among investors.

Bond yields are rising, and that is normally a negative for stocks. However, Barron's notes, bond yields are still near historic lows, and increases in interest rates are now frequently being taken as signs of economic strength, with stocks generally rising in response. "We expect equities to significantly outperform bonds into year-end," the JPMorgan strategists say, while projecting double-digit returns for stocks over the next year.

5 Stocks That Can Outperform

Stock Forward P/E Dividend Yield
Applied Materials 8.9 2.1%
BorgWarner 9.1 1.6%
Caterpillar 11.8 2.3%
KeyCorp 10.5 2.5%
Parker-Hannifin 14.9 1.6%

Source: Yahoo Finance, data as of Oct. 1.

More detail on why Barron's likes the 5 stocks in the table above is presented below.

Applied Materials. This company is a leading supplier of the equipment used by other firms to manufacture semiconductors. A slump in demand for computer memory has flowed back to a softening demand for chip-making equipment, and the consensus forecast indicates that Applied Materials will post a 11% dip in sales revenue from its fiscal quarter ending in July to the one ending in October.

Meanwhile, Barron's cites a report from Cowen & Co. projecting that spending on chip making equipment will rebound next year. Cowen also indicates that Applied Materials' forward P/E is well below its 5-year historical average of 14, and that a valuation of up to 16 times forward earnings is reasonable. Cowen has a target price of $62 for the stock, implying a gain of more than 60% from current levels.

BorgWarner. A major supplier of key components for car, truck and bus power trains, whether their power source is gasoline, diesel or electric, BorgWarner has an aggressive plan to increase revenues by 32% from 2018 to 2023. Barron's believes that its valuation is unduly low.

Caterpillar. The heavy construction equipment maker has seen its stock price slump this year, despite rising earnings estimates, and its forward P/E has dropped significantly from its 5-year average of 18.4 times projected earnings. A negative overhang on the stock has been a fear that it represents a big target in a trade war. Positives include: retail sales up in 18 consecutive months, pricing power that has allowed it to pass along the cost of tariffs on imported steel, and a bump in orders through 2022, spurred by accelerated equipment-expensing rules in the tax reform bill passed late in 2017.

KeyCorp. The bank holding company expects 3% loan growth in 2018, and rising interest rates are a positive for its profit margins. Acquisitions have given it cross-selling opportunities in investment banking and commercial services. EPS are projected to rise by 27% in 2018 and 11% in 2019. KeyCorp's investment portfolio has more than $1.2 billion of fixed income securities maturing each quarter, and rising rates have given it the opportunity to earn an additional 120 basis points per annum on the reinvested proceeds.

Parker-Hannifin. The company makes a wide range of precision components for use in various industrial and aerospace applications. The total revenue opportunity in its many markets is about $130 billion, of which Parker-Hannifin has an 11% blended market share. The company has a goal of increasing EPS by 10% per annum, driven by a combination of revenue growth and profit margin expansion. Barclays believes that management has been too conservative in its guidance, and the consensus view is that the profit margin is headed toward 15%, up from 13.7% today.

Looking Ahead

The biggest risk to the analysis from JPMorgan and Barron's is that the economy and the stock market really are at or near tops right now. Oppenheimer, for one, believes that "the United States is entering a slowdown regime." (For more, see also: The Economy Is Flashing Warning Signs To investors.)

Meanwhile JPMorgan is not speaking with an entirely consistent voice. Another team at that firm recently advised clients to lighten up on U.S. stocks. (For more, see also: JPMorgan Defies Bulls, Tells Investors To Cut U.S. Stocks.)