Riskiest Stocks May Lead Year-End Rally: JPMorgan

With the U.S. midterm elections now behind us, and that source of uncertainty resolved, many investors are now focused on which stocks and sectors are most likely to outperform. Marko Kolanovic, the widely followed global head of quantitative and derivatives research at JPMorgan, forecasts a year-end rally that he believes will be led by small cap and emerging market stocks. "Appropriate exposures may be high-beta indices such as Russell 2000 and MSCI Emerging Markets," Kolanovic wrote in recent note to clients, as quoted by CNBC. Both indexes were battered in the October market sell-off and have had a rough 2018 so far, as detailed in the table below.

2 Risky Asset Classes May Lead The Rally

Index or ETF YTD Gain Drop From High
Russell 2000 Index 0.9% (11.1%)
iShares MSCI Emerging Markets ETF ( EEM) (15.0%) (23.6%)

Source: Yahoo Finance; based on adjusted close data as of Nov. 9.

Significance for Investors

"We believe (out of consensus) that a split Congress is the best outcome for U.S. and global equity markets," Kolanovic wrote in his note, per CNBC. "As the President cannot count on Congress or the Fed for more easing, he will need to do what is in his power to keep the economy rolling—drop the damaging trade war and turn it into a winning deal," he added. As a result of the October stock market sell-off and decelerating economic growth in China, he believes that "progress on the trade war is more, rather than less likely."

The top four constituents of the MSCI Emerging Markets Index are, per MSCI: Tencent Holdings Ltd. (TCEHY), Taiwan Semiconductor Manufacturing Co. Ltd. (TSM), Samsung Electronics Co. Ltd. (005930.Korea), and Alibaba Group Holding Ltd. (BABA). These stocks are down from their respective 52-week highs by 42.9%, 18.3%, 22.1% and 31.6%, per Yahoo Finance.

Kolanovic believes that the most important cause of the October sell-off was politics. "It was essentially a miscalculation and a conflict between the U.S. Administration and Fed going into important midterm elections," he wrote. With that miscalculation now in the past, he sees positive sentiment taking hold again in the stock market, driven by factors such as increased share repurchases and strong earnings.

Kolanovic also foresees another boost to stock prices coming from a "rolling short squeeze" through the year-end, as bearish investors who have been engaged in the short selling of individual stocks, particular market sectors, or various market indexes get surprised by the rally that he predicts. In the classic short squeeze, a rising stock price prompts short sellers to close their positions. Doing so requires buying the underlying shares, thus setting off a bidding war that propels their prices yet higher.

Looking ahead to year-end and into 2019, Bloomberg reports that six market sectors are particularly likely to see moves, either up or down. The table below summarizes key observations.

6 Stock Sectors To Watch

Pharma & Biotech: Political gridlock may lessen the odds for price restrictions.
Industrials: Gridlock likely to reduce the chances for a big infrastructure bill.
Technology: Expect more regulatory scrutiny.
Banks & Financials: Trump-appointed regulators will continue to loosen rules.
Energy: Low impact from midterms, possible restrictions at the local level.
Cannabis: Voters approved recreational use in two states, medical use in one more.

Sources: Bloomberg, The New York Times

The most recent U.S. Watch report from Bank of America Merrill Lynch asserts that a divided Congress is "moderately bullish for equities." They believe that "a modest infrastructure bill might see bipartisan support" and that this would be good for industrials and materials. In their opinion, a split Congress bodes well for defense spending, and thus the aerospace & defense industry, and also for health care, since no new health legislation is likely to pass. However, growing support in both parties for regulation of internet-based companies may hurt the communication services sector.

Looking Ahead

Given data indicating that economic growth is slowing more quickly outside the U.S., JPMorgan's call to invest in emerging markets may look rather risky right now, unless one buys into the scenario that President Trump's trade war rhetoric and actions are likely to abate. Meanwhile, a contrary opinion on small caps is offered by PIMCO, which recommends that late cycle investing calls for a move towards high quality large caps and away from generally riskier small caps.

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