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- JPMorgan’s John Normand says investors are making an critical mistake that could leave them misaligned as the US economy slows.
- Normand says investors are betting on strong economic growth that isn’t likely to materialize, and their error has helped push stock indexes to all-time highs.
- He’s telling investors to prepare for weaker growth with slowly rising inflation as well as slower profit gains for S&P 500 companies.
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With US stocks near all-time highs, JPMorgan is warning that investors are misreading the situation.
Thanks to this year’s big rally, stocks are priced for a "near perfection" scenario where the economy growth at an above-average clip and inflation is stable, according to John Normand, head of cross asset fundamental strategy. But he says investors are only half right because there won’t be much improvement in growth.
That expected letdown in growth is encouraging a shift to a long-neglected strategy. JPMorgan says it expects growth stocks, which have dominated for most of the 10-year bull market, to take a backseat to more defensively-oriented value stocks.
"We were cautious on value style over the past year, but look for a rotation in market internals in (the second half)," Normand wrote.
Specifically, JPMorgan is calling for financials and energy stocks to lead the way in the coming months. Energy in particular has lagged the market badly this year: The S&P 500 energy sector is up 11% this year, an otherwise solid number that looks somewhat weak compared to the benchmark’s 20% overall gain.
According to Normand, that misplaced hope about economic growth has driven stocks to outperform bonds. He thinks the more cautious bond market has a better view of the likely trajectory of the economy as well as interest rates.
That means bonds could fare better as investors react to weakening profit growth.
"On average over the past 50 years, equities have stopped outperforming bonds about two months after earnings growth peaked," he says, adding that the peak in earnings growth was six months ago.
The shift Normand is predicting could come into view this week, as it’s the beginning of an earnings period where S&P 500 profits are expected to decline. He writes that if the drop in earnings is coupled with disappointing company guidance, it might push investors into a more defensive posture, sending bond prices up and stocks down.
"Since equity and credit outperformance versus bonds tends to track earnings momentum and since these two corporate assets have been beating bonds for longer than they usually do, just a brief dip in EPS growth seems a pre-condition for sustained gains," he wrote.
For JPMorgan and Normand, that defensive stance also includes long positions on gold, oil, and defensive currencies like the Swiss franc and Japanese yen compared to other major-economy currencies.
But he’s not adopting a completely bearish stance. With the US economy and corporate profits likely to keep growing and the Federal Reserve signalling that it will cut interest rates, he thinks there is more room for stocks to rise and says he is overweighting stocks compared to credit.
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