The best start to a year in three decades is a hard act to follow, but there are a lot of great reasons for stocks to climb to new heights before the rally comes to an end, according to a strategist at JPMorgan Chase & Co.
“Our key theme remains that the current market backdrop has similarities to ’15-’16 mid cycle correction episode, and not to the end of the cycle,” said Mislav Matejka, head of global equity strategy at JPMorgan Chase & Co., in a Monday report.
The strategist highlighted that after a nearly 20% correction in 2015 and 2016, stocks rose 43% in the following two years.
“Similarly, we believe the current bounce is far from done and we believe equities could potentially make new highs for the cycle before the next recession starts.,” he said.
The S&P 500 SPX, -0.39% and the Dow Jones Industrial Average DJIA, -0.79% both rallied 11% in the first two months of the year, the biggest January-February gain for the large-cap index since 1991 and the strongest for blue chips since 1987. The dramatic surge follows on the heels of a painful selloff in December that pushed major benchmarks deep into negative territory for 2018.
Big gains in January and February have tended to bode well for the remainder of the year, according to Savita Subramanian, an equity and quant strategist at Bank of America Merrill Lynch.
“A positive January-February has historically led to a positive year 87% of the time since 1928 and an average +16.8% total return, compared to a 54% hit rate and 3.7% average return when returns were negative in January-February,” she wrote in a note to clients.
But aside from leaving the gate in turbo mode, Matejka expects stocks will get a boost from a combination of the Federal Reserve’s more conciliatory tone on interest rates, stabilization in the yield curve, and a likely U.S.-China trade agreement.
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The Fed in recent week has backed off from its hawkish stance on monetary policy and reiterated its wait-and-see approach on future rate hikes.
The strategist, in fact, cautions that a mounting sense that the Fed may have turned too dovish could trigger concerns among investors that the central bank is falling “behind the curve” and result in pushing the 10-year Treasury yield higher.
Still, real rates, typically defined as interest rates adjusted for inflation, remain supportive. None of the previous economic downturns started with real rates below 2%, he said.
The real rate is currently between 2.25% to 2.5%.
Meanwhile, despite concerns about slowdowns in major economies such as China and Europe, global activity momentum is expected to improve. Labor markets in key regions remain robust and a U.S. recession has never materialized when the jobless rate is falling, according to the strategist. The U.S. unemployment rate hit 4% in January.
Recent fears about China may also be overdone.
“In contrast to popular wisdom, we believe that China is healthier now than it was in ‘15-’16 episode, when pressures on the Chinese yuan were significant, Chinese house prices were falling and corporates had overcapacity problems. All these factors are much more supportive currently,” Matejka said.
Even corporate earnings, which have emerged as a potential headwind, are less of an issue than some strategists believe.
“EPS revisions remain negative, but crucially equities never wait for earnings in order to recover,” he said. “In 2016 the market was ahead of the earnings by almost a full year. We believe earnings trends will improve materially in second half of the year.”
And for all the market’s impressive gains year to date, stocks are still attractive from a valuation point with S&P 500 price-to-equity ratio at 16.8 times.
Stocks tumbled Monday, with all major indexes trading sharply lower, on worries that stocks are becoming increasingly vulnerable to profit-taking in the wake of the recent gains.
“Some tactical indicators are starting to look stretched, but in our view fundamental investor positioning is much lighter than what the price moves alone would suggest,” he said, noting that funds that have exited equities have yet to return.
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