Stock market: Momentum trend flashes for first time since tech bubble

In recent days, investors have suddenly fled the so-called momentum stocks that have been loved for their strong past performance and growth prospects. They've rotated into value stocks.

Marko Kolanovic, JPMorgan's global head of macro quant and derivative strategy, identified a pattern within this shift that has only happened twice before.

He said the move into value stocks is likely to continue, and advised investors on how to be positioned so they can capture the strongest upside going forward.

To casual observers, the stock market has traded in a relatively benign fashion over the past few days.

But some remarkable shifts that took place underneath the surface caught the attention of strategists including Marko Kolanovic, JPMorgan's global head of macro quant and derivative strategy.

Chief among them was a massive rotation away from the best-performing stocks and into those that had been neglected.

Starting last week Friday, investors ditched many of the so-called momentum stocks that have been favored during this bull market because of their earnings-growth prospects, and opted for value names that had relatively underperformed for an extended period.

Kolanovic's research had earlier shown that value stocks were underperforming relative to momentum and low-volatility stocks in a manner not observed for any factor pair since the tech bubble.

A closer look at the recent trading action revealed yet another historic milestone for momentum.

On Friday, JPMorgan's momentum indicator of small-cap stocks reached its maximal negative reading, while the same indicator for large companies on the S&P 500 reached its maximal positive reading. A divergence of this magnitude has only occurred twice before: in February 1999 and during the tech bubble, according to Kolanovic.

“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 in a recent note to clients.

If Kolanovic's stats are not astonishing enough, consider that the momentum factor suffered its biggest single-day decline since 2009 on Monday, according to Bloomberg data.

Can the shift persist？

In light of these milestones, the big question is whether the rotation from momentum to value stocks can continue. Kolanovic believes so for at least three reasons.

First, he expects a broad inflow into stocks as corporate buyback activity ramps up over the next three weeks before the third-quarter blackout period.

Secondly, several countries are still injecting monetary and fiscal stimulus to support their economies. These measures tend to kick in with a delay, and they could prop up value stocks and the broader market in the coming months, he said.

And finally, he sees reason to be optimistic that the US will make progress during its trade negotiations with China in October. The Trump administration knows that a recession would be politically devastating for the 2020 elections, and is incentivized to make headway with China.

If this rally ensues and lifts previously unloved value stocks with it, you wouldn't want to be caught on its wrong side.

“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 said.

“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.”

Here are heavily traded exchange-traded funds that can be used to play the themes Kolanovic identified:

Small cap: iShares Russell 2000 ETF (IWM)

Cyclicals: SPDR Consumer Discretionary Select Sector ETF (XLY)

Value: iShares Edge MSCI USA Valued Weighted ETF (VLUE)

Emerging markets: iShares MSCI Emerging Markets ETF (EEM)