Last Year, A Former Analyst Nailed What's Happening In The Markets And Economy Right Now

There’s been a violent “internal correction” going on in the stock market with investors and traders dumping high-growth, momentum stocks for more cheaply-priced, value stocks.

This phenomenon has caused the Dow Jones Industrial Average and S&P 500 to hit new highs, even as the average stock tumbles into bear markets.

Some folks like UBS’s Art Cashin have warned that these types of trading patterns precede bear markets.

But the fact that we continue to get signs of economic growth presents a conflict for the bears. Just today, we learned that small business optimism is at its highest level since the financial crisis.

Before Tom Lee unexpectedly left his position as chief U.S. equity strategist at JP Morgan, he predicted this rotation from growth stocks into value and explained how it would work in the context of economic growth. It was his second of “6 Investment Themes For 2014,” which he outlined in his December 13, 2013 note (unfortunately, we don’t have permission to repost his figures):

#2: Value to further outperform Growth…

Growth looks likely to see its 6 year winning streak end in 2013. As shown on Figure 23, Growth is underperforming by 274bp this year after a very impressive streak of outperformance (2007-2012). The reason we expect Value to outperform in 2014 comes down to the following framework:

  • We anticipate GDP growth to broaden in 2014 and this implies that growth will be less scarce in terms of companies achieving better revenue profiles. Hence, investors will likely be less willing to chase traditional growth stocks and “unit growth” stories;
  • After reaching its widest spread in nearly a decade in July 2012 (see Figure 25), we believe the P/E differential between “Growth” and “Value” is likely to narrow (Figure 25 measures it by z-score). Consider that the average “growth” stock trades at nearly 18x today while the average value stock is 13x.

That first bullet is key.

You see, since the financial crisis, revenue growth prospects have broadly been pretty anemic due to uncertainty and weak economic growth. Investors seeking growth had been to turn to secular growth (that is, businesses that grow regardless of economic conditions) like the social media stocks.

But with economic prospects improving, growth has broadened. In other words, growth companies like the social media stocks aren’t the only growth plays in town. This is what Lee meant when he predicted that “growth will be less scarce.”

The NFIB regularly surveys small businesses, asking managers for what they consider to be the single most important problem. What’s striking is the collapse of sales as a concern. This would imply that sales prospects are improving for small businesses.

When Lee was still at JP Morgan, he had a 2,075 year-end target for the S&P 500, which at the time was the most bullish forecast on Wall Street.

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