While last year was the year of momentum stocks, more and more signs are pointing to a shift toward value stocks for this year. JPMorgan analysts say the increasingly dovish tone of the U.S. Federal Reserve and the weakening U.S. dollar both signal that value stocks are more likely to outperform than momentum stocks.

Short covering drives recovery

The U.S. stock markets have rallied since their lows in February, and most analysts seem to agree that a short squeeze is to be credited with that rally, although JPMorgan analyst Dubravko Lakos-Bujas and team also credit “fundamentally insensitive strategies.” Some analysts think there’s more room for short covering, but the JPMorgan team said in a report dated April 7 that they don’t see much room left. They base this view on their high frequency stock and ETF Utilization Ratio, which they say has “almost fully normalized to pre sell-off levels.”

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They add that trend-following funds have already covered the majority of their short positions and now are nearly neutral on equities. Meanwhile risk parity portfolio and macro funds’ equity exposures are near where they were in the last part of last year, and long/ short strategies are still higher than average and possibly moving off the highs seen in the middle of last month.

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U.S. dollar the deciding factor

Lakos-Bujas and team believe that most of the technical factors are now in the past and that equity valuations are high. As a result, they believe earnings growth must reaccelerate and the U.S. dollar must weaken further before investors should become more constructive on U.S. stocks. They also think a sudden earnings growth acceleration triggered by increased consumer spending is only wishful thinking at this point as they see “the oil bonanza largely getting consumed.”

If the U.S. dollar does weaken, they believe profits might reaccelerate from the slump they’ve been in recently.

Favoring value stocks

Overall, the JPMorgan team expects U.S. equities to move sideways this year, and they believe several arguments continue to support their view that value stocks are the place to be right now even though momentum stocks have seen a mass sell-off recently.

For example, they said the valuation spread between long and short momentum stocks remains wide and that these trades still look crowded.

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Further, they see value stocks as “unloved” and “disproportionately penalized relative to Momentum stocks in the past two years, influenced by extreme macro positioning contingent upon a continuation of diverging policies between the Fed and foreign central banks.”

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Further, they said the dollar and momentum stocks have historically shown a positive correlation, which implies that the weakening of the currency should cause momentum stocks to weaken. Momentum stocks are also negatively correlated with inflation expectations, and the JPMorgan team said that even as inflation expectations rise, if growth is still lackluster, value stocks will probably outperform momentum stocks. And finally, they believe value stocks would help investors diversify and possibly hedge against rising risks.

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Their own U.S. Quant Macro Index also suggests that value may be better than momentum right now, as they say it tends to have a three- to six-month head-start on the “coincident economic indicator.” They said higher sentiment drives their index higher, and other factors have stopped falling and begun rising a bit. The only negative on their index is liquidity.

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They prefer the Energy, Materials and Financials sectors.

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