Stock market investing: JPMorgan trades for rally, hedges for crash

The trade-war negotiations in October will be a key determinant of what happens next in the stock market and the global economy, according to Marko Kolanovic, JPMorgan's global head of macro quant and derivative strategy.

He is optimistic that the negotiations — along with a technical rotation from momentum to value stocks — will be bullish for the market in the months ahead.

But in preparation for alternative scenarios, he recommended six trading themes that should capture the market's upside while also providing hedges against losses.

Click here for more BI Prime stories.

The stock market's future hinges a great deal on what happens during the trade negotiations between the US and China in October.

That's according to Marko Kolanovic, JPMorgan's global head of macro quant and derivative strategy, who is getting ready for multiple outcomes.

In the interim, he is leaning towards the likelihood that the global economy will not sink into a recession should the trade war escalate.

Traders, too, have recently sided with this view. Their optimism for productive trade negotiations has helped the S&P 500 rebound from its swoon in August to within 1% of its all-time high.

The market's recovery was particularly beneficial for stocks that were considered undervalued and had missed out on gains on the way up. Kolanovic observed that so-called value stocks had been underperforming relative to momentum stocks in a manner not observed for any factor pair since the tech bubble.

He expects this technical rotation to continue being a bullish force for stocks. But he also wants investors to be well-positioned in case the market turns south.

The six recommendations below are designed to capture the upside of a rebound in the months ahead while safeguarding against losses if the trade war suddenly escalates again. All quotes are attributable to Kolanovic.

1. Remain overweight equities versus underweight government and corporate bonds.

“We increase the government bond UW in our long only portfolio, given risks of continued mean reversion from the technical flow-driven sharp rally last month, and in-line with our overall risk-on portfolio stance.”

2. Overweight US, Japan and emerging-market equities.

“Given that the S&P 500 is heavy in bond proxies and secular growth, we see higher upside potential in small caps, cyclicals, value, and Emerging Market stocks than the broad S&P 500. 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.”

3. Overweight US small and mid versus large-cap, value versus low-volatility stocks given their record valuation divergence.

“We believe that this week's value rotation can continue and the broad market can move higher going into October negotiations, and if real progress is made, continue into a more sustained rally.”

4. Long US three-year, long 30-year Italy versus Germany and 10-year Spain versus France

In Europe, the dovish ECB easing package has also occurred against a backdrop of a receding of political risks in Italy after the formation of a new Five Star – PD coalition government. Given the mainstream nature of PD, we see only limited chances of a confrontational approach with the European Commission on the 2020 budget.

“Given this cleaner political landscape, we see QE and search for yield as the main drivers exerting continued tightening pressure on Italian spreads to Germany going forward. Our strategists continue to favor OW periphery spread exposure, via 30y Italy vs. Germany and 10y Spain vs. France.”

5. Short AUD/JPY, GBP/USD bear put spread, long CHF versus USD

“ Despite forecasts that further easing will be necessary (and the ongoing unemployment rates that are still a ways from [the Reserve Bank of Australia's] goals, thought are at least stable), our base case remains that that easing doesn't arrive until the first half of next year, although there is some risk of an earlier delivery in November / December if our call on Fed cuts is realized.”

6. Overweight energy, stay Overweight precious metals and agriculture

“The August rebound in manufacturing PMI, increased policy support, and light investor positioning leave us with a positive risk bias for commodities overall, despite looming risks of a slowdown. We expect continued rotation into Value assets, which include most commodities (particularly energy, base metals and agriculture).”