Market sell-off is about 80 percent over and will be reversed by share buybacks, JP Morgan says

Key Points
  • Technical factors have driven the recent market sell-off, which will be reversed once fundamentals come back into play, according to J.P. Morgan.
  • Share buybacks in particular should help reverse the downdraft, which resumed Thursday.
  • J.P. Morgan strategists recommend small-caps and mega-caps as the best places to be when the bull market resumes.
A trader on the New York Stock Exchange. 
Brendan McDermid | Reuters

The recent mini-correction in stocks has been driven mostly by technical factors and should reverse as companies progress through earnings season, according to J.P. Morgan strategists.

One of the key figures will be share buybacks, which have propelled much of the nine-year-old bull market and will resume as more companies report and emerge from the pre-earnings quiet period. Other factors cited that could contribute to a turnaround include a generally stronger profit outlook, a decline in volatility and current bearish positioning that will reverse as confidence returns.

"Ultimately, the evolution of fundamentals rather than technicals will dictate the duration and end of this cycle," Dubravko Lakos-Bujas, head of U.S. equity strategy at J.P. Morgan, said in a note to clients. "Tame inflation combined with a still positive earnings backdrop and non-inflationary growth should allow this bull market to run for longer."

Lakos-Bujas sees the technical-driven selling as about 80 percent over. Systematic strategies along with commodities trading advisors are helping to drive the drawdown, which saw the S&P 500 shed about 7 percent at one point.

The major averages have climbed back and recovered much of their losses, though Thursday saw another decline after minutes from the most recent Federal Reserve meeting, released Wednesday, indicated the central bank remains committed to a steady diet of interest rate hikes ahead.

Stocks slide on higher interest rate concerns
Stocks slide on higher interest rate concerns

Longer-term fundamentals indicate that the downdraft should pass soon, Lakos-Bujas said.

Wall Street figures companies will buy back upwards of $1 trillion of their own shares this year, thanks in part to a windfall from last year's tax cut, which lowered the corporate rate and provided incentive to repatriate profits stored overseas. The buybacks will help improve market liquidity and inspire confidence about the overall market picture, according to the J.P. Morgan report.

The current situation is "a temporary correction within an ongoing bull market," Lakos-Bujas wrote.

In particular, the firm likes small-cap stocks because of their risk-reward picture as well as mega-caps that will benefit from defensive positioning that prevailed heading into the sell-off and could reverse after another strong earnings season. The S&P 500 collectively is expected to show a year-over-year profit gain of 19.1 percent, according to the latest FactSet estimates.

Both the S&P 500 and the Russell 2000, which tracks small-cap stocks, hit "extremely oversold" levels last week, according to the analysis.

"In addition to being cheap in absolute terms, valuation looks even cheaper if taken in context of low global interest rates," Lakos-Bujas said.