This week’s violent sell-off was a ‘regime shift’ to new leaders, not a market top, Tom Lee says

Finance news

It’s been a tough start to the fourth quarter for U.S. equities. But after an autopsy of trading in October, Fundstrat’s Tom Lee said the pullback looks more like a changing of leaders and laggards than a reason to sell.

“A few anomalies about this sell-off suggest a regime shift is potentially behind the violence of the market moves, as opposed to this being a ‘equities are peaking’ sell-off, and further affirms our take that this is a pullback that needs to be bought,” Lee said in a note to clients.

For one, Lee pointed out that energy, financials, real estate, health care, and staples and utilities, which have mostly under-performed this year, are actually leading. Over the past 8 days, value has outperformed by a “whopping” 150 basis points, Lee said.

“Doesn’t this feel more like a ‘laggard becomes a leader’ trade?” Lee, former chief equity strategist at J.P. Morgan, wrote in the note. “Perhaps the best place to start is to look at the ‘musical chairs’ taking place at the style and sector level.”

Tech stocks, which have led the market’s historic bull run, saw a two-day slaughter this week. The Nasdaq Composite Index fell into correction territory, down 10 percent from its recent highs.

Lee highlighted the steepening yield curve as a sign of improved forward growth outlook and an inverse relationship of ETF volumes to volatility products. The combined inverse volatility to ETF relationship was at 6 percent on the New York Stock Exchange Thursday, which Lee said matches the February reading and is a “sign of a bottom.”

The Dow’s 1,300-point sell-off this week was fueled by the idea that rising rates are bad for the economy, by trade tensions, by late-cycle fears — or, as Lee said, “earnings are as good as it gets” — and some overall market fatigue. Stocks recovered on Friday, though, as tech shares rebounded and those rates fears subsided. Better-than-expected bank earnings also helped boost the Dow Jones Industrial Average more than 270 points but it still ended the week down 4 percent.

To be sure, Lee said there is a risk that markets will get nervous with a 10-year Treasury yield above 3.25 percent.

“Equity markets generally saw corrections when interest rates touch the long-term downtrend in place since 1980 and that trendline today is 3.25 percent,” he said. “But we believe we are in a reflationary environment, more akin to 1945-1980, and hence, rising rates tend to be associated with rising stock prices.”

Bottom line, Fundstrat is a “slow buyer” of the pullback. The firm is betting that strong seasonals will be dominant in 2018, meaning stocks will rise both from earnings season, “even if guidance is not spectacular,” and from post-midterm rally.

“While markets globally are retracing, we believe the risk-on trade will be US equities,” Lee said. “The US has the best visibility and pro-growth administration and policies. Hence, we see US equities as the high-quality safety trade for global investors.”