Technology stocks next to run

Richard Madigan, chief investment officer of JPMorgan’s Private Bank, talks these days of ‘rational exuberance.’

That’s a riff, of course, on the famous “irrational exuberance” phrase first uttered by former Fed Chairman Alan Greenspan in the overheated 1990s. Madigan’s iteration refers, in his view, to the logical shift back into equities from the cash sidelines preferred by investors throughout the recession.

More importantly, after calling the return of US equities back in May 2012, Madigan thinks the markets are at another major inflection point. In the near term, he believes domestic stocks will continue moving up, some 8% in the next 12 months. But he’s looking out for the next big shift and emerging markets are again looking compelling.

Near term at home, Madigan thinks the US technology sector is bound to pop and urges investors to play technology through the midcap space. When US consumers inch further out of their shells, and the largest tech companies begin to shell out the huge cash stockpiles sitting idly on their balance sheets, patient investors who have cherry-picked tech midcaps will realise considerable value.

Madigan says folks are watching tech giant Apple (ticker: AAPL) – to take the pulse of the sector. “Apple is to Tech what China is to Emerging Markets,” he says. “Everyone is focused on them to get a sense of where the momentum is heading, whether they are shifting to short-term tactical or long-term strategic.”

What he means by that is, just as Apple has transitioned from Steve Jobs to Tim Cook, China’s new President Xi Jinping is succeeding Hu Jintao – and challenges await both. China’s new leadership is grappling with the shift from an export-driven economy to one that relies more heavily on its burgeoning middle class consumer. But it isn’t an equity culture right now – it’s a culture of savings and yield, says Madigan – so China is more compelling as a market over a 10-year horizon, as the new leadership makes good on the promised liberalization.

At the end of the day, though, “neither Apple nor China is going anywhere,” he explains, “They are still the 800 pound gorillas in their relative markets and they’re changing because the world is changing.”

So watch Apple but play the sector through midcap tech stocks, and watch China, but play it through its periphery countries, he says. China has $US3.5 trillion in reserves and 1.3 billion consumers, so keep an eye on how all that potential wealth will affect trade flows. Generally, exports from ASEAN countries (an Asian trade bloc) have grown 15 to 20% year over year, in contrast export growth in the US and Europe is zero to five percent. Furthermore, last year discussions began about the creation of a new Asian trading bloc, called the Regional Comprehensive Economic Partnership, which includes China, nine other Asian nations and six surrounding partners.

Madigan is currently bullish on Australia and Japan but is watching India, South Korea and Taiwan for opportunities. Each has had supportive monetary policy, will continue to benefit from an improving global recovery and all, for better or for worse, are deeply invested in China’s economic future.

Beyond the improving fundamentals of emerging markets, the gap in valuation between them and developed markets is stark, with emerging markets trading at a 30% discount. Ultimately, US equities will have to give up some of its leadership, Madigan figures, because “the disconnect in relative value is so wide that one has to go down and the other has to go up.”

There is also a psychological narrative to this shift in trends. As folks become more comfortable investing in equities again, they naturally gravitate to the developed markets first, where they feel most comfortable. As things stabilise, however, Madigan thinks investors will begin to look for value abroad, particularly in emerging markets.

Madigan’s calls have added weight because he began repositioning his clients back into US stocks in May 2012, before the final quarter of 2012 saw a turn in sentiment. “Most of my peers gave us a hard time when we came into this year overweight US equities,” he crows.

That move into US equities coincided with rebalancing his client’s bond portfolio, trimming it from 39% in May 2012 to 29% where it stands today, while also cutting duration to two and a half years. The move sought, of course, to counter the inevitable rise in interest rates. Since then, “taper-talk,” as Madigan likes to call it, has pushed the 10-year Treasury up about 100 basis points.

“People feel better in general about the normalising environment,” Madigan says, “And instead of selecting specific commodities, bonds, currencies and stocks, we’re looking at how all those pieces fit together into a more normal risk profile again.”

That’s not an entirely original idea, of course. Barron’s and Penta have been reporting the return of risk-tolerance for some time. Even so, it’s always nice to hear a heavy like JPMorgan’s private bank confirming the world is back spinning on its axis.

This article was first printed in Barron’s, and is reproduced with permission.