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JP Morgan Strategist Tom Lee: Expect a 20% Year End Market Rally

Matt Nesto

Now that NASA has gotten out of the rocket launching business, there must be an unemployed countdown expert out there somewhere, who could give the proper finesse and delivery to that famed phrase, "3 — 2 — 1 — Blastoff!"

I say this because that is exactly what we are poised to see in the U.S. stock market, according to Tom Lee, chief equity strategist at JP Morgan. He's looking for a 20% year-end rally — from current levels — that would take the S&P 500 to about 1470. Talk about a Santa Claus rally; the last time the S&P closed at the level was December 2007.

"It's sort of hard to expect through conventional wisdom," Lee says in the attached clip, adding that a "20-plus-percent" rally in the next 2 1/2 months is doable. And as he pointed out in our previous piece, the return of risk-taking, a trough in the trend of economic data, continued improvement out of Europe and China, and a tailwind from lower crude and commodity prices will be the main catalysts.

Lee assembled a 3-part strategy that has generated a list of 21 stock picks that he thinks are poised to ride this rocket to new heights.

Step 1 has to do with earnings revisions. Lee's team has uncovered 10 sub-industries in the S&P 500 with positive estimate changes over the past month, at a time when the broader index has seen expectations taken down by about 2.5%. Tires & Rubber, Oil & Gas Refining, Footwear, Home Furnishing Retail, and Specialized Finance are the top 5 and they saw their estimates pushed upwards by 7 to 27%.

Step 2 is all about his observation that risk-taking is back, and to make the Lee list, you must have a "beta that is greater than 1", which means have volatility traits that are greater than those of the broader market.

Step 3 to make it in to the "elite 21 Club", you need to also be rated "overweight" by JP Morgan research.

Mix it all together and you get a peek at what pent up demand looks like.

REITs and Hotels dominate the list, accounting for 11 spots or 52% of the total list. Orient Express (OEH), Starwood Hotels (HOT), Marriott International (MAR), Wyndham Worldwide (WYN), and Hyatt (H) make the cut. For REITs, SL Green (SLG), Boston Properties (BXP), Lexington Realty Trust (LXP) are a few of the list-worthy.

Lee thinks under-invested hedge funds will play a big role in the run-up saying that, historically, they get bullish when credit spreads rally and that "they will have to make a big reversal of position."

Also on his list of positive earnings revision candidates, are four so-called Specialized Finance companies that also hide out in the badly beaten Financial sector alongside of his REIT picks. They include American Express (AXP), Moody's (MCO), and two exchanges CME Group (CME) and Intercontinental Exchange (ICE).

Before you sell the farm, you should be aware that as bullish as Lee is on the next couple months, he is still uncertain about the "swirling dynamics" that cloud the outlook for 2012, including the chance of a recession, the upcoming elections, further stimulus, and gains in emerging markets. Officially, he expects the S&P 500 to earn $105 a share in earnings next year, "so the market should be modestly rising at least."