Ally image shows title “Market Outlook. Q1 2021” with a screen of stock tickers in the background.

We don’t know about you, but we are looking forward to what 2021 has to offer.

It’s bound to be a better year for humanity. For one, COVID vaccines are going into arms as you read this. While the general population may have to wait a while longer for a shot, it’s looking good that many people will get one this year.

If everything goes according to plan, we could be heading for an economic boom. There’s even been reference to the “roaring ’20s,” the post-World War I period during the 1920s marked by economic success and prosperity. While that may be a bit of an extreme comparison, it may not be too far off. Consumers have money in the bank, and they’re itching to spend it on post-quarantine activities. Afterall, consumer spending could determine the speed of the recovery.

But here’s the thing about the best-laid plans: They often go awry. For example, nobody predicted that the S&P 500 would end 2020 16% higher, knowing that a global pandemic was on its way. Yet here we are.

The title reads “Good Riddance 2020: The S&P 500’s Wild Ride.” The chart shows the S&P 500’s activity in 2020, highlighting the –34% plunge in March and the following rise of 68% from March to December.

At the start of 2021, stocks are off to a good start, even after the S&P 500 posted its best end to a year in decades. With that momentum, you’d think this could be a banner year for the market. Don’t get us wrong: as you will read, we expect major recovery boxes to be checked in earnings, the economy and policy this year. But we wouldn’t be strategists without assessing our risks. The stock market’s performance in the opening quarter could run into resistance from a persistent rise in COVID cases, shutdowns, or the market’s lofty price tag/valuation (price of the market versus its earnings power).

Generally, we expect the year ahead will be brighter than the last. Here are four big things we’re watching as the year kicks off.

Earnings to Lead Performance

The outlook for profitability has steadily improved as the clouds of uncertainty began to part in the second half of 2020. Not only has vaccine distribution begun, but regulatory uncertainty has subsided with the passing election, and more stimulus is on its way to consumers and small businesses. This backdrop will likely accelerate sales growth and offer corporations more confidence with regard to spending and growth.

The expectation for 2021 is that S&P 500 earnings per share will return to 2019 levels, completely recovering 2020 pandemic losses. Cost cuts in the past year, combined with accelerated sales growth will drive margin expansion and ultimately earnings growth. This is the typical pattern seen in recoveries. In 2021, sales and earnings growth are projected to reach the highest levels since 2018.

Chart title reads “Earnings could fully recover in 2021.” The chart tracks the S&P 500 Quarterly Earnings Per Share and the S&P 500 Quarterly Sales Per Share from 2005 to an estimate for 2021, highlighting two periods of recession (2008 and 2020), when both earnings and sales dropped, the former more drastically so. Other than those two points in time, both lines are generally rising.

While that is an encouraging sign, we suspect there is likely more room for upside from the current estimates. Additional stimulus hasn’t been fully baked into consensus numbers and the strength of the consumer has consistently been underappreciated throughout this recovery. In the chart above you can see that sales are projected to recover more quickly than earnings. This feels like a disconnect as top line growth typically falls to bottom line results faster in earlier stages of a recovery.

We expect guidance for 2021 to be more upbeat than might be expected by the market. Companies that have reported fourth quarter results thus far are exceeding expectations and raising guidance as trends improve. Examples of this include Nike, which reported that its overseas markets, including China, are showing signs of accelerated growth. Accenture’s strong quarterly performance was a sign of improving IT spending. Paychex noted solid customer retention and an increased number of new customers, which resulted in an improved outlook.

While some of the upside for 2021 may be priced into the market, with the S&P 500 trading at a 22.4x price-to-earnings ratio (P/E) on a forward twelve-month basis, we believe that doesn’t account for what could be a bigger and faster recovery in sales and profit this year.

Sector Rotations

You could say 2020 was a tale of two halves, for many reasons. From a sector perspective, technology, Amazon, communication services, and health care led the first half. As investors began focusing on 2021, the second half of the year was led by industrials, materials, and financials. Even some retailers, small caps, and biotech stocks showed outperformance versus tech over the same period. Though the winners in the first half continued to also do well, they experienced more volatility.

2021 is likely to look similar to the second half of 2020. Value sectors, like the financials, should do well as investors position for the end of the pandemic and as interest rates rise. The Russell 3000 Value Index is still below its 52-week high and has underperformed growth for four years running. Value has a good track record of performing well in the early part of an economic cycle.

Title reads “Value Shines in Early Economic Rebounds.” The chart shows value stocks versus growth stocks from March 2009 to March 2010 after the financial crisis. Value stocks rose 77% and growth stocks rose 69% during that time.

Cyclical sectors, such as industrials and materials, which performed well in the second half of 2020, should be a key beneficiary of the earnings recovery in 2021. Additionally, many cyclical companies will benefit as various countries recover at different times given their overseas exposure.

Overall, we see the greatest opportunity in 2021 from sectors benefiting from the rebound but still below pre-pandemic highs. Growth is likely to take a back seat but given the economic dynamics at play, we aren’t anticipating a major sell-off in the growth sectors. As usual, a diversified portfolio is the best way to prepare for the year ahead.

The Economic Boom

2021 could be a year of catching up for many Americans. We haven’t been able to enjoy experiences like restaurants, travel, and concerts normally for several months now, and the vaccine could be the ticket to normalcy.

That pent-up demand will be supported by the record amounts of cash flowing through the system and the possibility for another big round of fiscal stimulus. Consumers who make it out of the pandemic with their finances intact could spend more money to make up for lost time.

Based on that, you’d probably guess we’re heading for a year of blowout growth. But it’s not that simple.

Chart title “A Year of Growth Ahead.” This chart shows the quarterly GDP growth for the first three quarters of 2020 and the forecasted quarterly GDP growth through 2021. Q1 2020 and Q2 2020 were at –5.0% and –31.4% respectively, while Q3 2020 saw 33.4% growth. The remaining quarters are forecasted as follows: 4.6% (Q4 2020), 2.5% (Q1 2021), 3.6% (Q2 2021), 3.8% (Q3 2021), 3.4% (Q4 2021).

The economy’s momentum will need to remain resilient for a solid recovery to continue. The current expectation is for GDP growth to remain above average for much of 2021. But keeping an eye on the progress in the jobs market will be important in the year ahead.

The unemployment rate is at its highest in seven years, and 10.7 million workers are still unemployed. About 38% of the unemployed population hasn’t had a job in at least 27 weeks. These people are considered “long-term” unemployed and are at higher risk of not finding a new job. Given the rise in COVID cases, parts of the country are still under restrictions or shut down and many individuals have limited activities outside of their homes, keeping job openings at depressed levels.

For an above average recovery, jobs trends will need to turn around in a sustained way. An increase in demand should force the hand of corporations to begin hiring, but that may take some time. We remain optimistic about the future of the jobs market. For now, the prospect of higher growth ahead may be enough to keep the market chugging along in 2021.

The Fed’s Future Plans

We can thank the Fed for a 16% pop in stocks in the year of a pandemic. Since the central bank leaped into action in March by cutting rates to zero and committing to buying bonds in order to save the economy, stocks reached new record highs and the economy has bounced back.

We expect the Fed’s support to remain intact through 2021. The weak unemployment picture leaves enough uncertainty to justify this. As a reminder, the Fed exists to promote maximum employment and stable prices. We think the Fed will be especially careful, erring on the side of keeping conditions accommodative for longer than needed. However, we aren’t in the camp that they will need to use additional tools or increase current stimulus. Fed policymakers currently predict rates will stay historically low at least until 2023. Ultimately, that supports riskier assets such as stocks.

The largest risk to Fed policy is inflation. If the prices of goods increase faster than wages, the Fed may be forced to cut its market support or raise rates in order to keep economic growth in check.

Title reads “High Hopes, Low Inflation.” The chart shows year-over-year inflation (Core Personal Consumption Expenditures) from May 2015 to November 2020 rising and falling between about 1 and 2% against the Fed’s target of 2.0%.

We don’t expect this scenario to be a significant threat in 2021. Inflation is growing at a 1.4% annual rate, below the 2% growth that the Fed has deemed ideal for the economy. Wall Street economists don’t expect inflation to reach that target for at least another two years.

However, inflation expectations can change quickly, and some signs of excess are popping up. Speculative areas of the market, such as initial public offerings and alternative asset classes, are getting a little overheated.

If spending picks up and if the economy starts roaring post-COVID, like in the ’20s, the Fed may have some important decisions to make. But the probability of them changing course this year is low.

The Bottom Line

The roaring ’20s comparison may be a bit of a stretch. But we think there are several reasons for upside in the stock market this year. The market path will likely look different in 2021 than it did in 2020, and we feel good about the set up entering the new year. There will likely be some bumps or pauses along the way, but there is no reward without risk.

Happy investing in 2021!

Callie Cox, Senior Investment Strategist, contributed to this article.


 
Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.


 
Headshot of Callie CoxCallie Cox is Ally Invest’s Senior Investment Strategist. In her role, she helps educate Ally Invest customers about the financial markets through engaging content and strategic initiatives. Callie has worked in financial research for her entire career, with stints at LPL Research, TABB Group and Bloomberg. Her work has been featured in Bloomberg, the Financial Times, Yahoo Finance, and Barron’s (among other publications). You can also find her on Twitter at @callieabost.


The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.