Market Outlook: Q3 2020

Financial markets have turned from despair to hope, all in the span of three months.

Stocks posted their best quarter in more than 20 years, and the economy bounced back with force. It’s been a reversal of fortune for investors, who weathered the S&P 500’s quickest 30% plunge in recent memory as the coronavirus pandemic emerged.

We’re not quite out of the woods yet, though – a reality that’s become apparent over the past month. Investors have struggled to reconcile stocks’ climb near record highs, as that would seem to imply the world is getting back to normal. Sure, there has been a lot of improvement, but economic data and earnings estimates indicate we may be a long way from the pre-COVID economy. New coronavirus hotspots have also popped up around the country, sparking fears that another outbreak could lead to more economic pain. After two months of victories, there are reasons to be cautious.

Outlooks are tough to write in a year that has been full of both good and bad surprises. We can’t predict the unpredictable, but we can do our best to analyze economic and earnings trends to project where the stock market could go over the short- and long-term. While we believe things are moving in a positive direction, there remain some unanswered questions. We’re buckling up for a bumpy ride from now until the end of the year.

Line graph depicting the S&P 500’s average performance from 1950 to 2019 with the third quarter average return at 0.6%

The Pros

Markets: Looking for Direction

Stocks had a spectacular second quarter. The S&P 500 gained 20%, its biggest quarterly increase since the fourth quarter of 1998. In April and May, markets seemed determined to hit new highs no matter what. In fact, the S&P 500 pushed within 5% of its all-time high on June 8.

Since then, the market story has shifted to one of indecisiveness and confusion. There have been success stories recently, like technology stocks climbing back to overall highs, but the overall market has been running in place for weeks now, perhaps as the market prepares for earnings season.

Economy: A Warp-Speed Recovery

Economic reports we’ve seen lately have blown Wall Street’s expectations out of the water. There’s no doubt now that reopenings have sparked a fierce economic recovery that supported the April and May rally.

Companies are rehiring at a rapid pace, adding 7.5 million jobs in May and June. This has been a crucial development for the recovery: It shows people are getting back to work after the shutdowns, and it has helped U.S. consumer confidence strongly rebound. The economy’s resilience could continue to surprise everyone (even Wall Street) – and recover quickly. If that’s the case, new stock-market highs could be in sight.

Earnings: Moving the Right Way

Second-quarter earnings results will begin to be announced in earnest next week. It isn’t going to be a pretty quarter – the current consensus estimate is for S&P 500 earnings growth to decline 44.7% year over year with all 11 sectors posting a decline (a rare occurrence). Since this is the “pros” section, there is good news: This may be as bad as it gets. The second quarter is expected to be the trough in earnings declines this year. In the third quarter, S&P 500 profits are expected to fall 26.7% year over year. That’s still very weak by historic standards, but take it with a grain of salt. Since analysts are effectively driving blind with companies withdrawing guidance for the year, it is possible there is more negativity baked into earnings estimates than is warranted.

Bar graph depicting quarterly S&P 500 earnings estimates. Estimating -24.5% for 2020 and 30.7% for 2021

Additionally, 2020 and 2021 growth forecasts have stabilized over the past six weeks, which is a positive sign for the market. When estimates stop deteriorating, it has historically been a sign that earnings growth will stabilize and can begin to recover, barring any unforeseen hiccups.

Policy: Strong Support

Monetary and fiscal policy have undoubtedly played big roles in this recovery. And each has helped fuel the stock market rally.

Policymakers’ unprecedented actions have led to a surge of available cash for consumers and companies, which has flowed through the system to drive consumer spending and calm markets. The first-quarter policy response has been a clear victory. The economic downturn has been devastating, but it could’ve been a lot worse if the Federal Reserve and lawmakers hadn’t acted as quickly as they did. The Fed is still fully committed to the cause, and that’s led to a surge of cash in the financial system, which we expect will continue to support the stock market.

Line graph depicting year-over-year change in U.S. money supply since 1970. The line spikes up in recent years.

The Cons

Markets: Nervous Signs

The foundation of the rally is showing signs it is losing its footing. While the S&P 500 managed to close above its 200-day moving average at the end of the second quarter, only 42% of its members closed above their own 200-day moving averages, the lowest percent to do so since April 2000.

The road could get bumpier. We’re entering a tough stretch for the stock market. Since 1950, the S&P 500 has averaged a 0.6% gain in the third quarter, its weakest performance out of all four quarters, just as we enter the heart of the summer.

Other markets also continue to give nervous vibes. The 10-year Treasury yield is still near a record low, showing investors are hiding in more conservative bonds. Gold, which is considered a hedge for economic turmoil, is trading at seven-year highs. The CBOE Volatility Index, or the VIX, closed the quarter above 30 (nearly 10 points above its historical average), a sign there could be an above-average chance of stock volatility ahead. The VIX has averaged 19 over the past 30 years, so anything above that is considered a sign of nervousness in the market.

Economy: Plateauing?

While the economic progress has been encouraging, it isn’t clear how sustainable the current rate of economic recovery will be. The response to coronavirus case increases remains the key risk. We have already seen some hotspots walk back reopening plans because cases have surged. It may be a stretch to say the entire U.S. economy will completely close again, but progress could slow as the economy reaches a partially open “new normal.” The sustainable growth rate may ultimately be below what we saw before the recession hit. That could mean it may be a while before the economy fully recovers.

Chart listing bear markets since 1956 and months to full recovery. The average months from bear market end to full market recovery is 35 months. The average months from recession end to full market recovery is 33 months.

Looking at job losses, the economic recovery seems to have a long way to go. The U.S. economy has still lost 14.7 million jobs since February. Consumer confidence, while rising, is still low relative to where it was just a few months ago. That leaves potential for long-term damage, which could drag the recovery out for years.

Policy: A Wild Card

Despite the positive implications from recent fiscal policy, it may be one of the market’s biggest wild cards.

Fiscal policy, or the stimulus doled out directly to consumers and businesses from the government, may be at risk of disappearing soon. Enhanced unemployment benefits are scheduled to expire on July 31. The first round of Paycheck Protection Program loans, which provided eight weeks of funding for small businesses willing to keep their employees on payroll during the shutdowns, are set to run out in the next month or so. The tax deadline, which has been pushed to July 15, could lead to another big bill for struggling households.

Future fiscal stimulus isn’t guaranteed, either. Lawmakers are discussing another spending package, but we have yet to see an agreement with less than a month from enhanced unemployment benefits ending. The threat of fiscal stimulus running out could be a near-term risk for stocks. If Congress doesn’t extend stimulus, we could face an economy with an immediate spike in permanent job losses and no safety net.

As stated above, the Fed has been committed to stabilizing markets with monetary policy since the crisis. However, any loss of support (reduced bond buying, etc.) wouldn’t bode well for the market.

Election: Uncertain Outcome

If that isn’t enough to digest, remember that we have a presidential election coming up in November. Given the current social, economic, and cultural shifts, there is increasing uncertainty surrounding the outcome of the election. In the past, stocks have performed relatively well in the third quarter of election years. Since 1950, the S&P 500 has averaged a 1.1% return in the third quarter during election years (higher than its average third-quarter return non-election years). In fact, the last two years of a presidential term have been the strongest for stocks historically.

This year, there is speculation that the Democrats could sweep in November, winning both the Presidency and both chambers of Congress. While anything could happen between now and November, the potential for that type of outcome could add some angst for investors in the third quarter as they contemplate the likelihood of a reversal of Trump’s tax overhaul. Politics aside, the election adds another layer of uncertainty, and rhetoric from either side could be a catalyst for stock swings in either direction.

Line graph depicting the S&P 500’s average performance in election years from 1950 to 2019 with the third quarter average return at +1.1%.

Proceed with caution.

We’re encouraged by the progress we’ve seen across the board lately. It’s tough to argue with the economic response to reopenings, and there’s still a feeling of hope in the marketplace. However, we’d still proceed with caution, as we expect some bumps in this quarter.

Stocks’ biggest pro is stimulus. The Fed’s ongoing efforts could cushion equities against another big decline, as we’ve seen investors rush in to buy any dips lately. In fact, any new Fed stimulus or more fiscal stimulus could provide another boost for stocks. Conversely, stocks’ biggest con is the lack of stimulus.

There’s a lot to take in as an investor, especially these days. If you’re investing over a longer horizon (five years or longer), it may be best to ignore near-term ups and downs in the market.

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

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 frequently shares her knowledge as a guest on national news outlets such as CNBC, CNN, Fox Business News, and Bloomberg News. She also serves on the board of Better Investing, a non-profit organization focused on investment education.