Market Outlook: Q4 2020

What a year 2020 has been!

With just three more months left, we’re drinking the pumpkin spice lattes, getting out the Christmas decorations, and preparing to wave goodbye to one of the worst years in memory. But before doing that, we need to prepare for some fourth-quarter market action.

Ironically, this rough year hasn’t derailed stocks too much. Yes, we’ve had our ups and downs, including one very big down from February to March. Still, the S&P 500 ended the third quarter up 4.1% year-to-date after an unusually strong summer. Stocks did hit a September swoon, but believe it or not, we’ve since recovered most of those losses. Now, we’re entering what is typically a strong period of the year for the market.

But that doesn’t mean it will come easy. Given the unpredictability of 2020, putting trust in past trends could be difficult. And the calendar is packed. Over the next three months, we’ll have to contend with a presidential election, a continuing struggle over fiscal aid, and a possible cold-weather COVID surge. To keep the historical uptrend alive, investors will look for positive news on stimulus and a vaccine.

The graph illustrates the average S&P 500 return by quarter for 2020. Q1 had an average return of 2.4%. Q2 had an average return of 1.8%. Q3 had an average return of 0.6%. Q4 is predicted to have an average return of 3.9%.

All told, we don’t expect the next three months to be as smooth as history implies. In fact, investors should prepare for September’s volatility to continue. But never fear, with volatility comes opportunity. Preparing your cash and a wish list ahead of market hiccups can benefit you in the long run.

Below, we’ll dig into the market drivers that will compete for investors’ attention in the fourth quarter. We’ll also help prioritize which of these drivers matter most.

Mixed Economic Backdrop

An economic recovery is likely underway. And on the surface, things look pretty good at the moment. We’re in the early stages of growth, and consumers are spending like COVID never happened. Retail sales have fully recovered after falling off a cliff in March, and consumer confidence is increasing at the fastest pace since 2003. Importantly, the consumers have improved their financial position over the past several months, reducing debt and hanging on to cash.

The graph illustrates that retail sales, which have been steadily increasing since 2010, have bounced back after a large dip in March 2020.

That’s partially why we’ve seen a surge in homebuying lately. Existing home sales hit 6 million in August, a 13-year high. New home sales exceeded 1 million for the first time since 2006. Consumers feel good enough about their finances and their future to make such a big financial decision. Similarly, construction spending is on the rise, and manufacturing has picked back up again after a deep contraction in the spring.

But not every part of the consumer economy is flourishing. One part we can’t ignore is the high number of people who remain out of work. In September, job growth slowed for a fourth straight month (to a 661,000 increase). While still a big increase, at that rate it’ll take 17 months to dig out of the 10.7-million job hole since COVID began. It’s harder to say if the job losses are temporary, too. Permanent job losses are rising at a rapid pace.

The consumer may be more financially fit than they have been in the past, but the engine of consumer activity is the job market. And that engine may be running low on gas, with some companies shedding jobs and other businesses closing for good. Just last week, Disney, Allstate and Goldman Sachs announced major layoffs. Several major airlines have cut jobs recently as bailout money has run dry. It’s tough to have an economic recovery without a strong consumer.

Other indicators are also pointing to a slowing recovery. The Conference Board’s Leading Economic Index, which combines several economic data points to gauge the direction of the economy, has shown growth is moderating.

Overall, the economy is chugging along, but at what seems like a decreasing rate. Market performance could take a cue from slowing growth as the easy gains may have already been made in both the economy and the stock market.

Improving Earnings

The economy may be mixed, but both investors and Wall Street are feeling pretty good about corporate financial performance. Third-quarter S&P 500 earnings reports, which start rolling out on October 13, are expected to confirm that the worst is behind us and that the second quarter was the trough for corporate profit declines.

Plus, growth expectations have been on the rise over the past three months, a good sign that reopening has helped businesses rebound quickly. Currently, analysts think S&P 500 profits declined 23.3% year-over-year last quarter. That would be a pretty weak quarter by historical standards, but it’s 3 percentage points higher than projections in mid-July.

The graph illustrates the year-over-year change in earning from Q1 2019 through Q2 2020, as well as the projected year-over-over earnings from Q3 2020 through Q4 2021. Q3 2020 is highlighted, illustrating the projected 23.3% year-over-year decline.

That’s an unusual but encouraging trend. Usually Wall Street analysts will lower expectations ahead of quarterly reports as they fine tune numbers with the latest information available.

Normally, you’d assume that as expectations move higher, it’d be more difficult for companies to beat those expectations. But that’s not always the case. Earnings expectations have moved higher two times in the last decade: in 2018 when tax policy changed and in 2011 when the market was still recovering from the Great Financial Crisis. While there was significant uncertainty both times, analysts correctly guessed that the environment was improving, and pushed their estimates higher. Companies still outperformed their expectations, too.

Don’t overthink these adjustments. Today, there is similar uncertainty, and most companies are no longer providing financial guidance, which makes it harder for Wall Street to come up with accurate estimates.

It’s important to look ahead, too. The outlook for the remainder of the year and next year will provide crucial clues on where the market goes from here. Things are looking up so far. Wall Street projects profits will grow by double-digit percentages year over year in 2021. These estimates have remained stable, too, an encouraging sign for the market. When estimates stop deteriorating, it has historically been a sign that earnings growth is recovering. But as this year has proven, things can change quickly.

Market Moves

The third quarter was (mostly) smooth for stocks. Investors cheered on better-than-feared earnings and a brightening outlook in July and August. But as economic growth began to slow and stimulus plans stalled, the S&P 500 slid almost 10% from September 2 to September 23.

That was an unsettling drop, but it may have been a big opportunity for patient investors to reap the rewards of what could be a strong finish to the year. Since 1950, the S&P 500 has risen an average of 3.9% in the fourth quarter, its best performance by far out of the four quarters.

While it’s hard to say for sure why stocks tend to finish the year strong, it could be due to enthusiasm about the upcoming year and a renewed interest in the market after its usual third quarter slump.

While we’re looking forward to the holiday season and what could be another Santa Claus rally, we’re still feeling a little cautious. After all, there are several signs that the fourth quarter could be filled with more market swings.

For one, stock valuations are still high, even after the September decline. The S&P 500’s price is 23 times higher than its expected earnings over the next 12 months (often referred to as the price-to-earnings or P/E multiple), according to S&P Capital IQ data. While that’s come down from 25 times in June of this year, it’s still around the most expensive stocks have been since at least 2000. For context, the ten-year average multiple is 16 times. The CBOE Volatility Index, or the VIX, at 27 is still stubbornly high too, signaling that investors are preparing for more volatility.

The graph illustrates the VIX Index close compared to the VIX index average from September 2019 through September 2020. From September 2019 through February 2020, the VIX Index close remained below average. Since February 2020, the VIX Index close has remained above average.

Volatility isn’t new to this market, though. And while it can be uncomfortable, it doesn’t last forever. The S&P 500 has moved 1% or more in about 47% of trading days this year, the most since 2008.

All told, though, the S&P 500 has pushed higher this year. In the past 18 months, the index is about 19% higher. There are lots of reasons to expect a rocky fourth quarter. But as 2020 has taught us many times, thinking longer-term can pay off.

Repeating Historical Trends

It may be difficult for the market to rely on economic and earnings data to push the market to new highs in the months ahead.  More likely, an outside force may be necessary to help fourth quarter historical trends become reality this year. Stimulus and vaccine news have been key supports of the market rally and that isn’t likely to change in the final push of the year.

Fiscal Stimulus

Nothing has made investors more anxious than the prospect of the next fiscal aid package (enhanced unemployment benefits, stimulus checks, loan forgiveness). Future economic and earnings depend on it. It’s the most important driver of the market right now. That is, absent the eradication of the coronavirus.

Why, you ask? The economic backdrop is showing signs of slowing, and there are worries that layoffs will increase in the fourth quarter given prior aid packages dried up two months ago. Without a vaccine, the economy will not be able to return to full capacity, making fiscal aid necessary to keep things on track. Getting a deal from Congress soon is unlikely given President Trump’s request for his representatives to stop negotiating a relief package until after the election.

While the consumer has enough saved up to weather the storm for a little while longer, and other parts of the economy are doing just fine, the clock is ticking. Struggling small businesses, pandemic-prone sectors, and unemployed consumers need more help. In addition to helping the economy, it would help earnings growth expectations from falling.

A Vaccine

Positive vaccine news has a tendency to cheer us all up. A viable COVID vaccine becoming available and ready for mass distribution would be a shot in the arm to the economy. Of course, the arrival of a vaccine has been a moving target, and the chances that we’ll see one in 2020 are getting slimmer. But it wouldn’t be the first time we’ve been surprised in 2020. We’ve seen huge health innovations over the past several months, and the world is racing to find a viable treatment.

If we do get a workable vaccine with a solid distribution plan, it could be a springboard for the stock market. In investors’ eyes, a vaccine means the pandemic is over. While it may not be that simple, any headlines hinting towards a vaccine could lead to a short-term market pop.

Fourth Quarter vs. The Long-term

The emotional rollercoaster that is 2020 shows no signs of slowing down this year. We expect volatility will persist as economic inconsistencies, election speculation, stimulus drama, and vaccine news create a tug of war for investors. And that’s not all: there are other simmering issues, like trade tensions with China.

We anticipate stimulus news to be the strongest driver of market activity in the quarter. That’s not to say the other issues won’t matter. Investors just recognize that stimulus could be most critical to supporting the economic recovery until a viable vaccine is ready. The election will likely cause bumps, but we expect them to be more temporary as investors adjust to the event. Focus will return to the recovery in growth at the end of the year as investors remember their long-term goals.

Buckle up for a wild ride. And prepare for opportunity.


 
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.