2021 Stock Market Outlook: Covid Vaccine, Political Gridlock, Possible Recovery

by Anna-Louise Jackson and Benjamin Curry

Forbes Advisor

Thursday January 14, 2021

The year that brought so many surprises is shaping up to be a surprisingly good one for investors, and that's a timely reminder for 2021.

The S&P 500 is hovering near an all-time high, on track for better-than-average returns for 2020 and in the midst of a bull market—all of which might seem downright boring if you didn't know the full story. This feat, however, is even more remarkable given the shocking speed and severity of the market's crash earlier in the year.

In just 33 days, the S&P 500 plummeted nearly 34%, for its fastest-ever descent into a bear market. There were days that this benchmark saw double-digit declines of as much as 12% as years of gains were wiped out in a matter of days.

Of course, stock prices ended up roaring back with a vengeance. The S&P 500 recouped its bear market losses and reached a new record high by mid-August, then went on to notch one new all-time high after another.

Heading into a new year, investors need to remember both the highs and lows of 2020's wild ride. Wall Street strategists say stock prices are headed higher, but they caution that there's likely to be continued volatility in 2021—as well as the potential for more surprises.

There are some catalysts we already know about that could push the market higher—a Covid-19 vaccine is likely to arrive in the early months of 2021 and the Federal Reserve intends to keep interest rates low for the foreseeable future. However, the unknowns include how robust the economic recovery will be, the timing of another stimulus package from Congress and the broader impact of potential gridlock in Washington.

Here's what four professional investors will be watching in 2021.

Covid-19 Vaccine Progress

The coronavirus pandemic will remain a, if not the, major theme for the stock market in 2021. What exactly will professional investors be watching as the Covid-19 story evolves?

"Development of the vaccine is right up there at the top of the list," says Jon Adams, senior investment strategist and portfolio manager at BMO Global Asset Management. The stock market has jumped higher recently on positive news about a coronavirus vaccine from pharmaceutical companies, and Adams says he expects more such announcements heading into 2021.

Meanwhile, the number of Covid-19 cases in the U.S. and around the world has been rising sharply in recent weeks, increasing the likelihood that widespread lockdowns "could tamper some enthusiasm," Adams says. "The key issue for investors will be assessing the short-term versus the medium-term outlook for the virus."

What's more, no one knows the exact timing of vaccine releases or how long it will take to distribute them, notes Megan Horneman, a director and portfolio strategist at Verdence Capital Advisors. "The next six to nine months still is a very precarious situation."

Political Gridlock in Washington, D.C.

Mark your calendars—professional investors already know that January 5 could be a very big day for markets. That's when Georgia will hold run-off elections for its two U.S. Senate seats. The unusual dual run-off election will most likely be "the first major event we're going to have to contend with in 2021," says Liz Ann Sonders, senior vice president and chief investment strategist at Charles Schwab.

Georgia's Senate run-offs will determine which party has control of the U.S. Senate, which currently leans Republican. And Senate control will be the lynchpin determining who gets to call the shots for passing legislation in Washington, D.C., for at least the next two years as the Democrats are already in control of both the White House and House of Representatives. This outcome will impact the fate of everything from a second stimulus package to infrastructure investments, Sonders says.

It may seem counterintuitive, but Wall Street actually prefers divided government and a certain amount of gridlock, notes Sam Stovall, chief investment strategist at CFRA Research.

The S&P 500 has seen its best average returns when a Democrat has control of the White House and control of Congress is split between two parties, says Stovall, although this exact scenario has only occurred four times since World War II. More broadly, the stock market historically has done well under new Democrat presidents, posting average gains of 17% in the subsequent year, he adds.

Stock prices surged in the days following Joe Biden's victory—with an assist from some positive Covid-19 vaccine news—which suggests to Stovall that "investors were heartened that instead of a blue wave, there's likely to be a tsunami of gridlock."

Will There Be a Second Stimulus?

While Wall Street may cheer the potential for political gridlock, Main Street won't be satisfied by this outcome. Congress failed to pass a second stimulus bill prior to the election, and Americans are hurting for additional assistance to alleviate the financial hardship created by the pandemic.

All four strategists agree that another stimulus bill is unlikely to arrive until early 2021.

Federal Reserve policymakers have made it clear the next move to boost the economy must come from lawmakers, putting more pressure on Congress to get a deal done early in 2021. "Fiscal relief needs to be more targeted to people who are out of work or businesses that are just hanging on," says Sonders. "The Fed is correct in saying that."

Still, the prospect of Washington gridlock suggests any stimulus bill may be insufficient to really help people who are struggling the most?—or a bill may not get passed at all, according to Horneman. "If we don't get some sort of a well-targeted fiscal stimulus plan, I think the first half of 2021 is going to be challenging," she says.

Fed to Keep Interest Rates Low

Fed policymakers have promised to keep interest rates low for years, after slashing the Fed Funds rate to near zero in March. Central banks around the world will likely keep interest rates ultra low as the global economy recovers from the coronavirus pandemic, Adams says.

The low interest rate backdrop will encourage investors to continue favoring equities relative to bonds because of the prospect of relatively higher returns. In turn, that could help to push stock prices higher, notes Horneman.

"Regardless of the economic climate, as long as there's not some other exogenous event we don't know about, that does support being in the equity market," she says.

Meanwhile, the Fed could once again roll out quantitative easing (QE), an unconventional monetary policy tool that involves buying Treasuries and other securities to support markets and the economy. The central bank had eased off this program as the markets stabilized in the latter half of 2020.

"If there start to be real problems in the financial system, the Fed could step in with more QE," Sonders says. Still, investors shouldn't necessarily come to rely on (or expect) this support. "Just because we get a phase of volatility doesn't mean they'll feel compelled to step in; they will look at if it's a threat to financial stability," she says.

The Great Rotation

Tech stocks are the heavyweights in this stock market, and they've done much of the lifting to push the broader market higher over the last decade. Could 2021 be the year that new leaders emerge? The strategists say that's possible.

The universe of stocks can be divided into growth versus value. Growth stocks are companies that investors expect to grow at a faster rate than the overall market while value stocks are companies they believe to be underpriced. Since September, S&P 500 value stocks have risen while growth stocks have fallen—and yet the broader market still has gone up over that period.

This suggests investors are starting to favor value stocks relative to growth stocks, though Adams says he's not quite ready to "call the end of the growth trade." Still, he expects that potential shift in market leadership to be "a really important theme for 2021."

That's a good reason to watch the "power of the newly minted day traders" who have become a much more dominant force for the market in 2020, Sonders notes. In the past, these traders were in the cart following the horse of institutional investors, she says, but that relationship has evolved.

What's more, "speculative fervor" among the day-trading crowd has helped to define some short-lived rotations—like from growth to value—and shaped the mini peaks and troughs in the market since the new bull market began in March, Sonders says. This adds to some uncertainty for 2021, however, because these traders have more influence than in the past, even during the speculative dot-com bubble.

Still, Stovall says it's possible that a much-anticipated, broader shift could happen in the market that favors small-caps relative to large-caps and international stocks. "Maybe 2021 is the year of the great rotation," he says.

Economic Growth and Corporate Earnings

Last but not least, investors will closely monitor the pace of economic growth and corporate earnings, as they do every year. However, with Covid-19 cases spiking nationwide and many states instituting broad shutdowns again, it may be more difficult to forecast these trends in 2021.

Before the new year even arrives, there's the fourth quarter to contend with—and estimates for gross domestic product (GDP) growth for this period have been falling. For example, a tool from the Federal Reserve Bank of New York now suggests the U.S. economy grew about 2.9% in the fourth quarter, down from a prior estimate of nearly 7.3%. And those types of estimates could get worse before the quarter ends in December, Sonders cautions.

The economic recession caused by the coronavirus pandemic isn't over, at least according to the National Bureau of Economic Research (NBER), which makes the official announcement of these dates. There has been speculation about a possible double-dip recession, in which the economy briefly recovers from a recession only to fall into another shortly thereafter, but the strategists say that's not likely.

Rather, the economy is likely to improve along with containment of the virus. As that happens Stovall expects publicly traded companies will feel "more emboldened" to increase their outlooks for 2021. And in general, earnings will probably be positive in the coming year, when compared with 2020, Horneman adds.

Meanwhile, Sonders says consumers could unleash some pent up demand for spending on goods and services once there's a vaccine. In the second half of 2021, she'll look for signs the economy has changed in a post-pandemic world—such as whether consumers focus more on saving than spending, thereby contributing less to GDP. Personal consumption spending currently represents nearly 70% of U.S. GDP, but if Americans become more savings oriented in the new year, "there could be some long-lasting changes," says Sonders.

Finally, the current recovery will need to broaden—bringing more people back to the workforce—so investors can answer the following question posed by Adams: "Is the economy strong enough to stand on its own two feet?" While he says it's possible the economy could "take another step back" before a vaccine is widely available, the longer term outlook is positive.

"Hopefully we'll be getting back to some type of normal environment in 2021," Adams says.

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