What's Next for Stocks

Welcome to the warp-speed, whiplash stock market. Following the shortest bear market ever, the S&P 500 soared 60% from its March 23 low to a record high on September 2. A reversal brought the benchmark down nearly 7% from a record high in just three trading days, with the tech-heavy Nasdaq falling from its apex into official correction territory, down 10%. Is the correction over? The bull-market case remains strong, but so does the case for a very choppy market coming up.

Many market watchers said the recent pullback was due, and some wondered how stocks had risen so far in the first place, given the economic suffering caused by COVID-19. “There is a widespread narrative that Wall Street bullishness is divorced from Main Street fundamentals,” says Leuthold Group chief strategist Jim Paulsen. “However, the marriage between Wall Street and Main Street looks as strong as ever.” That’s because the stock market looks ahead—and focuses not on whether things are good or bad, but whether they are getting better or worse. By that measure, many economic and market indicators are flashing green.

On the heels of a contraction in gross domestic product of nearly 32% in the second quarter—the worst quarter ever—the third quarter will show a sharp turnaround, with the Atlanta Federal Reserve’s GDPNow model (which is not an official forecast) showing growth at an annual rate of 30.8%. The model predicted third-quarter growth of just 11.9% on July 31, indicating that “the rebound is accelerating,” says Phil Orlando, chief stock strategist at investment firm Federated Hermes. Federated estimates that third-quarter GDP will rise at a 23.2% annual rate, followed by growth of 8.9% in the fourth quarter.

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In August, the unemployment rate fell to 8.4%, from a peak of 14.7% in April. “Eight percent unemployment is really bad,” says Orlando. “But it’s a lot better than 15%.” Auto sales have surged, housing is in a boom, and the manufacturing sector has expanded for four months in a row, according to a survey of purchasing managers.

Wall Street analysts expect earnings for companies in the S&P 500 index to drop nearly 20% this year compared with 2019—but they see a 28% jump in profits for 2021. And the Federal Reserve remains a strong support for stocks, signaling in mid September that it plans to keep its benchmark short-term interest rate near 0% through 2023. With yields on bonds and cash so low, stocks by comparison become more attractive, prompting the TINA (there is no alternative) rationale for stocks among many pros.

Still, it’s not all gangbusters ahead. “It has been a V-shaped economic recovery, but it will turn more wavy from here,” says Bob Doll, chief stock strategist at investment firm Nuveen. For stock investors, that means a lot of “churn,” he says, as the market also grapples with geopolitical uncertainty—the U.S. election, primarily—and sorts out the next bunch of market leaders. Overshadowing all is the risk of a second wave of coronavirus versus the race for an effective vaccine. Stocks are likely to close out the year “without big upside and no big downside—but with a lot of chop,” says Doll.

What to do now. Stock valuations overall, and especially for fast-growing tech stocks that have been leading the charge, are lofty. Although strategists have been lifting year-end forecasts for the S&P 500 to keep up with surging stock prices, “the easy money has been made,” says Orlando. His firm has already recommended that investors pocket some profits in large, U.S. growth stocks and spread some of the proceeds among areas he expects to play catch-up: U.S. small-company stocks, value-priced stocks—those trading at relative bargains in relation to earnings and other measures—and international shares.

And, yes, that means you should pare back your tech holdings. “Are you loaded to the gills in tech stocks? Congratulations,” says Doll. “Take a bow, and take some money off the table.” Or at least consider the next generation of tech leaders, say analysts at Goldman Sachs. Compelling opportunities include companies helping to computerize health care, digitize businesses and automate work processes, as well as e-commerce, digital payment and biotech firms. Stocks the analysts recommend include Intuitive Surgical (ISRG), Autodesk (ADSK), ServiceNow (NOW), PayPal (PYPL) and Vertex Pharmaceutical (VRTX).