Market Outlook: New Risks For Investors In The Second Half Of 2021

The U.S. stock market is making it out of the coronavirus crisis, and the S&P 500 and Nasdaq are hitting record highs. Now what?


With the flames of Covid-19 reduced to embers in the U.S., at least for the moment, the reopening of the U.S. economy provides a tailwind for stocks in 2021. Yet the market appears to be at a crossroads, holding on to big gains from last year and early this year while facing new risks that shape the stock market forecast for the next six months.

Since February, a historic market rally has moderated as investors try to figure out what happens next with the economy’s reopening, an inflationary bulge, possible new taxes, stimulus spending and unexpected shortages of goods ranging from semiconductors to flavored syrups at Starbucks (SBUX).

From a historic perspective, the roughly 12% gains in the major stock indexes so far this year are nothing to complain about. The average S&P 500 annual return is about 10%.

But after a monumental rebound from the March 2020 lows, the stock market went into a necessary consolidation. From its March 2020 low, the Nasdaq soared nearly 114% to a peak on Feb. 16. The composite then fell into a funk, pulling back as much as 13% before regaining the momentum that carried the index to record highs the past week.

For much of 2021, strength in value and cyclical stocks — many of them battered last year in the pandemic — made the S&P 500 a better bet than the technology- and growth-heavy Nasdaq. But the S&P 500 also slipped into a horizontal range that made it hard to make much money, no matter what stocks or sectors you picked.

“After a nearly 90% rally off the March 2020 lows, it’s not much of a surprise that since mid-April the S&P 500 index has been choppy and generally moved sideways,” Jeff Buchbinder, equity strategist at LPL Financial, said in a May 24 report.

Stock Market Forecast For Next Six Months

No one expected the Nasdaq to repeat its 43.6% surge of 2020. Much smaller returns follow the big market years.

Before 2020, the Nasdaq had four years of gains greater than 40% since its 1972 debut, according to Investor’s Business Daily research. The best year after such a surge was the 16.9% advance in 2010, when the market was still recovering from the 2008 financial crisis. The worst annual performance after a 40%-plus gain was in 2000, when the dot-com bubble burst and the Nasdaq collapsed 39.3%.

Since 1950, the S&P 500 gain in the second year of a bull market has averaged about 13%, Buchbinder says. That allows for some upside in what remains of 2021. In bull markets that followed 30% or greater declines, as the current one does, the average gain in the second year has been 17%.

Worth noting: The average maximum decline in the S&P 500 at any point in the second year of its bull markets was about 10%, Buchbinder wrote. This year, support at the 50-day moving average has kept S&P 500 pullbacks to no worse than 6%.

The market’s flattening wouldn’t be much of a problem for growth stock investors if enough stocks were rallying from breakouts. But gains have been possible only through great stock picking.

For many investors, even a 10% portfolio return has been difficult to achieve in 2021. Heavy churn in market leadership makes it harder for stocks to sustain runs and reach normal 20% to 25% gains from buy points.

Reflecting that frustration, most IBD stock lists are lagging the S&P 500 this year. Through Friday, the IBD 50 was up 9.7%, the Big Cap 20 9.5% and Sector Leaders 13.7%, the latter essentially matching the S&P 500.

From value to growth stocks, and from technology to industrials, the U.S. stock market’s taste has been fickle and uneven in 2021. Homebuilders and building products led from January to a May 10 peak. Those industry groups are now trending lower. Leisure products topped in early May and are now flattening.

Farm machinery led until mid-March. From early March to early May, auto parts and trucking were some of the hottest stocks. They’ve been sputtering since May 10.

A ‘New Normal’ For Market Rally; Three Giants Near Buy Points

Stock Market Forecast For Next Six Months: Market Rotation

Some analysts say this year’s stock market has seen more sector rotation than usual.

The market is feeling a big impact from supply-chain woes as production restarts take longer than usual. Also weighing on the market are inflation worries fueled by consumer prices rising at their fastest clip since 2008. And going forward, these impacts are “not really clear,” said Greg Swenson, senior analyst at Minneapolis research firm Leuthold Group.

“Everyone is trying to feel things out,” Swenson said, which is why he believes the market keeps rotating. The big question, he adds, is when the Fed will start tapering its stimulus.

In the second half of 2021, “We will continue to see fits and starts” in market leadership, said Sean Naughton, senior manager of U.S. equities at RBC Wealth Management. Many investors remain attached to growth stocks, even while other sectors outperform.

“That muscle memory will be difficult to break,” he said. But the Fed is turning more hawkish, which puts higher-risk assets at a disadvantage.

As he looked to the 2021 stock market six months ago, Naughton was bullish on financials, especially banks. Today, Naughton still favors financials. Despite easing since April, the trend in 10-year yields favors the sector, he adds. The expanding economic recovery should also benefit the stocks. “We believe this will be a durable recovery,” he said.

Stock Market Forecast For Next Six Months: Financials, Materials In Spotlight

With more people back to work, the labor market is improving and consumers are on stronger footing. Americans have some of the best debt levels in 40 years, meaning they can afford to borrow more.

Materials — chemicals, metals, mining and the like — comprise another sector that should do better in a continued cyclical recovery. Businesses have resumed orders, and while many face higher costs, high consumer cash levels should make it easier to absorb higher prices.

The strong rally in value and cyclical stocks gave a good start to the 2021 stock market, but that surge is now in an expected pause, Leuthold’s Swenson notes. Still, he expects cyclicals and value stocks to outperform in the stock market in the next six months. With higher interest rates, value stocks look attractive. Materials can benefit from rising commodity prices. Leuthold also is bullish on retail and consumer stocks as the reopening of the economy unfolds.

The biggest risk for the second half of 2021 is inflation, Swenson and some other analysts believe. Also a concern for the stock market in the next six months: supply-chain constraints, if they expand to more industries or spread more than expected.

While there are reasons to favor some sectors over others, IBD investing principles advise investors to stick with leading stocks mainly in leading industries. Currently, oil exploration, pipeline, refining and other oil-related groups are leading the market. Cybersecurity, telecom, aerospace, shipping, internet, steelmakers, some health care, software and retail groups also are leading. In finance, consumer lenders and real estate investment trusts are performing well.

Software and medicals have taken the lead since financials and industrials fell out of favor in the first half of June.

Stock Market Forecast For Next Six Months: Growth Stocks Start To Outperform

What should investors look for in stocks?

Superior fundamentals define leading stocks, and an earnings rebound has left many companies with sharply improved sales and profit growth.

Technically, the best stocks also distinguish themselves with sound base patterns The problem is that so many stock breakouts from proper buy points on a technical basis haven’t been as productive this year as they normally would be. Taking profits at 10%, rather than the normal 20% to 25%, may be a useful strategy.

Growth stocks, however, are starting to outperform. The iShares Russell 1000 Value ETF (IWD) this year is up about 16%, beating iShares Russell 1000 Growth (IWF) (up about 11%). But in June, the growth ETF is winning, up 5.1% to the value ETF’s 1.1% decline.

Nvidia (NVDA), Adobe (ADBE) and Alphabet (GOOGL) have already broken out and re-established their leadership positions.

The following are other key factors in the stock market forecast for the next six months.

S&P 500 Earnings Growth

S&P 500 earnings growth was explosive in the first quarter, and analysts keep pushing up their estimates. For all of 2021, analysts’ consensus sees 34.8% EPS growth and 12.1% revenue growth for the S&P 500, according to FactSet. Those would be the best results since 2010.

For the second quarter of 2021, the estimated earnings growth is an outstanding 61.9%, the highest since the fourth quarter of 2009 (108.9%). In the second half of 2021, the hot profit growth pace should moderate. In the third quarter, analysts estimate earnings growth of 23% and revenue growth of 12%, FactSet says. And for the fourth quarter, the consensus calls for an EPS gain of 17.4% and revenue increase of 8.9%.

While the second quarter will be the high-water mark for earnings and economic growth in 2021, that won’t mean the end of the growth cycle, Wells Fargo Senior Global Market Strategist Scott Wren noted in a report Wednesday. “We feel market participants are smart enough to know that comparisons against year-ago numbers resulting from a very deep recession are not in any way, shape or form representative of the norm going forward,” he said. “Over the balance of the year and certainly for the calendar year as a whole, we would still categorize growth to be ‘robust,’ to put it mildly.”

The combination of bulging profit growth and moderate stock gains means the S&P 500’s forward price-earnings ratio is falling, Liz Ann Sonders, market strategist at Charles Schwab, noted in a midyear stock market outlook. That should please value investors. Valuation, says Sonders, “is to a large degree a sentiment indicator; or perhaps better put, an indicator of sentiment.” There are times when investors are willing to pay high multiples for certain stocks, and times when they won’t.

Is Margin Debt Too High?

Margin debt is another factor to consider in the stock market forecast for the next six months. Margin debt today has exploded to nearly $1 trillion, raising concerns of an overly bubbly market. Schwab’s outlook cited a Ned Davis Research analysis that found the market flashes sell signals when margin debt starts descending from major peaks. The S&P 500 followed those periods with losses three to 18 months later.

Nick Reece of Merk Research believes margin debt is not yet at alarming levels. The rate of change in margin debt vs. the S&P 500 has declined over the past few months, he said in a research report. “In the previous two major market tops for the S&P 500 (2000 and 2007), margin debt rose significantly relative to the equity market. … It may be worth noting that margin debt didn’t rise relative to the stock market coming into the 2020 Covid crash, and the market recovered to new all-time highs quickly.”

Performance Of Small-Cap Stocks Vs. Large-Cap Stocks

Small-cap stocks have outperformed, with the Russell 2000 index up about 18% for 2021 through Friday but consolidating since mid-March. Small caps tend to do well for several years after a crisis low, says Nicholas Colas, co-founder of DataTrek Research. The Russell 2000 beat the S&P 500 in 2000 and 2010. It also beat the S&P in 2020 and is outperforming this year. But by mid-March, small-cap stocks just got too hot, too fast, he says. The Russell 2000 outperformed the S&P 500 by more than 30 basis points.

The Russell 2000 gets part of its early-cycle outperformance from lower U.S. corporate high-yield bond spreads, Colas adds. “That’s because so much of the Russell is unprofitable (about a third of the stocks) and the cost of marginal capital therefore matters to many of the companies in the index.” In a scenario where 10-year Treasury yields remain low, the Russell’s outlook is weaker because of heavier exposure to banks, while big tech flexes strong earnings leverage, he notes.

IPO Stocks And Tech Stocks 2021 Performance

This year’s market winners include a number of recent IPO stocks, such as Upstart Holdings (UPST) (up more than 500% from the IPO pricing), Inari Medical (NARI) (up about 400%) and Lemonade (LMND) (up 250% despite a big pullback).

With 113 initial public offerings, the second quarter was one of the busiest for the IPO market, according to Renaissance Capital. IPOs averaged a return of 34%, thanks to strong first-day rallies. “After a strong start, weaker market conditions dampened activity mid-quarter, before IPO performance and new issuers roared back in June, the busiest single month since August 2000,” the research firm said Friday.

Some 50 stocks that went public this year have more than doubled from their IPOs. But investors must choose wisely — the overall IPO market lags the S&P 500. The Renaissance IPO ETF (IPO) is up about 2% in 2021, and IPOX 100 U.S. (FPX) is up around 7%.

After playing a big role in the 2020 stock market recovery, the largest tech stocks have been much more subdued. That’s a sign that the market is less dependent on its flagship companies for gains. (AMZN) has been consolidating since September. Facebook (FB) also started consolidating in September but broke out to new highs in April. And Apple (AAPL) has been basing since late January.

Microsoft (MSFT) is at new highs after three basing periods since September. Alphabet is more of a success, up about 40% this year.

Juan Carlos Arancibia is the Markets Editor of IBD and oversees our stock market coverage. Follow him at @IBD_jarancibia


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