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10 Things That Could Derail the Stock Market Recovery

Wayne Duggan

The market may be recovering, but nothing is guaranteed.

After more than two months of steady gains and the best 50-day stretch in the index's history, the S&P 500 is up more than 35% from its health crisis low. Investors seem to be pricing in a significant economic recovery in the second half of the year, but the U.S. still has plenty of obstacles in the near term. DataTrek Research co-founder Nicholas Colas is optimistic about the trajectory of the stock market, but new market highs are far from guaranteed. Colas recently compiled a list of 10 things that could derail the stock market recovery.

Unemployment and labor force participation numbers

The S&P 500 rallied after the Labor Department reported May jobs numbers that Colas described as a "welcomed surprise." However, he says job losses during the current recession have occurred disproportionately within lower-skilled industries, such as hospitality and retail. Fortunately, most of the 2.5 million new jobs created in May came from these types of blue-collar industries, including leisure and construction. These lower-skilled workers have less flexibility to adapt to an evolving economy, and they could be in trouble if the number of jobs in their industries doesn't fully recover to pre-crisis levels.

Holiday consumer spending

The retail industry has been one of the hardest hit in 2020. But the silver lining for retailers is that the worst of the downturn has occurred in a seasonally weak time of year. Colas says there's no doubt consumer spending in the critical holiday shopping season will be down in 2020 compared with 2019. But the key for investors is just how bad the fourth quarter will be. If companies realize holiday demand will be worse than anticipated, they could reduce seasonal hiring or even lay off more workers to cut costs and help preserve their bottom lines.

November elections

There is still plenty of time between now and November, and the 2016 election is a reminder of the dangers of relying too heavily on polling numbers. But Colas says the stock market should probably be discounting at least the possibility of higher corporate tax rates in 2021. Fortunately, since 1976, the S&P 500 has averaged a 14.3% annual gain under Democratic presidents and a 10.8% annual gain under Republicans.

Trade war

Whether justified or not, U.S. sentiment toward China is at a low point, and politicians will likely ramp up negative China rhetoric as the November election approaches. If political tensions between the U.S. and China start to rise, the January "phase one" trade deal could be at risk, and China could choose to ramp up economic pressure on the U.S. Colas says the Chinese government likely understands the significance of political posturing before an election. But Chinese officials have their own base to placate and can't afford to look weak on a global stage when American politicians take public shots.

Second wave

Since the first wave of COVID-19 hit, health officials have been warning Americans about the potential for a second wave of infections. Recent spikes in hospitalizations in certain regions of the country suggest that the nation is still struggling with the first wave of the outbreak. Colas says the timing, severity and economic fallout of a second coronavirus wave could be disastrous for investors. Peak flu season starts in December, and the threat of infection alone could be enough to keep American shoppers at home and out of crowded stores, restaurants and other businesses.

Negative interest rates

The possibility of negative U.S. interest rates has been one of the most controversial topics in 2020 on Wall Street. Federal Reserve Chair Jerome Powell was adamant in May that negative rates are "not something that we're considering." However, high-profile critics have been pressuring the Fed to drop rates below 0% for the first time. President Donald Trump has called negative rates an economic "gift," but experts disagree on the effectiveness of negative rates in stimulating European economies. Colas says he wishes talk of negative interest rates "would just go away."

Strong dollar

The U.S. dollar is a global currency benchmark that tends to gain strength relative to other currencies during economic uncertainty. Unfortunately, a strong dollar hurts U.S. companies that generate revenue overseas because sales completed in foreign currencies convert to fewer U.S. dollars. About 40% of S&P 500 earnings come from outside the U.S. The dollar has weakened significantly in the past month, which is good news for U.S. investors. But Colas says investors need to keep the dollar's recent move in perspective, given that it's still closer to its three-year high than its three-year low.

2021 earnings expectations

In a typical recession, corporate earnings tend to bounce back quickly once the recovery stage begins. Colas says the S&P 500 is pricing in roughly 20% earnings growth in 2021, which is certainly reasonable based on historical economic cycle data. However, he says the 2020 recession is atypical in many ways, and the 2021 earnings recovery could also be atypically weak. The S&P 500's forward 12-month earnings multiple is already about 21, more than its five-year average, according to FactSet. If earnings disappoint to the downside, it may be difficult to maintain that valuation.

International recovery

About 40% of S&P 500 earnings come from international markets. A strong U.S. economic recovery would certainly be good news for investors. But if the rest of the world struggles to gain traction with recovery, upside in U.S. stocks could be limited. Colas says the S&P 500 will need significant contributions from international markets to get anywhere close to the 20% 2021 earnings growth that is priced into the market. The head of the International Monetary Fund recently said the fund will likely further cut its forecast of a 3% contraction in 2020 global GDP.

Automation

For years, economists, politicians and investors have discussed the potential economic effect of automation and other disruptive technologies, and Colas says the 2020 environment may have accelerated that disruption dramatically. The recent economic shutdown essentially compacted a decade's worth of change in areas such as working from home and online shopping into roughly 90 days, according to Colas. The potential lasting effect on the labor market is the issue Colas says he spends the most time considering. Unfortunately, predicting the medium- and long-term impact the last three months will have on the American workforce is difficult.

Possible bumps on the road to market recovery:

-- Unemployment and labor force participation numbers

-- Holiday consumer spending

-- November elections

-- Trade war

-- Second wave

-- Negative interest rates

-- Strong dollar

-- 2021 earnings expectations

-- International recovery

-- Automation



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