Stock Market Outlook for Q4 2021

The fourth quarter tends to be the best performing quarter of the year, but after all the volatility and market unpredictability throughout 2021, what can investors expect for the last months of the year?

Stocks have been on a roll as another mostly successful earnings season has unfolded, but there are reasons for investors to be both optimistic and cautious for the fourth quarter of 2021.

There are several risks that are at the forefront of investors' minds, including concerns over the delta variant, inflation, supply chain disruptions and labor shortages. But low interest rates and solid corporate earnings provide a foundation of support for equities.

To help you navigate these headwinds and tail winds, we gleaned insights from Liz Ann Sonders, chief investment strategist at Charles Schwab, and other investing experts. Here's what you need to pay attention to in the last quarter of 2021 to find the best investment opportunities and finish the year strong:

Inflation and the Federal Reserve

One of the prices investors are paying in this stage of the pandemic is high and persistent inflation eating away at returns. As inflation pressures have remained high, they weigh on investors' consciences as they are trying to find ways to generate more yield to maintain their purchasing power.

Sonders highlights two kinds of inflation: procyclical and countercyclical.

Procyclical inflation is a rise in prices due to a heavy wave of consumer demand, which tends to occur when the economy is strong. Countercyclical inflation is when prices are so high that it actually puts pressure on economic growth.

"I think we have shifted from procyclical inflation to countercyclical inflation," Sonders says. U.S. GDP growth came in at an annual rate of just 2.0% in the third quarter, according to preliminary federal estimates. Goldman Sachs also recently cut its projection of U.S. GDP growth for the rest of the year from 5.7% to 5.6%.

The Federal Reserve closely monitors inflation in an effort to help keep prices stable and as a guide on how it will treat monetary policy. Despite persistent inflation worries, key Fed officials have said they view inflation as transitory. If that view survives, the Fed is on track to start tapering its asset purchases by November and could raise interest rates in 2022, which could put pressure on growth stocks.

Sonders says transitory inflation means something different than what the Fed was referring to when it first started using the term, going beyond the base effects of inflation. "For the first three months of the surge, the comparisons were to last year's lockdown period, where you actually went into a deflation mode. Clearly, the supply chain bottle necks are not going away anytime soon."

With inflation likely to persist, Steve Chiavarone, head of multi-asset solutions, portfolio manager and equity strategist at Federated Hermes, says, "We recommend that clients position their portfolios for continued upward pressure on inflation and interest rates in 2022."

That said, he expects cyclical sectors to perform best, including energy, financial, materials and industrials.

Bonds Losing Appeal

Bonds are a traditional portfolio diversifier that uses interest income to balance out the volatility associated with stocks. But recently, investors are questioning whether they should ditch the traditional portfolio stabilizer for more risk to achieve their goals in this lower-yield world.

Equities, then, are sought for growth, while bonds are allocated for stability to mitigate risk. But investors are worried that bond market performance has not been keeping up with the pace of inflation.

"Bond yields are so low that they don't offer a competitive alternative to equities," says Terry Sawchuk, CEO of Sawchuk Wealth, based in Troy, Michigan. As a result, cash will likely continue to feed into equities, he says, supporting stock valuations.

Focus on Value Stocks

For investors willing to take on more risk and allocate more in stocks, experts say to invest in high-quality companies that are set to benefit from a global economic recovery with reasonable valuations.

For stock-picking investors, Sonders says, "Focus less on sectors and more on factors." Factors are a way to categorize stocks based on how they react to market conditions and include value, growth and momentum.

Stocks with strong value fundamentals like free cash flow yield and rising earnings revisions are among those investors should be paying attention to, Sonders says. Seek out companies that have strong growth potential that are reasonably valued. As earnings season is underway, be sure to see how S&P 500 companies are performing in their earnings reports relative to previous years and if the company offers any forward-looking guidance. This data can help investors understand how to value the company in the future.

What's Next for the Stock Market?

Most experts have a positive outlook on U.S. equities for the rest of the year. "Momentum will continue to build as earnings continue to be solid for the next few weeks," Sawchuk says.

However, Sawchuk continues, the market may be choppy heading into 2022. "I am anticipating a market pullback heading into 2022," he says, citing potential adjustments to capital gains rates, elevated stock valuations and continued supply chain disruptions, among other factors.

With elevated stock market valuations across the board and already high market expectations, some investors may have trouble justifying further gains in the market.

But Ryan P. Johnson, Ohio-based director of portfolio management and research for Buckingham Advisors, says that as long as there is growth in earnings, market gains will follow. "Earnings are expected to grow double digits again in Q4, but growth could decelerate to the single digits for the full year 2022."

Since stock valuations are stretched, already at an above-average forward price-to-earnings multiple, Johnson says, earnings will need to be the catalyst for market gains.

So far, so good. More than 80% of S&P 500 companies that have reported are beating estimates for the third quarter.