Wall Street week ahead: History suggests rally may slow for US stocks in 2020

The outsized rally in the US stock market this year may give way to a more muted performance in 2020 if history is any guide. The benchmark S&P 500 is up nearly 28% for the year, which if the market closed this week for the year, would mark the second-best annual performance for the index since 1997.

However, investors who are hoping the rally will continue charging ahead through next year may be disappointed. The S&P 500 has returned an average of 6.6% in the year following a rally of 20% or more since 1928, slightly below the 7.6% return in all years, according to research from Bespoke Investment Group.

Fund managers and strategists say there are several reasons to believe that the stock market will not continue on a path of notching double-digit annual returns like it did during the late '90s tech bubble.

"We're up a lot this year, but we had a historically bad 4th quarter last year," said Ryan Detrick, senior market strategist for LPL Financial. "This isn't because of spectacular growth in the economy but the market realizing that we're not going to have a recession."

The S&P 500 posted its biggest drop since the 2008 financial crisis last year as investors worried that the trade war between the United States and China would push the global economy into a recession. The Federal Reserve's decision to change course in early January from its path of raising interest rates helped fuel the rally in the stock market this year.

The Fed also helped spark a bond rally that pushed 10-year Treasury yields near historic lows and boosted dividend-paying stocks, further pointing to concerns about the strength of the US economy, said Liz Ann Sonders, chief investment strategist at Charles Schwab.

"There are not a lot of investors in the bond markets losing their shirts because the economy is running ahead of expectations," she said.

The November presidential and congressional elections will likely weigh on politically sensitive sectors like healthcare as 2020 progresses, Sonders said, adding another market headwind that could prevent another string of outsized gains like the late 1990s.

"You had a bunch of strong years back then because we were in the midst of a tech bubble and there was no cap on valuations. Now we have real legitimate companies but there's not the same sign of excess valuation," she said.

Few on Wall Street expect a bear market in 2020. There are few signs of a recession looming in the year ahead, while the market has seemed unfazed by issues such as President Donald Trump's impeachment or ongoing trade tensions, said Jonathan Golub, chief US equity strategist at Credit Suisse Securities.

"Given historically low interest rates and risk premiums, we believe valuations have further to run," he said. He added that he expects the S&P 500 to end 2020 near 3,425, a roughly 7% gain from its Thursday trading price.

Investors may realize larger gains by investing in smaller companies next year, said Steven Chiavarone, a portfolio manager of the Federated Global Allocation fund.

Large-cap stocks in the S&P 500 are over-valued compared with the smaller companies in the Russell 2000 index, he said. At the same time, the Russell 2000 slightly underperformed the larger index this year by posting a 23.2% gain, leaving it primed for a "catch-up trade" given that smaller companies tend to benefit more from low interest rates, he said.

"We think there's a chance that you will see upside surprises from earnings next year and that could draw investors back to an asset class they've been overlooking," said Chiavarone.