2020 has been a historical year from a variety of perspectives, and the stock market is no exception.

The year started off with a strong rally in many high-growth tech stocks, and expectations that global growth was starting to pick up after decelerating since 2018 due to the trade war.

As a result, the S&P 500 was trending higher, making new, all-time highs. However, this pretty picture was wrecked by the coronavirus which caused a 35% crash in stock prices in a little more than a month.

In turn, the Federal Reserve unleashed massive amounts of stimulus to support financial markets by cutting interest rates to zero and starting a bunch of programs to inject liquidity into various markets including corporate bonds. It doubled-down on its dovish stance by stating that interest rates will remain at zero until 2022 and adjusting its inflation framework to make clear to investors that interest rates won’t increase until inflation meaningfully climbs above 2%. Previously, the Fed would begin to tighten in anticipation of interest rates hitting 2%.

There was similar aggression on the fiscal front. Due to the economic effects of the shutdown, Republicans and Democrats came together to pass a wide array of bills to boost unemployment checks, provide payroll support to businesses, and investments in health research. In total, this year’s deficit is expected to be $3.1 trillion due to a combination of lower tax revenue and increased expenditures.

However, this has undoubtedly had positive impacts on the economy as measures like consumer spending and housing have bounced back to levels higher than 2019. Other parts of the economy remain off levels from a year-ago but continue to show improvement on a month to month basis.

These factors also led to a V-shaped rebound in stock prices with the S&P 500 making new highs in August. Over the last two months, the market’s momentum has stalled, and we’ve traded in a sideways range between 3,200 and 3,500.

Most likely, this is a healthy consolidation for the market. Overbought conditions are being relieved to set up the market for its next move higher. For investors who want to take advantage of this bull market and the recent dip, they should consider adding three ETFs with promising prospects into 2021: ARK Genomic Revolution Multi-Sector ETF (ARKG - Get Rating), Invesco Dynamic Leisure and Entertainment ETF (PEJ - Get Rating), and the Materials Select Sector SPDR ETF (XLB - Get Rating).

Reasons to Expect a Q4 Rally

All of these ETFs offer an intriguing upside. However, another important point is the overall trend in the general market, and investors should expect that stock prices will trend higher in the fourth quarter and through 2021. The best way to track the general market is through the SPDR S&P 500 ETF Trust (SPY - Get Rating).

The main factor is we had a major capitulation event in March 2020. Due to this and the economic uncertainty, there is a massive amount of money on the sidelines, specifically institutional funds. As this money is deployed, it will drive the market higher.

We’ve seen previous major capitulatory events – March 2009, May 2012, and February 2016 – from those lows, prices kept moving higher and were strong in the following year. It’s also not a coincidence that the Fed was also aggressively dovish during those periods like it is now.

In addition to the Fed, fiscal stimulus is also likely to be deployed if the economy starts to show signs of weakness. This also another reason to be supportive of the “buy the dip” trade. The polls also show a 65% chance that Joe Biden wins the Presidency and a 60% chance that Democrats win the Senate. This would increase the size and chances of stimulus being passed.

Another major catalyst for stock prices is that fund managers are underinvested and underexposed. The average fund is down around 7%, while the S&P 500 is up 5% YTD. The average fund manager is also underinvested in terms of stock exposure. Fund managers are assessed by how they perform relative to their benchmarks.

If they end the year underperforming by a significant margin, there is the chance that they will lose capital or their jobs. So, if stock prices keep creeping higher, many fund managers would be forced to buy, pushing shares up even more.

Of course, this dynamic is happening during a pretty bullish time seasonally. As the chart below shows, Q4 during a Presidential election year tends to be bullish. And, the gains could be particularly outsized this year if fund managers are piling in.

(source: LPL Financial)

ARK Genomic Revolution Multi-Sector ETF (ARKG)

While the markets are expected to move higher into Q4, investors should look at growth areas. Among these, biotechs are intriguing. The sector is benefiting from increased investment due to COVID-19, however, long-term fundamentals are solid due to the aging population and constant need for new treatments and therapies.

Additionally, the biotech sector has traded sideways for the last 5 years, while earnings have kept increasing, meaning that valuations are attractive. Within biotech, the most exciting area is genomics. ARKG is an ETF that gives diversified exposure to this group.

Genomics is in the early stages of transforming medicine. Currently, they are used more in diagnostics but scientists anticipate that they could be used in the future to repair cells at the cellular level and would lead to a future of “personalized medicine”. ARKG is a diversified way to take advantage of new development in medicine.

ARKG is rated a Buy according to the POWR Ratings. It has an “A” for Trade Grade and Industry  Rank with a “B” for Buy & Hold Grade. Amongst Health & Biotech ETFs, it’s ranked #4 out of 38.

Invesco Dynamic Leisure and Entertainment ETF (PEJ)

PEJ is composed of a basket of restaurants, entertainment, and retail stocks. What’s interesting is that in recent months it’s shown signs of outperformance after underperforming for the duration of the rally. This is despite negative headlines with case counts rising and failure to reach agreement on a second stimulus deal.

The best trades come when sentiment is the most depressed. Currently, no sector is hated more than casinos, restaurants, and travel stocks. While many stocks made new highs since the March bottom, this group has massively underperformed.

Negative sentiment has increased in recent weeks as it’s clear that we are on the verge of a “second wave: However, the data is also clear that deaths are not increasing as treatment has significantly improved. Many also believe that the prevalence of mask-wearing and social distancing means that viral loads are lower.

Additionally, TSA travel data, restaurant booking figures, and recent reports from casinos show that normalization is continuing. The world is going to return to normal at some point whether it’s in 2021 or 2022. Already, we are seeing a movement towards normalization despite case counts rising and no vaccine.

Materials Select Sector SPDR ETF (XLB)

Another interesting sector is materials stocks. For one, they have been in a downtrend since 2018, so they are interesting from a contrarian, value perspective. Additionally, one tailwind for the sector is that we are on the verge of a restocking cycle as inventories will need to be replenished as the world returns to normal.

Further, every government is using fiscal stimulus to combat the economic slowdown due to the coronavirus. This means more infrastructure projects. Already, we are seeing bullish price action in cyclical commodities like copper, iron ore, and lumber. All of these indicate that building activity and manufacturing will do well.

On a technical basis, XLB is outperforming on a shorter timeframe. If the virus gets worse to the extent that it will slow economic activity, then the sector will benefit from additional fiscal and monetary stimulus. If the recovery continues, then XLB will also do well due to the increased demand for materials.

According to the POWR Ratings, XLB is a Strong Buy, and it has an “A” for Trade Grade and Buy & Hold Grade. Among Industrial ETFs, it’s ranked #1 out of 33.

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SPY shares fell $4.33 (-1.25%) in premarket trading Monday. Year-to-date, SPY has gained 8.97%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...

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