- We are slightly underweight large-cap equities as we can find much more attractive valuations further down in market cap. Additionally, we believe 2025 earnings estimates look too optimistic.
- The forward S&P 500 P/E ratio is currently in the top 15% of the past 30 years. Across the average of five different valuation measures the S&P 500 is in the 93rd percentile versus history.
- The S&P 500 is currently expected to deliver EPS growth of 14% with profit margins expanding by 1 percentage point to an all-time high. Margin expansion is necessary to leverage the anticipated 6% sales growth. However, the broader economy and inflation are both expected to slow. How do companies expand margins with this backdrop? AI might help, but it is too soon to expect significant cost savings. We believe estimates will be reduced to the high single digits.
- Equities have entered a period of seasonal weakness. We anticipate volatility as markets react to economic data in the gap between Q2 and Q3 earnings seasons, coinciding with the Fed’s expected easing. Meanwhile, high valuations by historical standards may make further gains challenging.
- Our base case is that the Federal Reserve will achieve a soft landing, supported by easing monetary policy. However, we see downside risks from loosening labor conditions, rising delinquencies, and weak ISM manufacturing data. While the current levels are not that concerning, it is the downward trend that concerns us.
- If downside risks were to lead to a recession, we believe it would be mild. In such a scenario, we anticipate the Fed will respond aggressively with rate cuts, and we would likely use any equity correction to increase our exposure.
In August, we further increased our underweight position in Growth while maintaining a slight overweight in Value. The top 10 companies in the Russell 1000 Growth Index now make up 59% of the Index, compared to 36% five years ago. These top companies have changed over time, but their combined weight has doubled from 30% five years ago. As asset allocators, we must be mindful of stock-specific risks even within "diversified" indices.
- While the Information Technology sector has performed strongly this year and in recent years, it hasn't been the only source of returns. By early September, the Utilities sector emerged as the second-best performer. This is partly due to anticipated rate cuts. Higher yielding Utilities tend to outperform when the Fed cuts rates. But another driver is more surprising. Utilities are not typically associated with AI, but independent power producers have benefited from the growing power demand needed to support AI data centers, as AI searches require over 30 times the power of traditional internet searches.
- While we believe rate cuts will enable the economy to land softly, a harder landing could lead to allocation changes. Cyclical companies are more likely to benefit from lower interest rates than Growth stocks. However, worsening economic data could negate the effects of easier monetary policy. If this happens, we may adjust our style exposure until we see signs of economic improvement that favor Value stocks.
- Our biggest risk is if Growth continues to outperform given our underweight. There is a saying: "The market can stay irrational longer than investors can stay solvent." While we believe Growth stocks are overextended, they could remain so longer than expected. The IT sector is projected to have slightly stronger earnings growth in 2025 than traditional Value sectors like Health Care, Energy, and Materials, but it starts with much higher valuations.
- We maintain an overweight in mid caps and a neutral stance on small caps, as valuations compared to large caps remain compelling.
- In April, we removed our small cap overweight due to concerns about earnings. Throughout the year, earnings growth expectations have steadily declined. 2024 is on track to be the second consecutive year of revenue and earnings declines, while mid-caps are projected to have slight earnings growth this year.
- We are looking for an opportunity to increase small cap exposure. However, this is complicated. Small caps generally perform best when interest rates are low or declining, especially during post-recession recoveries. However, since we expect a soft landing rather than a typical post-recession recovery, that scenario is unlikely. Still, with imminent rate cuts, low valuations, and a potential economic rebound, small caps could benefit.
- Looking ahead to 2025, the S&P 600 Small Cap Index is projected to grow 19%, while Russell 2000 earnings are expected to surge by 42%, with nearly half of the non-earning companies expected to turn profitable. In the S&P 600, 8 out of 11 small cap sectors are expected to have 2025 earnings growth exceeding the S&P 500’s 14%.
- For the S&P 400, mid caps are expected to see earnings growth of 16%. Like large caps, profit margins are doing a lot of the work to get to these earnings growth estimates. However, revenue growth is expected to pick up significantly from 2024, which would be consistent with rising profit margins.
- Given the slowing economic growth we anticipate, it may be difficult for small and mid-caps to deliver on these earnings expectations. However, with the Fed entering an easing cycle, we believe investors may look through earnings weakness. Why? The earnings hurdle is much lower due to weak earnings over the last two years and the current low valuations. Investors may shift towards asset classes that would benefit from lower interest rates.
Equity Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
The Touchstone Asset Allocation Committee
The Touchstone Asset Allocation Committee (TAAC) consisting of Crit Thomas, CFA, CAIA – Global Market Strategist, Erik M. Aarts, CIMA - Vice President and Senior Fixed Income Strategist, and Brian Cheyne, CFA, CIMA - Senior Investment Strategy Specialist, develops in-depth asset allocation guidance using established and evolving methodologies, inputs and analysis and communicates its methods, findings and guidance to stakeholders. TAAC uses different approaches in its development of Strategic Allocation and Tactical Allocation that are designed to add value for financial professionals and their clients. TAAC meets regularly to assess market conditions and conducts deep dive analyses on specific asset classes which are delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800-638-8194 for more information.
A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value
