In this section, we include charts and concepts that are not necessarily thematic in nature and may, at times, even be in contrast to our own views. Some of these charts are sourced from our sub-advisors who allow for differentiated insight into a variety of asset classes on a global scale. Others, we have sourced ourselves as we find them compelling and may reflect views that are somewhat unique and may not be emphasized by the financial media.
This cycle is unique and difficult to characterize. It has also moved at a very rapid pace. We use a number of economic signals to help gauge where we are in the cycle and today, those signals cover the gambit from very early cycle to late cycle and many in between. Our model suggests we have moved into the late cycle. That the stock market fell into a bear market and the yield curve inverted suggests that we may be entering a recession—not represented on this chart.
The Search for Yield
When trying to understand current low Treasury yields, we explored a number of different fundamental Treasury models. The Model below has been historically robust. It is important to recognize that the unique circumstances surrounding the pandemic could mean this historically derived Model is currently less informative. Our bond yield model has moved up with 2-year Treasury yields and inflation. If we plug in the current implied year-end Federal Funds rate and lower inflation readings we expect by the end of the year, the model suggests a 10-year Treasury yield of about 3.0%.
We had been suggesting that investors move out the risk spectrum to pick up additional yield. But with higher investment grade yields, the Fed pushing on the brakes, and signs of late cycle conditions, we are now putting more emphasis on higher quality credit.
Active Versus Passive
Note the cyclical nature of active and passive strategy returns over time. Recently, trailing five-year return observations for the S&P 500® Index ranked above 55% of active large-cap managers (on a gross return basis; it would be even higher net of fees). Yet note how the S&P 500® Index tended to rank higher than active funds during periods of high absolute returns. Our research suggests that absolute returns over the next five years may be more muted due to current high valuations. Now may be a good time to consider more active exposure.
While the S&P 500® Index has outperformed the MSCI EAFE® and Emerging Markets indexes over the last cycle, international stocks still represent a healthy hunting ground for active managers given the consistently high representation in the top 100 performing stocks.
The weight of the top 10 stocks in the S&P 500® Index reached a new high in December 2021, representing 34% of the Index’s market cap. Historically high concentration in the S&P 500® Index suggests a less diversified portfolio in a historical context. This observation is supported by the diversification ratio, which indicates that the U.S. stock index is the least diversified since the Dot-Com boom. It also means that a very small number of stocks are having an outsized influence on index returns and valuation. Through August, the equal weighted S&P 500® has outperformed the market weighted index by almost 4%.
Valuations Around the World
As a reference, we provide valuation measures for various domestic and international indexes. The valuation range dates back to 1995.
The Mid-Cap Gap
Mid cap earnings are rapidly coming back relative to large cap, but they have yet to pull relative prices up with them. Historically the Russell Midcap® Index has seen both earnings and price outperformance during the early stages of an economic recovery. The mid-cap index has been helped by a larger Energy weight and less international exposure cushioning earnings from the dollar rally.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
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.
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