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Equity Return Potential Insights

By Richard "Crit" Thomas, CFA, CAIA
U.S. Equities
asset allocation and equity risk

Equity Return Potential

Conclusion: 2021 was a year of rapid earnings growth with dramatic and broad-based positive earnings surprises throughout the year. While companies struggled with labor and supply chain pressures, strong demand and the ability to pass through price increases allowed them to overcome these headwinds. We believe 2022 will be different with slowing growth and difficult earnings comparisons. Price increases may become more difficult as consumer cash levels decline and higher commodity prices (e.g., fuel) may crowd out some spending. Relative valuations keep us interested in mid and small cap stocks, though the earnings tailwind is likely to moderate there as well.

Market Cycles

While a one-month market decline in 2020 doesn’t fit the definition of a bear market (sustained decline of at least three months), we believe that history will treat this decline as a bear market regardless. This recovery has been strong, already surpassing five past bull markets.

Bull and Bear Markets Since 1928

Source: Bloomberg, (based on daily closing prices)

Economic Cycle

In the blink of an eye, we have seemingly gone from early cycle to late cycle. The speed of this cycle speaks to the truly unique circumstances surrounding it. Customarily, the economy takes the elevator down and the stairs back up. High levels of cash savings and pent up demand have allowed for a rapid economic recovery. We will let our model speak for itself, but are less confident in its signal given the current unique economic backdrop is inconsistent with historical cycles used to create the model. Stronger consumer and business balance sheets and low debt service obligations are not indicative of late cycle conditions.

Stage of the Economic Cycle Model

*Model based on Capacity Utilization, Unemployment Rate, Treasury yield spreads, Consumer Confidence Indexes, and Conference Board business cycle indicators
Source: Bloomberg


We see earnings growth as the key to the market cycle, with profit margin expansion and contraction being the key source of earnings cyclicality. The previous bull market saw very strong earnings growth with profit margin expansion being the dominant driver. This cycle may be very different as we start it with much higher profit margins (and higher valuations as well). It is important to note that high concentration in the top weights in the S&P 500® Index is having a distorting effect on weighted index measures. That said, the equal weighted index is rapidly catching up in terms of performance and margin rebound.  

S&P 500 Profit Margin

Returns are annualized. Data may not total due to rounding.
*Based on analysts’ annual estimates for revenue and EPS.
Source: Bloomberg, S&P Dow Jones Indexes


All valuation measures have their flaws, this is why we use numerous and different measures. Comparisons with past valuation peaks are distorted as today’s trailing EBITDA, cash flow, and sales were near cyclical lows, while past valuation peaks occurred late in the cycle when those measures were at cyclical highs. Still, even if we substitute forward estimates for those measures, valuations are at historical highs. It is unprecedented to start a cycle with such high valuations. While the market has sold off, most valuation measures remain historically high.

Valuation Measures
Based on the S&P 500® Index
as of February 2022

*Ranked 1 through 5, with 5 representing historically high levels
**Cyclically Adjusted Price-to-Earnings ratio. It is the current S&P 500® Index price divided by the 10-year moving average of earnings adjusted for inflation
Sources: Bloomberg, Robert Schiller - Yale University

  Rank 1-5*
Shiller CAPE** 5
Trailing EV/EBITDA 5
Trailing Price/Cash Flow 5
Trailing Price/Sales 5
10-Year Treasury Yield 1
Profit Margin 5
Summary Signal (Average) 4.3

S&P 500 Valuation MultiplesSources: Bloomberg, Robert Shiller – Yale University

Touchstone Equity Risk Model

The Touchstone Equity Risk Model brings together the economic cycle, market fundamentals, and valuation considerations previously depicted. It is a way to measure potential upside based on fundamentals, though we recognize that sentiment can carry the market beyond what the fundamentals suggest. There are many unique elements about this cycle that raise questions surrounding how well a quantitative model will perform. Additionally, the speed with which this happened raises the question of whether the last cycle truly ended or was just interrupted. Either way, our Model suggests the expected return going forward is likely to be rather modest.

Touchstone Equity Risk Model

*Risk Model based on S&P 500® Index valuation metrics (EV/EBITDA, P/S, P/CF) and profit margin, Unemployment Rate and Term Spread.
Sources: Bloomberg, Touchstone Investments

Glossary of Investment Terms and Index Definitions

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.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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