Market Risk Signals
Conclusion: A shift to early economic cycle conditions along with a very accommodative Fed and fiscal stimulus provide an attractive backdrop for stocks. That said, the brevity of this downturn and the speed with which stocks have recovered meant that we were not able to fully refuel the gas tank and bring overall valuations down to levels that are cheap. There are now fewer areas within the market that look attractive, suggesting a more muted return outlook for the market until earnings catch up with prices. Still, looking out over the next three to five years, we believe U.S. stock market returns in general will compare favorably to those delivered by fixed income.
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.
Source: Bloomberg, (based on daily closing prices)
In the blink of an eye we have gone from late cycle to early 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 point to a rapid economic recovery. Stronger consumer balance sheets and low debt service obligations provide a strong base from which the expansion can build.
*Model based on Capacity Utilization, Unemployment Rate, Treasury yield spreads, and Consumer Confidence Indexes
We see earnings growth as the key to the market cycle, with profit margin expansion and contraction being the key source of earnings growth. The just completed bull market saw very strong earnings growth with profit margin expansion being the dominant driver. This cycle will 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.
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 at 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.
Based on the S&P 500® Index
as of May 2021
|10-Year Treasury Yield||1|
|Summary Signal (Average)||4.3|
Sources: Bloomberg, Robert Shiller – Yale University
Touchstone Equity Risk Model
The Touchstone Equity Risk Model brings together the economic cycle, market fundamentals, and valuation considerations. 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. While our economy has moved to an early cycle phase, the market has already discounted much of the economic rebound. The speed with which this happened raises the question of whether we truly ended the last cycle or just interrupted it. Either way, the expected return going forward is likely to be lower than the historical average looking out over the next three to five years.
*Risk Model based on S&P 500® valuation metrics (EV/EBITDA, P/S) and profit margin, Unemployment Rate and Term Spread.
Sources: Bloomberg, Touchstone Investments
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.
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