Market Risk Signals
Conclusion: A shift to early economic cycle conditions along with a very accommodative Fed and fiscal spending support 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 still areas within the market that look attractive, but overall current market levels suggest a more muted return outlook for the market for the remainder of this cycle.
Market Cycles
While a one-month market decline 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)
Economic Cycle
- In the blink of an eye we have gone from late cycle to early cycle, something that typically takes at least 12 months. Customarily, the economy takes the elevator down and the stairs back up. This time may be different given the significant monetary and fiscal response to the crisis. Additionally, the economic shutdown had a much greater impact on low-wage hourly workers, which suggests a less meaningful economic impact. Though we could see a second wave of white-collar job losses if this period of social distancing is prolonged.
*Model based on Capacity Utilization, Unemployment Rate, Treasury yield spreads, and Consumer Confidence Indexes
Source: Bloomberg
Fundamentals
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. The next cycle will be very different as we will be starting the cycle with much higher profit margins (and higher valuations as well).
Data may not total due to rounding.
*Based on analysts’ annual estimates for revenue and EPS.
Source: Bloomberg, S&P Dow Jones Indexes
Valuation
- All valuation measures have their flaws, this is why we use numerous and different measures. Today it is even more difficult as it is unclear where the denominator of most measures will fall, and how quickly it will rebound. What we do know is that the numerator (price) has already rebounded strongly. Even by the most generous valuation measures the market looks to be fairly valued, which is not the best place in which to start a new bull market.
Valuation Measures
Based on the S&P 500® Index
as of May 2020
| Rank 1-5* | |
|---|---|
| Shiller CAPE** | 4 |
| Trailing EV/EBITDA | 5 |
| Trailing Price/Book | 4 |
| Trailing Price/Sales | 5 |
| 10-Year Treasury Yield | 1 |
| Profit Margin | 4 |
| Summary Signal (Average) | 4.0 |
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 (depicted on the three previous charts). 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. Regardless, the market does appear more attractive than we have seen in some time. That said, the risk of a viral resurgence in the fall is no longer being discounted and the sharp market rebound reduces return expectations from here for the remainder of the cycle.
*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
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.
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