Equity Return Potential
Conclusion: We believe equities will continue to struggle in the near-term until it becomes clear that the Fed is near the end of policy tightening. Visibility is low as to when this will occur; it could happen later this year or sometime next year. We believe that earnings estimates need to come down and it is likely that prices will follow. We are looking for an opportunity to increase equity exposure. Right now, we are doing this through cheaper small- and mid-cap stocks. Lower valuations or improving fundamentals would enhance the return prospects for large-cap stocks.
The S&P 500® officially entered a bear market in June. While the bull market that started in 2020 was short in duration, the return was near the historical median and surpassed five past bull markets.
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, though we were less confident in its signal given that the current unique economic backdrop is inconsistent with historical cycles used to create the model. Instead, the signal proved useful. We believe that we are likely to enter a mild recession later this year or early in 2023.
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 short bull market saw strong earnings growth with profit margin expansion being the dominant driver. Profit margins rose from 10% to over 13% during that cycle. We believe that further margin gains from here will be difficult given the likelihood of recession, though they are implied to move higher in analyst forecasts. Our proprietary EPS model suggests that S&P 500® EPS will decline over the next 12 months.
All valuation measures have their flaws, this is why we use numerous and different measures. While they have come down, valuations still remain high in a historical context by almost every measure. This is mainly due to the high starting place. Even if we substitute forward estimates, valuations look high, and we question the durability of these forward estimates.
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. Despite some of the unique aspects to this cycle, this model was helpful in indicating trouble ahead for the market.
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