Market Risk Signals
Conclusion: The current bull market exceeds many previous ones in terms of duration and return. This has led to historically high valuations and stretched profit margins. While these late market conditions suggest caution, we do not currently see the telltale signs of an impending bear market. That said, we are cognizant of the near impossibility of timing the market and believe that in the long term, time in the market will outperform a market timing strategy. We suggest managing the higher risk profile within an equity allocation.
Our views on U.S. Equity Risk are based upon market cycles, economic cycles, and historical valuations.
While there is historical precedence for the market to continue to rise, history would suggest it is closer to the end of the bull market than the beginning.
*Prior to 1962, S&P data was based on Robert Shiller’s research.
Sources: Bloomberg, Robert Shiller – Yale University
- Our indicators suggest that we are late in the economic cycle, though we have not seen the telltale signs of an impending recession. Signs of late cycle conditions include a tight labor market, inverted yield curve, and a higher level of consumer confidence about current conditions versus future expectations.
- The current economic expansion is the weakest we have seen since WWII. That said, it is on track to be one of the longest, which is historically consistent; weaker recoveries last longer. The 2018-2019 fiscal stimulus is helping to further extend the duration of this cycle. We also need to consider the recent shift in monetary policy away from further tightening. In theory we could move back to mid-cycle conditions, though we have no historical precedent for this.
*Model based on Capacity Utilitization, 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. This bull market has seen strong earnings growth with profit margin expansion being the dominant driver. After getting a late cycle boost from the corporate tax cut, we believe we are near a peak in profit margins for this cycle. This suggests there is little left in the gas tank to fuel additional earnings growth. We believe that further margin gains will be limited by higher labor cost pressures, higher input costs due to tariffs and the degree of and speed at which the lower tax rate is diminished by competition. In fact, 2019 profit estimates have decreased, due mainly to reduced profit margin assumptions. Looking into 2020 and 2021 profit margins are expected to reach new highs to support ~10% earnings growth in both years. We question these expectations.
*Based on analysts’ annual estimates for revenue and EPS. Source: Bloomberg, S&P Dow Jones Indexes
- In a historical context, S&P 500® Index valuation now looks high across almost all measures. Low interest rates are the remaining offset. The yield on the 10-year Treasury has moved lower this year due mainly to concerns surrounding slowing economic growth.
- While not a particularly adept timing tool, valuation, or the price one pays, is an important component in determining the potential return. Higher valuation levels, such as seen today, suggest lower than historical average returns over the next five years.
*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 Shiller – Yale University
Touchstone Equity Risk Model
- The Touchstone Equity Risk Model brings together the economic cycle, market fundamentals and valuation considerations.
- Due to our three- to five-year time horizon and the model’s leads and lags surrounding market tops and bottoms, we do not see this as a timing model, but as a tool for guiding positioning within equities. Historically high level model readings have corresponded with subsequent five-year rolling periods of lower returns and higher drawdowns and vice versa.
*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
Judged from a historic perspective, the market was in a topping process when three or more of the conditions below were present. Likewise, a recession has occurred within 12 months when four or more conditions were present.
*Touchstone’s Recession Indicator looks at six measures that typically precede a recession. They include trends in the S&P 500® Index, the Unemployment Rate and Credit Spreads, as well as the Leading Economic Index, and two spread measures of the Yield Curve.
Sources: Bloomberg, Morningstar
Market Breadth: Measures of market breadth attempt to describe how broad or narrow market leadership is with measures of the number of companies in an index that are participating in market rallies.
Small & Mid Caps Underperforming: Small- and mid-sized companies tend to be more economically sensitive than large-cap companies. Historically, bull markets have tended to crest near the end of an economic cycle. Small- and mid-sized stocks can provide an early signal of the economy losing momentum when these stocks begin to underperform large-sized stocks.
Speculative Investor Behavior: Often in the later stages of a bull market, investors become more speculative in the choice of stocks they invest. The Dot-Com boom in the late 1990s is an example of investors shifting their appetite toward more speculative companies.
Strong Equity Fund Flows: Investors often chase performance, but with a lag. Historically, it has been observed that investors can shift their allocation between equities and fixed income over the course of a market cycle with a preference for stocks over bonds later in the bull market cycle.
Inverted Yield Curve: The yield curve, as measured by the 2-year and 10-year Treasury yields, becomes inverted when the yield on the 2-year Treasury is higher than the 10-year Treasury yield. Yield curve inversion typically occurs due to Federal Reserve actions to slow economic growth.
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 advisor 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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