5 REASONS TO REMAIN PATIENT AND NOT RUSH INTO ......2019/10/24 · correction, we would expect risk-on leadership to be slow and steady as opposed to fast & furious. 5 R EASONS T

Portfolio Strategy

Copyright 2019 Cornerstone Macro. All rights reserved. This report is prepared exclusively for the use of Cornerstone Macro clients and may not be redistributed, retransmitted or disclosed, in whole or part, or in any form or manner, without the express written consent of Cornerstone Macro.

Michael Kantrowitz, CFA Stephen Gregory Emily Needell, CFA Justin Brant

(212) 257-4971 (212) 257-4972 (212) 257-4974 (212) 257-4973

[email protected] [email protected] [email protected] [email protected]

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2016 2017 2018 2019 2020

S&P 500 Value Rel. to Growth

October 23, 2019 CornerstoneMacro.com 1

5 REASONS TO REMAIN PATIENT AND NOT RUSH INTO CYCLICALITY JUST YETA lot of people are afraid of missing out on a potential cyclical rally here. Today’s report dives intowhy we don’t think those fears are warranted. While we do expect cyclicals to lead sustainably oncePMIs turn higher (likely a Q1 story), without a correction and corresponding re-pricing of risks, thereis unlikely to be a fast and furious charge higher for cyclicals. This may be a slow and steady wins therace story for cyclicals in 2020.

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1.0

1.1

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2006 2008 2010 2012 2014 2016 2018 2020

Value Relative PE NTM Growth Relative PE NTM

30% 21% 16%REITS

(VNQ-USA)

(VNQ-USA)

Large Cap

(MGC-USA)

(MGC-USA)

DM

(VEA-USA)

(VEA-USA)

23% 21% 12%Mid Cap

(VO-USA)

(VO-USA)

Growth

(IUSG-USA)

(IUSG-USA)

EM

(VWO-USA)

(VWO-USA)

22% 19% 8%Value

(IUSV-USA)

(IUSV-USA)

Small Cap

(VB-USA)

(VB-USA)

Commodities

(GSG-USA)

(GSG-USA)

YTD U.S. Equity Returns

The Year Is Nearly OverValuations Still

PolarizedJan Feb Mar April

May June July Aug

Sep Oct Nov Dec

Nearly Everyone Is Positive On The Year

XXXXXXXX

XOnly One Week Left In Oct

Cyclicality Has Lagged For Nearly Three Years

Are We In A FOMO Trap?What's Driving The Fear Of Missing Out

Cyclicality (i.e. Value) Has Underperformed Since Late 2016

Valuations For Defense Are As Expensive (Relatively) As Ever

The Market Has Had Big Move Higher YTD

And Investors Are Worried About Protecting Their Portfolio

B

A

C D

A

B

C

D

PORTFOLIO STRATEGYOctober 23, 2019

CornerstoneMacro.com 2

THE RISK/REWARD PROFILE STILL FAVORS REMAINING DEFENSIVE

At this juncture, we continue to believe that risks are asymmetrically skewed to the downside. Wedo expect that we are closing in on a trough in PMIs (likely a Q1 2020 story), however we are stillseveral months away from that forecasted trough. Furthermore, with markets near all-time highsand P/Es still elevated, we do not see a reason to rush into cyclicality here. As we see it, acontinued decline in PMIs and EPS estimates remains a threat to markets and cyclical positioningin 2019. If we do get to the first quarter of next year (our forecasted PMI trough) without acorrection, we would expect risk-on leadership to be slow and steady as opposed to fast & furious.

5 REASONS TO REMAIN PATIENT AND NOT RUSH INTO CYCLICALITY

1) MARKET NEAR ALL-TIME HIGHS• FAST & FURIOUS CYCLICAL RECOVERIES TYPICALLY OCCUR AFTER CORRECTIONS,

NOT NEAR ALL-TIME HIGHS FOR THE MARKET

2) LITTLE FUEL FOR P/E EXPANSION• CYCLICAL RECOVERIES ARE TYPICALLY FUELED BY P/E EXPANSION. WE’VE SEEN

P/ES RISE ALL YEAR … NOT A LOT OF FUEL TO GO HIGHER FROM HERE

3) DOWNSIDE RISKS REMAIN FOR 2019• A) EPS SEASON AND 2020 ESTIMATES AT RISK• B) LATE IN THE CYCLE THE LABOR MARKET IS AT RISK OF WEAKENING

4) FORECASTED TROUGH IN PMIS COULD STILL BE SEVERAL MONTHS AWAY• POLICY PROXIES ARE SUGGESTING A Q1 TROUGH IN PMIS/CYCLICALS

5) THE UPCOMING CYCLICAL REBOUND IS LIKELY TO LAST FOR A LONG TIME• CYCLICAL REBOUND LIKELY TO LAST A YEAR OR LONGER ONCE IT GETS GOING

CONCLUSION: RISKS ARE ASYMMETRICALLY SKEWED TO THE DOWNSIDE• THE MOST DANGEROUS PERIOD FOR CYCLICALITY IS TYPICALLY JUST BEFORE

PMIS BOTTOM

Historically, it is unusual to see the market go frombeing decidedly defensive to sustainably cyclicalwithout a market correction. Dramatic returns tocyclicality typically occur AFTER periods whereinvestors price risks into the system (i.e. 2009,2016, etc.) Today, given that markets are near all-time highs and spreads and other risk metrics aremuted, we don’t believe that investors need toworry about missing out on a fast and furious popin cyclicality here.

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Oct-18 Dec-18 Feb-19 Apr-19 Jun-19 Aug-19 Oct-19

S&P 500

1) MARKET NEAR ALL-TIME HIGHS

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… 1) MARKET NEAR ALL-TIME HIGHSBelow we show that the major periods of risk reversals from defensive to risk-on leadership have come inthe wake of market weakness. While anything is possible, it would be surprising to see the extendedperiod of defensive leadership that we've seen in recent years give way to a sharp and sustained cyclicalrebound without a pullback first.

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2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Risk-On Rel. To Risk-Off Portfolio

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B C

D E FG

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Mar-00 Apr-00 May-00 Jun-00 Jul-00

Risk-On Rel. To Risk-Off Portfolio (S&P 500, L)

S&P 500 Price (R)

A

650

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950

1,050

1,150

1,250

1,350

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Jan-01 Jan-02 Jan-03 Jan-04


S&P 500 Price (R)

650

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950

1,050

1,150

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1,350

1,450

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52

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72

82

92

Jan-08 Jun-08 Nov-08 Apr-09 Sep-09


S&P 500 Price (R)

1,100

1,150

1,200

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S&P 500 Price (R)

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S&P 500 Price (R)

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S&P 500 Price (R)

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S&P 500 Price (R)

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Risk-On Recoveries

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E F

Episodes Of Cyclical Recoveries

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Fast & Furious Risk-On Recoveries Typically Occur AFTER Market Corrections



Most Of The Biggest Pops In Cyclicality (i.e. Value) Come

AFTER Market Selloffs.

Without A Recent Selloff, We See Low

Odds Of A BigCyclical Surge Here

The table to the right shows themonths in history where valueoutperformed growth by thewidest margin. Most of theseepisodes occurred at troughs inthe business cycle and aftermarket selloffs. In fact the vastmajority of these strong value-outperformance months werepreceded immediately by monthsof negative returns for the overallmarket. At this point, given that wehave not seen a correction in themarket and risks remain muted(i.e. credit spreads have not blownout), there is not a lot of fuel for ahuge pop in cyclicality.We can also look to the chart and table below to further the case that a fast and furious cyclical popis unlikely here. Cyclical rebounds are typically driven predominantly by P/E expansion. We’ve seenP/E expansion (not P/E compression) this year and the market’s P/E is only a little more than a pointaway from 20-year highs. This is not the type of backdrop where you would expect to see a largeP/E-fueled rally in the market.

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2015 2016 2017 2018 2019 2020 2021

S&P 500 P/E (L) Global Financial Conditions Index (Bloomberg, R)

20-Year High In P/Es

Rank Month

Value vs.

Growth

Previous Month

Return S&P 500

1 Mar-09 16.9% -11.0%

2 Jul-09 11.4% 0.0%

3 Aug-00 9.7% -1.6%

4 Nov-00 9.5% -0.5%

5 Dec-07 9.3% -4.4%

6 Mar-99 8.8% -3.2%

7 Nov-16 6.8% -1.9%

8 Dec-09 6.5% 5.7%

9 Jun-00 6.5% -2.2%

10 Apr-09 6.3% 8.5%

11 Dec-10 6.2% -0.2%

12 Sep-19 5.6% -1.8%

13 Dec-76 5.6% -0.8%

14 Mar-14 5.5% 4.3%

15 Oct-00 5.5% -5.3%

Avg 8.0% -1.0%

Median 6.5% -1.6%

Top Months Of Value Outperformance

Risk Reversals Are Usually Fueled By P/E Expansion … … Not A Lot Of Room For P/E Expansion From Here

PE Expansion Typically Drives Markets In Risk Recoveries

… 1) MARKET NEAR ALL-TIME HIGHS

2) THERE IS LITTLE FUEL TODAY FOR P/E EXPANSION FROM HERE

Trough

P/E

Return

EPS

Return

Oct-90 7.2% -3.8%

Aug-92 3.5% 0.7%

Nov-96 7.7% 3.2%

Oct-98 31.3% -5.0%

Nov-00 5.8% 3.9%

Mar-03 10.0% 3.1%

Nov-08 32.3% 2.0%

Oct-11 14.2% -0.6%

Jul-12 2.4% 1.6%

Feb-16 8.7% 0.8%

Aug-17 3.3% 2.8%

3 Months After Trough

In Risk On



3) DOWNSIDE RISKS REMAIN FOR 2019A. Q3 EPS SEASON AND 2020 ESTIMATES AT RISKWe are getting into the thick of EPS season now and we view the next several weeks as a potentialperiod of vulnerability for equities. Over the last week, we have seen 2020 EPS estimates declinesharply and news headlines are increasingly picking up on this trend. The market continues toremain susceptible to downward EPS estimates for as long as PMIs continue to fall. We think thetrough for PMIs will be in early 2020.

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Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Oct-19

S&P 500 EPS Estimates

CY 2020SP50

Dec '17 Dec '18 Dec '19E Dec '20E Dec '21E

CY CY CY CY CY

EPS 133.61 161.45 163.56 180.41 199.02

Growth 12.0% 20.8% 1.8% 10.3% 10.3%

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Global PMI (Adv 2 quarters, L)S&P 500 Positive Sales Surprises (%, R)

Q3 EPS AT RISK OF MISSING

Analysts Are Taking the Knife to

Their 2020 Profit Estimates 10/21/2019 Bloomberg

2020 ESTIMATES STILL TOO HIGH

STILL TOO HIGH?!?

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US ISM (L) S&P 500 EPS Revisions (Up As % Of Total, R)

The Market Needs Better Earnings To Move Sustainably Higher From Here

Analysts Cut S&P 500 Profit

Estimates by Most in 9 Months10/21/2019 Bloomberg

Wall Street isn’t buying its own

forecast for 2020 earnings 10/8/19 Yahoo Finance



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Initial Unemployment Claims (L)Fed Funds Rate Advanced 2.5yrs (R)

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Initial Unemployment Claims (L) Fed Funds Rate Advanced 2.5yrs (R)

Claims Usually Begin To Rise About Two-And-A-Half Years AFTER A Fed Tightening Cycle

BEGINS

3) DOWNSIDE RISKS REMAIN FOR 2019B. LATE IN THE CYCLE THE LABOR MARKET IS AT RISK OF WEAKENING

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Initial Unemployment Claims (L) S&P 500 (Log Scale, R)

Bear Market

Bear Market

Bear Market (Early)

Bear Market (Late)

Bear Market Bear

Market

Bear Market

???

RISING CLAIMS ARE USUALLY A CATALYST FOR LARGE DECLINES IN EQUITY INDICES

Bear Market

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Low In Claims

THIS IS THE TIME IN THE CYCLE WHEN THE LABOR MARKET IS AT RISK OF WEAKENING

In addition to Earnings, the labor market is another potential threat to markets here. Typically, theemployment backdrop begins to weaken about 2.5 years after the Fed begins raising ratesconsistently, and we are at that threshold today. Although claims have not moved much yet, weare seeing several labor market proxies begin to flag caution (i.e. big drop in ISM Mfg Employment,ISM Services Employment, NFIB Small Biz Compensation Plans, etc. )



4) THE FORECASTED TROUGH IN PMIS COULD STILL BE SEVERAL MONTHS AWAY

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ISM Manufacturing New Orders Index (L) Fed Funds Rate (Inverted, YoY Bp Chg, Adv 18m, R)

March 2020

March 2021,

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We Have Many Tools To Forecast The Turn In LEIs, They All Point To A Q1 Bottom

TROUGHFORECASTED BY

FED FUNDS

We have several tools which we useto forecast where PMIs shouldbottom. Currently, long rates areforecasting a January trough, whereasshort rates are predicting a Marchturn around in PMIs. Regardless ofwhich way you slice it, we believe weare still several months away from atrough in PMIs. You historically do notget a trough in cyclicality until you seea trough in PMIs.

5) ONCE CYCLICALITY STARTS WORKING … IT IS LIKELY TO PERSIST FOR A YEAR OR MORE

ONCE PMIS RECOVER, THERE IS LIKELY TO BE A

LONG STRETCH OFCYCLICAL LEADERSHIP

FORECASTEDPMI

TROUGH

MARCH ‘21

DANGERZONE FORCYCLICALSWE EXPECT THE CYCLICAL RECOVERY

TO BEGIN IN Q1 OF 2020 AND

LAST THROUGH AT LEAST Q2 OF

2021 … AND MAYBE BEYOND.

Another reason to remain patientand not rush into cyclicality today isthat once cyclical leadership doesget going, it is likely to last for a longtime. Our charts (one exampleabove) show that the runway forrisk-on leadership is likely to persistthrough at least Q1 2021 if notlonger.

TODAY TROUGH FORECASTEDBY LONG RATES

SEPT2019

OCT2019

NOV2019

DEC2019

JAN2020

FEB2020

MAR2020

TROUGH FORECASTEDBY SHORT RATES



CONCLUSION: RISKS ARE ASYMMETRICALLY SKEWED TO THE DOWNSIDEAt the heart of our cautious stance is the notion that we don’t think PMIs have bottomed yet. Theworst period for markets and cyclicality is typically just BEFORE the trough in PMIs and so therisk/reward profile, in our view, is simply not in favor of getting cyclical just yet.

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-5.0%0.0%5.0%

10.0%15.0%20.0%25.0%30.0%

-6 Months -3 Months -1 Month Month OfLow In ISM

+1 Month +3 Months +6 Months

Mkt Returns At ISM Lows (Average, Annualized)

Months Before The PMI Bottoms Months After The PMI Bottoms

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Low To High EPS Variance(Average, Annualized)

Months Before The PMI Bottoms Months AfterThe PMI Bottoms

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High To Low Volatility (Average, Annualized)

Months Before The PMI Bottoms Months AfterThe PMI Bottoms

MARKETRETURNS

CYCLICALFACTOR

DEFENSIVEFACTOR

**Includes PMI bottoms (Jan 2016,

Nov 2012, Dec 2008, Oct 2001, Jan

1996, Jan 1991)

THE MOSTDANGEROUSPERIOD FOR

CYCLICALITY ISTYPICALLY JUST

BEFOREPMIS BOTTOM

Documents

5 REASONS TO REMAIN PATIENT AND NOT RUSH INTO ......2019/10/24 · correction, we would expect risk-on leadership to be slow and steady as opposed to fast & furious. 5 R EASONS T