Executive Summary

  • A Cautious Near-Term Equity Outlook — Plotting our sector and regional equity recommendations on the face of an “investment clock” suggests a cautious near‑term outlook for equities.
  • A Defensive Tilt — There is currently a defensive tilt in both our sector (overweight Health Care, underweight Energy, Materials) and regional (underweight CEEMEA, Latin America) recommendations.  This defensive tilt, which is driven by bottom-up factors, suggests that the biggest gains for equity markets in the current cycle may be behind us.
  • A Useful Rule-of-Thumb — In a complex global economy characterized by asynchronous economic cycles and monetary policies, this stylized model is overly‑simplistic.  However, it is a useful rule-of-thumb in helping determine the relative attractiveness (or unattractiveness) of stocks.

Figure 1: The Cornerstone Capital Global Equity Strategy Investment Clock

GMSR_Clock
Source: Cornerstone Capital Inc.

“Do You Like Stocks?”

“Do you like stocks?” is something we are asked frequently.  We are often tempted to reply with a question of our own:

  • “Do you like food?”

In other words, it depends.

When we introduced the Cornerstone Capital strategy model in the April 2014 edition of The Cornerstone Journal of Sustainable Finance & Banking we wrote that:

  • We start with the assumption that only two things ultimately determine the fair value of equities: earnings and P/E.  In the short term, other factors may play a role — e.g., sentiment (“fear” or “greed”), politics (including geopolitical issues), macroeconomic variables (e.g., Central Bank tightening or easing) etc. — but, in the long run, we believe it all comes down to earnings and the valuation of those earnings.  A number of factors drive valuation multiples at any point in time, including perceptions of corporate governance.

Estimating the fair value of equities helps gauge how stocks are valued in absolute terms, but not in relative terms.  At any point in time, stocks may look “cheap” or “expensive” versus their historical valuations, but there may be other asset classes available to investors that are even “cheaper” or “more expensive.”

Reading the Global Equity Strategy Investment Clock

Developing a multi-class asset allocation model — that also incorporates Environmental, Social and Governance (ESG) factors — is a lofty undertaking.  In this report, we take a first step by introducing our global equity strategy “investment clock”, which helps flesh out the equity outlook implied by our sector and regional recommendations.  So, for example, if our sector and regional recommendations had a very cyclical bias (e.g., overweight Energy, overweight CEEMEA), the implication would be that we were constructive on equities overall; if they had a defensive tilt (e.g., overweight Health, overweight North America), the implication would be we were generally cautious on equities.

To be sure, our global equity strategy “investment clock” is a rule-of-thumb, albeit a useful one in the absence of a more systematic multi-class asset allocation model.  The concept is that we visualize the global economic cycle in terms of the face of a clock — see Figure 2.

  • 12 o clock is the peak of the global economic cycle.
  • 6 o clock is the trough of the recession.
  • When the hands of the clock are at 3 or 9, the global economy is either moving from slowdown into full‑blown recession (3), or shifting from recovery to all-out boom (9).

Figure 2: The Cornerstone Capital Global Equity Strategy Investment Clock

GMSR_Clock
Source: Cornerstone Capital Inc.

As we discuss in detail below, plotting our sector and regional equity recommendations on the face of this “clock” is a useful rule-of-thumb in helping determine the relative attractiveness (or unattractiveness) of stocks.  Our most recent regional and sector recommendations were published in the January 2015 edition of the Cornerstone Capital Regional and Sector Strategy: Monthly Update and have a defensive tilt.  These recommendations would seem to imply that the near-term outlook for equities is cautious.

Current Sector and Regional Recommendations

Figure 3 summarizes our current sector recommendations; Figure 4 summarizes the regional recommendations.

Figure 3: Sector Recommendations as of January 2015

Geraghty_9Jan15_Figure3
Source: Cornerstone Capital Inc.

Figure 4: Regional Recommendations as of January 2015

Geraghty_9Jan15_Figure4
Source: Cornerstone Capital Inc.

Combining the sector and regional models, Figure 5 illustrates sector over- and under-weights by region.

  • We are overweight or neutral Health Care in all regions.
  • We are underweight or neutral Energy and Materials in the majority of regions.

Figure 5: Combining the Regional and Sector Models as of January 2015

Geraghty_9Jan15_Figure5
Source: Cornerstone Capital Inc.

From Economic Peak to Slowdown: Underweight Equities

Going back to the concept of the “investment clock,” Figure 2 illustrates that 12 o clock is the peak of the global economic cycle.  Assuming that stock markets are discounting mechanisms, all the positive fundamental news should be fully reflected in stock prices at the peak of the economic cycle.  As markets look out further, they begin to discount the prospects of an economic slowdown — or even a recession — so that, in most instances, stock prices trend lower at this point in a cycle.

In terms of sector and regional recommendations, an environment of slowing global growth is likely to be one in which defensive sectors and regions outperform more cyclical ones.  Conceptually, Figure 6 illustrates some of the sector and region over- and under-weights that would be optimal in an environment of slowing global growth (utilizing the current weights of defensive and cyclical sectors in the different countries and regions).

Figure 6: A Defensive Posture — Consistent with an Equity Underweight

Green = Overweight, Orange = Neutral, Red = Underweight

Geraghty_9Jan15_Figure6
Source: Cornerstone Capital Inc.

Figure 7 illustrates current sector and regional recommendations, which are based on bottom-up forecasts.  While not identical to Figure 6, the shading in Figure 7 is also defensive in nature: We are currently overweight or neutral Health in all regions; we are underweight or neutral Energy and Materials in the majority of regions.

Figure 7: Current Sector and Regional Recommendations as of January 2015

Green = Overweight, Orange = Neutral, Red = Underweight

Geraghty_9Jan15_Figure7
Source: Cornerstone Capital Inc.

In terms of Figure 2, these sector and regional recommendations suggest we are someplace between 12 and 3 o’clock, implying that the biggest gains for equity markets in the current cycle may be behind us.

Reaching the Trough of the Economic Cycle: Neutral on Equities

As our stylized global economic cycle progresses, the world’s central banks ease monetary policy to help boost growth, which is a positive for interest rate sensitive sectors such as Utilities and Financials — Figure 8.  However, for the asset class as a whole, the recessionary environment is unfavorable, so that the relative attractiveness of equities is still not compelling.

Figure 8: Favoring Rate Sensitive Sectors and Regions —  Consistent with a Neutral Outlook on Equities

Green = Overweight, Orange = Neutral, Red = Underweight

Geraghty_9Jan15_Figure8
Source: Cornerstone Capital Inc.

From Recovery to Boom: Overweight Equities

Gradually the global economy recovers, which benefits “early cycle cyclicals” in sectors such as Consumer Discretionary and Industrials — Figure 9.  Stocks as an asset class begin to look relatively attractive.

Figure 9: Favoring Early Cycle Cyclicals  —  Consistent with a Positive Outlook on Equities

Green = Overweight, Orange = Neutral, Red = Underweight

Geraghty_9Jan15_Figure9
Source: Cornerstone Capital Inc.

Reaching the Peak of the Economic Cycle: Neutral on Equities

Finally, the global economy accelerates from recovery to boom.  “Late cycle cyclicals” — such as Materials and Energy — enjoy strong relative earnings momentum (Figure 10), although the attractiveness of equities as an asset class begins to wane as all the good fundamental news becomes fully discounted in stock prices.

Figure 10: Late Cycle Cyclicals  —  Consistent with a Neutral Outlook on Equities

Green = Overweight, Orange = Neutral, Red = Underweight

Geraghty_9Jan15_Figure10
Source: Cornerstone Capital Inc.

A Cautious Near-Term Equity Outlook

Plotting our sector and regional equity recommendations on the face of an “investment clock” is a useful rule-of-thumb in helping determine the relative attractiveness (or unattractiveness) of stocks.  Currently, this rule-of-thumb suggests a cautious near-term outlook for equities.  An environment in which defensive sectors and regions are favored over more cyclical ones implies a slowdown in global economic growth, which is typically negative for equities relative to other asset classes.

The full report is attached along with important disclosures.

Michael Geraghty is the Global Markets Strategist at Cornerstone Capital Inc. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.