Merrill Lynch investment clock theory has been regarded as the standard for a long time since it was proposed, and it is the mainstream asset allocation framework. However, due to the low effectiveness of the traditional Merrill Lynch investment clock in China, its application in China has been questioned.

We believe that Merrill Lynch investment clock is essentially a theory of economic cycle fluctuation, which has its hypothetical premise and logic, but because of the particularity of China's policy-making framework and liquidity, it is different from the hypothetical premise of Merrill Lynch clock. It leads to its low effectiveness, but it should not be considered invalid. The improved Merrill Lynch clock according to the actual situation of our country still has high accuracy.

Merrill Lynch clock has created a top-down investment approach. The influence of economic cycle on the trend of large categories of assets seems to be different from cycle to cycle, but in fact it is pressed with the same rhyme. The improved Chinese investment clock still has strong theoretical and practical significance.

In 2004, Merrill Lynch put forward the "Merrill Lynch investment clock" based on the study of the 30-year historical data of the United States from 1973 to 2004, linking the economic cycle with asset rotation and industry strategy.

Merrill Lynch investment clock divides the economic cycle into four stages: recession, recovery, overheating and stagflation, while asset classes are divided into bonds, equities, commodities and cash.

Start at the lower left of the Merrill Lynch investment clock and rotate clockwiseThe economy rotates in turn along the "recession-recovery-overheating-stagflation" cycle, while bond markets, stock markets, commodities and cash lead large categories of assets in turn.

The investment clock of Merrill Lynch is essentially an economic cycle fluctuation theory based on demand-side changes. The main logic behind it is that fundamentals and monetary policy interact to form a short-term economic cycle, thus affecting the trend of large categories of assets. Investors can profit from the trend in the cyclical transformation by identifying the important inflection points of fundamentals and monetary policy.

Merrill Lynch clock basically conforms to the classical theory in the United States.On the basis of the Merrill Lynch report, we further extend the time range to September 2020 to test the applicability of the Merrill Lynch clock.

We divide the period from January 1970 to September 2020 into 34 economic cycles. The statistics show that:

1) in terms of periodic rotationBefore the 21st century, the clock cycle of Merrill Lynch basically followed the law of rotation. After the 2008 financial crisis, the global sustained low interest rates and leading easing led to a longer-term recovery than the other three cycles, and the law of rotation weakened.

2) in terms of asset performance, the overall correct rate of Merrill Lynch clock is 88%.Among them, the correct rate of recession is 57%, the average yield of bonds is 6.3%, the correct rate of recovery is 100%, the average return of stocks is 20%, the correct rate of overheating is 78%, the average rate of return of commodities is 26.7%, the correct rate of stagflation is 100%, and the average yield of cash is 5.1%.

The traditional Merrill Lynch investment clock is not effective in China.We also test its application in China according to the method of Merrill Lynch clock.

We divide the period from December 2002 to September 2020 into 33 economic cycles. The statistical results show that:

1) in terms of periodic rotationOnly a few cycles follow the cycle rotation law of the Merrill Lynch clock, and most of the cycles jump back and forth or rotate counterclockwise. "overheating" and "recession" are the two cycles with the longest duration in China.

2) in terms of asset performance, the overall correct rate of Merrill Lynch clock is 40%.The correct rates of recession, recovery, overheating and stagflation are 30%, 50%, 50% and 33%, respectively.

Why is the effect of Merrill Lynch clock deviating in China?We think there are three main reasons.

1) there are differences in the framework of monetary policy making between China and the United States.The Fed's monetary policy framework is mainly around the Taylor rule, setting policy interest rates based on the output gap and changes in inflation, which is basically the same as the main factors that divide the cycle of the Merrill Lynch clock. Therefore, there is a clear equation between US policy interest rate and output gap and inflation, and then affect the trend of large categories of assets through market interest rates.

On the other hand, China's monetary policy needs to take into account multiple objectives, including economic growth, full employment, price stability, internal and external balance, prevention of financial risks, and so on. Different goals may require monetary policy in the opposite direction and increase the difficulty of monetary policy decision-making, which is also different from the logic behind the Merrill Lynch clock.

2) the performance of large categories of assets in China is affected not only by fundamentals and monetary policies, but also by financial supervision, reform and other policies.For example, the commodity bull market caused by the supply-side structural reform in 2016 is based on changes in the supply side, which is contrary to the logic on the demand side of the Merrill Lynch clock; and the stock market in 2015 is due to a large amount of capital and leverage entering the market, and market changes are out of line with the real economic cycle, resulting in policy markets and capital markets.

3) inflation, as the main variable in the division of Merrill Lynch clock cycle, may deviate from the actual operation of the real economy because of its deficiency in concept, category and measurement, which has a certain impact on the accuracy of the division of economic cycle.

Based on the particularity of our country, we think that the application of the traditional Merrill Lynch investment clock in our country can be improved. As the logical chain from economic growth and inflation to the performance of large categories of assets is non-linear, we can shorten the logical chain and improve the prediction accuracy of large categories of assets by selecting other observation variables.

Output gap and inflation are some of the input variables of monetary policy, while "currency" and "credit derivation" are the main output variables of monetary policy, and the logical chain between monetary policy and large categories of assets is more direct.

Logically, money and credit can also be unified with an economic cycle constructed by output gaps and inflation:

1) during the recession, the output gap worsened, inflation fell, monetary policy relaxed, and the financing demand of the real economy was weak, corresponding to "broad money + tight credit".

2) during the recovery period, the output gap improved, inflation fell, monetary policy was sound, and real financing demand rebounded, corresponding to "wide currency + broad credit".

3) during the overheating period, the output gap improved, inflation rose, and the central bank tightened liquidity, while the real financing demand was still strong, corresponding to "tight money + broad credit".

4) during the stagflation period, the output gap worsened, inflation rose, it was difficult for the central bank to relax money, and the demand of the real economy was sluggish, corresponding to "tight money + tight credit".

Taking the monetary and credit cycle as the main variables for dividing the economic cycle, we divided the period from December 2002 to September 2020 into 26 cycles, and found that the overall accuracy of the improved Chinese investment clock for the allocation of large categories of assets reached 73%. Significantly higher than the traditional Merrill Lynch clock.

Where:Wide currency + tight credit (recession) cycle, the correct rate of large categories of assets allocated to bonds is 83%; wide monetary + broad credit (recovery) cycle, the correct rate of allocation to stocks is 100%; tight money + broad credit (overheated) cycle, the correct rate of allocation to commodities is 57%; tight money + tight credit (stagflation) cycle, the correct rate of allocation to cash is 43%.

Further, we start from a meso-perspective.It is found that the three asset segments of stocks (different industries), bonds (different durations) and commodities (different varieties) also rotate obviously in the four cycles.

Stocks: 1) during the recession, the financial and consumer sectors are the most resilient; 2) in the recovery period, the cycle and the financial sector are the best choices; 3) in the overheated period, the cycle and consumer sectors are the strongest; and 4) during the stagflation period, consumption and growth sectors are the most resistant.

Bonds: 1) during the recession, the bond market is 100% bull, but the shape of the yield curve is different; 2) during the recovery period, the bond market is mainly a volatile city, and the overall shape of the yield curve tends to be flat; 3) during the overheating period, the bond market is 100% bear. the yield curve is flat as a whole; 4) during the stagflation period, bonds lack obvious trends and need to make discretionary choices.

Commodities: 1) during the recession, the precious metal performs best; 2) during the recovery period, the overall performance of industrial products is good, and the metal plate is the best choice; 3) during the overheating period, the metal plate performs best; 4) during the lag period, the precious metal is the most resistant.

Risk Tips:The economic fluctuation exceeded expectations.