The Feasibility Study of Merrill Lynch Investment Clock Theory in China's Asset Allocation

Yongzhe Li, Liyang Chen North China University of Water Resources and Electric Power, Henan 450045, China

Keywords: Merrill Lynch investment Clock theory; Output gap; Asset allocation

Abstract: Merrill Lynch investment clock theory is an effective method links the economic cycle and asset allocation strategy from the perspective of the overall macro-economy by judging the economic situation in the United States. However, the underlying mechanisms remain poorly understood in China for the economy system in the U.S and China have vast differences and this theory use the data OECD “output gap” which do not has uniform monthly value in China. To define the feasibility of the study in China, we have verified and improved the original theory through quantitative analysis. Intriguingly, the application of the ameliorated theory in China is more scientific. These results signify a critical role for Chinese people cannot obtain additional investment returns by using the traditional theory. We therefore propose that the original theory should be improved when it is applied to other countries.

1. Introduction After analysing more than three decades data of American economic history (1973-2004),

Merrill Lynch linked the economic cycle, asset rotation and sector strategy, and put forward the theory in 2004, which is a very practical and effective tool to guide the investment cycle. By indicating the real meaning of the theory, investors can realize the similarities and differences in every economic phases and make more rational and correct investment decisions.

Thanks to this theory, investors from the free market of capitalist countries can constantly change their investment operation in practice by judging the economic cycle, and obtain huge investment returns by investing in different types of assets in different periods. Whereas, as mentioned above, the economic background of this theory is free market, which requires asset allocation to change with the change of macroeconomic cycle. However, in the world market, different countries have different economic policies and there is still no clear conclusion on the practicability of the theory in China. This topic has not been involved by too many researchers.

It is of interest to know whether this theory still hold true in China. Therefore, we change the indicators used in the original theory, and standardize the definition of China's economy according to China's specific economic situation, so as to divide China's economic cycle. And we use Z-score and HP Filtering to verify our theory, in comparison with other techniques, this method has the advantage of analysing the trend of China's economy more scientifically, and define the economic cycle based on data back testing and law mining, rather than through simple indicators. The objective is to demonstrate the feasibility of the theory in China by studying the return on investment of different assets in different economic cycles.

2. Introduction of Merrill's clock investment theory and its application abroad 2.1 Theoretical content

According to the high and low values of the two macro indicators of economic growth rate (GDP) and inflation rate (CPI), Merrill Lynch clock divides the economic cycle into four phases, each phase corresponds to an economic situation, and puts forward the corresponding rate of return of asset allocation for each economic cycle.

2021 3rd Scientific Workshop on Advanced in Social Sciences, Arts & Humanities (ASSAH 2021)

Copyright © (2021) Francis Academic Press, UK DOI: 10.25236/assah.2021.00744

Generally speaking, the economic cycle can be divided into these four following phases: Reflation: low GDP & low CPI, indicating the level of economic growth is declining, and the

pressure of inflation is also decreasing. At this time, the government's monetary policy is relatively loose. Therefore, bonds perform best at this stage.

Recovery: high GDP & low CPI, representing the upward level of economic growth and the downward pressure of inflation. At this stage, because the elasticity of stock is greater than other types of assets, stock can obtain more obvious excess return than bonds and cash at this stage.

Overheat: high GDP & high CPI, showing the level of economic growth is rising, and the level of inflation is also increasing. Under this circumstance, due to the increasing pressure of inflation, the opportunity cost of cash is rising while “the government may introduce a series of monetary policies, such as increasing interest rates to curb the growth of inflation” [1], and the return on investment of bonds is decreasing. Thus, commodity is the best asset allocation tool.

Stagflation: low GDP & high CPI, illustrating the level of economic growth declines, while the level of inflation rises. In this stage, the yield of cash increases significantly. When the inflation is too high, the central bank is not willing to relax the monetary policy, so the performance of bonds becomes worse. Because of the serious decline of corporate profits, the investment yield of stocks is also at a low level.

2.2 Applications in the U.S. Merrill Lynch counts the times of different phases in America, calculating the return on

investment of four types of assets in each phase. The economic cycle...can be divided into 58 months of ‘reflation’... 131 months of ‘recovery’... 100 months of ‘overheat’ and 86 months of ‘stagflation’ totally”[2].

During “reflation”, such as December 1974 to January 1975 divided by the clock model, the most serious economic crisis broke out in the U.S. during this period. The Dow Jones index fell by 41.9% from January 1973 to December 1974. Meanwhile, the overall economy was accompanied by serious inflation, and the consumer prices rose by 11.4% in 1974. In this phase, the average return on bonds was 9.8%, higher than that on stocks (6.4%), commodities (- 11.9%) and cash (3.3%) respectively.

Similarly, in “recovery”, for instance, from March 1984 to December 1986, the U.S. government promoted the neoliberal policy to adjust the economy in the mid-1980s, vigorously issued bonds, reducing taxes for the rich class and other measures to make the U.S. economy recover. During the overall phase, the average return on stocks was 19.9%, higher than that on bonds (7.0%), commodities (- 7.9%) and cash (2.1%) individually.

In “overheat”, for example, from February to November 1999, the U.S. economy continued to grow as in the mid-1980s, the U.S. and several Western countries forced Japan to sign the Plaza Agreement, making the yen to depreciate sharply, causing Japanese enterprises to make large losses and withdraw from the European and American markets, which reversely promoted the rapid growth of the U.S. economy [3]. Meanwhile, at that time, the CPI remained at a relatively high level and sustained growth (from 1.61% to 2.62%). During the phase, the average return of commodities reached 19.7%, higher than that of bonds (0.2%), stocks (6.0%) and cash (1.2%) individually.

In “stagflation”, such as the March of 2002 to March 2003, the US economy began to grow from March 1991 to ten years, but in 2002, the US economy began to descend from the beginning of 2002 for the breakdown of the US network economic bubble and the economic structure, and also accompanied by severe inflation, most of the funds suffered negative returns during the whole stagflation period. The average return of cash is - 0.3%, much higher than that of bonds (- 1.9%) and stocks (- 11.7%) respectively.

After the statistical test, ML clock investment theory applied in America can achieve astonishing achievements. In addition to the jump or deviation in individual economic cycles, in other economic cycles, we will get more investment return rate if we can allocate assets according to the theory.

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3.The feasibility of Merrill's clock investment theory in China's asset allocation 3.1 China's economic fluctuation and asset return from 2002 to 2018

If ML clock investment theory is directly applied to China, China's economy can be roughly divided into two economic cycles since China's accession to the WTO in 2001.

Cycle I: 2002-2009 In 2002, China was in the recovery phase. Due to China's accession to the WTO, the GDP

growth rate increased dramatically (from 9.1% in January 2002 to double-digit), but the CPI was still negative growth. Until 2006, the CPI index hovered between 1 and 2. Meantime, China's stock market had a more obvious growth, though the overall Shanghai stock index was still in the recovery phase From 2002 to 2005, there was no big change (all below 1500 points), but from 2006, it increased sharply. By the end of 2006, it reached 2675.47 point. Apparently, China's stock returns were significantly higher than other types of assets.

Since 2007, China has entered into an overheat phase. The CPI index has increased rapidly (2.20 in January 2007 and 6.50 in December 2007) and GDP still maintained a high growth rate. During this period, the Shanghai Stock Exchange index has decreased significantly (rising to 6124.04 points from November 30, 2007, and then decreased rapidly). Meanwhile, China's commodity futures market has entered a bull market, from oil, and other commodities, such as Gold, nonferrous metals, agricultural products and other commodities had a strong momentum.

Until the outbreak of the subprime mortgage crisis in 2008, China's economic cycle quickly entered a reflation phase. The recession made the year-on-year growth rate of GDP began to decline from 11.3% in the first quarter of 2008 while CPI also dropped from 107.1 to 101.2 in December of that year. During this period of time, the Shanghai stock index fell continuously from December 2007, while the commodity market prices also remained low. However, the national debt index rose slightly in the middle of 2008, from 112.09 at the beginning of the year to 121.30 at the end of the year.

Cycle II: 2009-2018 Since 2009, China's economy has entered into recovery phases. The reason is that after the

outbreak of the subprime mortgage crisis, the Central Bank of China has rapidly adjusted its economic policies and adopted a series of measures to stimulate the recovery of the economy. The GDP growth rate has rapidly recovered to double digits in 2010. Meanwhile, the CPI index has been negative from February 2009 to October 2009 and is at a low level. The Shanghai Composite Index has rapidly risen to 2800 points from 1990 points in early 2009. In the meantime, the stock market recovered rapidly.

China's economy began to recover in 2009 and reached its peak in 2011. From 2013 to the end of 2015, China's economy entered a period of overheating as China's economy continues to recover, but the Central Bank did not raise interest rates in 2013, which makes the high GDP growth accompanied by high CPI. The Shanghai Stock Index fluctuated around 2200 points during this period. Although the national debt index rose slightly at this time, the bulk commodities performed well in this stage.

After 2015, China's economic cycle did not enter a stagflation period, but turned into a reflation period for China's foreign exchange policy, “the reform of foreign exchange policy on July 21st, 2005...made China only have a large-scale interest rate reduction since the 2008 economic crisis...and the overall interest rate fluctuates and adjusts in a small range”. With the development of China's economy and the change of the world economic environment, China's CPI index has not changed significantly, but the inflation situation was getting worse. With the end of the leverage bull market in 2015, the stock market conduction led to the reduction of CPI, making the overall economy once entered a recession. During this period, the national debt index was still rising steadily (from 146 points in 2015 to 169.88 points at the end of 2018), becoming the best investment tool in this period.

In 2018, China's economy entered a stagflation period because the Federal Reserve started to raise interest rates in 2018 and the Central Bank of China did not adopt the policy of interest rate

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hike, which makes the overall economy of China passively follow the relatively tight monetary policy to some extent. In this economic cycle, the performance of various investment markets was basically consistent with the cycle. For example, in 2009, the index of small and medium-sized sectors representing growth stocks in the stock market rose by more than 20% in that year. At the same time, commodity prices began to rise, and the rising trend continued until the beginning of 2011. From the second half of 2011, bond prices began to rise until the end of the bond bull market in 2015. At the same time, there was a short-term leverage bull market in the stock market in 2015, which started in 2016, commodities began a new round of sharp rise, and it was not until 2018 that the trade war and other factors ended. Therefore, at this stage, cash is a relatively stable investment tool.

3.2 Inspiration and thinking of Merrill clock in China’s application 3.2.1 Selection of economic indicators

If we want to test the application of the theory in China according to the traditional ML clock investment theory, we need to judge the stage of the economy through output gap and inflation trend, and make statistics on the performance of large-scale assets in each phase. However, there is no official statistics on output gap in China, because:

Output gap = (real GDP - potential GDP) / real GDP In the estimation of output gap, it is necessary to calculate the potential GDP, which is a trend

value and affected by many factors. Therefore, it is difficult and the error is large. Besides, although China has published GDP values every quarter, it is not conducive to the division of economic cycle because of its strong lag in statistics. Therefore, in this paper, PMI will be used to replace output gap to measure economic growth. According to the economic significance of PMI in reality, 50 is usually regarded as the dividing point of economic strength and weakness. When PMI value is higher than 50, it reflects economic expansion; when PMI value is lower than 50, it reflects economic contraction; and 50 is low prosperity line. In general, if PMI floats around 50, economic operation is stable.

However, there are still shortcomings in using PMI index instead of GDP to observe and divide the overall economy. The disadvantage is that PMI refers to purchasing manager index, and the direct industry where PMI index changes is manufacturing industry. However, in practice, the development of other industries in China has a great impact on the overall economy such as the tertiary industry. It is not strict to measure the overall trend of China’s economic change by the change of manufacturing industry.

Moreover, ML clock investment theory has a great defect in its content for it do not have certain standards for the economic operation, namely, the division of economic upward and economic downward, and the division of inflation degree. In theory, there is no definite value to define these economic indicators, so in the actual estimation and back test, the practicability and scientificity of the theory are reduced.

Although 50 is the boundary line of PMI index corresponding to economic situation, and for CPI index, inflation rate can be estimated by CPI. However, this division does not closely combine with the current economic situation in China, Therefore, it is not accurate and rigorous to set the CPI and PMI as the quadrant division standard of ML clock investment theory.

3.2.2 Back testing of China's business cycle division based on HP filter This paper will use Z-score and HP Filtering to measure back the performance of large class

assets in different economic and historical periods under the framework of Merrill Lynch clock, and then build decision module of allocation direction of big class assets. Taking the time series data of PMI and CPI as samples (monthly data from 2008 to 2020), the standard values of Z-score standardization of the two indicators are compared with the median. The mark larger than the median is up, and the smaller than the median is marked as down

The time series data samples of PMI and CPI are defined as up / down by HP filtering method. The up / down indicators of the above steps are positioned. According to the framework of Merrill

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Lynch clock investment theory, two groups and pairing are used to get the different economic cycle, namely, economic cycle, which is divided from 2008 to 2020.

Thus, we can define: GDP UP&CPI DOWN is the Recovery phase GDP UP&CPI UP is the Overheat phase GDP DOWN&CPI UP is the Stagflation phase GDP DOWN&CPI DOWN is the Reflation phase Taking Shanghai Shenzhen 300 index, commodity index, national debt index and gold index as

the representative of several kinds of assets in ML clock investment theory, the paper makes a retrospective survey of the return, volatility and sharp ratio of these kinds of assets in different cycles of ML clock divided by economic cycle in Table 1.

Table 1 HP filtering method output results in MATLA

CSI 300 index Commodity index National Debt index Gold index Yield

s VIX Shar

p ratio

Yields

VIX Sharp ratio

Yields

VIX Sharp ratio

Yields

VIX Sharp ratio

Phase

-0.2036

0.0110

9.5769

-0.086

0.01530

12.5663

-0.0435

0.00647

38.6617

-0.1828

0.00404

7.3558

Overheat

0.6806

0.0129

23.128

0.77898

0.01673

20.8475

-0.0255

0.00646

464.628

-0.2282

0.00402

46.320

Reflation

-0.0122

0.0053

13.262

-0.0011

0.0105

11.0898

-0.0209

0.00588

76.658

0.04769

0.00106

41.429

Recovery

-0.1608

0.0302

4.3984

-0.1005

0.03107

4.85037

-0.0487

1.37E-05

25.7954

-0.0342

0.00826

14.128

Reflation

0.30749

0.0308

33.706

0.28198

0.03211

26.4396

-0.0109

1.58E-05

837.248

-0.3296

0.00875

24.5020

Recovery

0 0 0 0 0 0 0 0 0 0 0 0 Overhe

at -0.01

29 0.0218

14.128

0.2623

0.02445

7.05758

-0.0258

1.00E-05

88.3488

0.18247

0.00813

8.8224

Stagflation

0.05656

0.0127

9.9109

0.05525

0.02873

7.31772

-0.0293

1.12E-05

49.4818

-0.0923

0.01061

9.5363

Overheat

-0.2501

0.0286

7.3391

-0.305

0.04347

6.10997

-0.025

2.81E-05

100.270

-0.1268

0.00890

12.2926

Recovery

0 0 0 0 0 0 0 0 0 0 0 0 Reflatio

n 0.880

57 0.0405

8.7792

1.7141

0.06322

6.13698

-0.1182

9.19E-05

66.9649

0.03700

0.01447

14.7127

Stagflation

2.15451

0.0450

4.6172

2.6831

0.06460

4.43986

-0.0227

2.45E-05

263.519

0.42649

0.00710

16.5022

overheat

The CSI 300 index represents stocks, the national debt index represents bonds, the commodity index represents commodities, and the gold index represents cash. According to the output results of HP Filtering Method in MATLAB, we can see that in the reflation period of the economic cycle, the return on investment is roughly bonds > currency > stock > commodity; in the recovery period, it is stocks > bonds > currency > commodity; in the overheat period, it is commodities > stocks > currency > bond; in the stagflation period, it is currency > commodity > stock > bond. Generally, the trend is in line with the changes of major asset allocation in ML clock investment theory, but there are still time months not in line with the clock trend.

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3.2.3 Verification of clock investment theory At the same time, use MATLAB to analyse and verify the trend of ML clock, observing whether

the trend of ML clock is strictly in accordance with the order of the clock, assume that the four cycles of ML clock are cycle1, cycle2, cycle3, cycle4, and give the statistical data in the Table 2

Table 2 The trend of ML clock

CYCLE1 CYCLE2 CYCLE3 CYCLE4 CYCLE1 Z L P CYCLE2 CYCLE3 CYCLE4

Where, Z means the number of times in the time series sample that the current is cycle1 and the next cycle is cycle2. Similarly, L is the number of times in the time series sample that the current is cycle1 and the next cycle is cycle3, P is the number of times in the time series sample that the current is cycle1 and the next cycle is cycle4. Thus, the result showed in Table 3.

Table 3 The trend of ML clock in China

CYCLE1 CYCLE2 CYCLE3 CYCLE4 CYCLE1 0 1 1 0 CYCLE2 2 0 0 1 CYCLE3 1 0 0 2 CYCLE4 0 1 2 0

It can be seen that the trend of ML clock in China is not in strict accordance with the above cycle, and the abnormal economic data and fluctuations in some years can still be seen between cycles.

4. Conclusions The basic assumption and logical relationship of the traditional ML clock investment model is

closely related to the monetary policy of the Federal Reserve, so it has stronger guiding significance for the allocation of large categories of assets. However, the monetary policy framework of the Central Bank of China needs to consider a variety of factors, so the correlation between macro conditions and the performance of large categories of assets is relatively low in some periods.

Different cultures and systems make the theory of pure market economy in the United States have some deviations in China's economic cycle operation. ML clock investment theory is a theory to judge the allocation of large categories of assets according to the economic trend, but the best application scenario is not in China. China's economy can’t be analysed purely by using ML clock investment theory. Therefore, in the actual investment process, we should not only look at ML clock investment theory, but also combine it with its application background and allocate assets according to China's actual economic situation.

References [1]John Maynard Keynes. The general theory of employment, interest, and money. London Oxford University Press, 1936. [2]Merrill Lynch. Global equity strategy: the investment clock, 2004. [3]Rui Huang. Research on the scale of Japanese national debt and its impact on economy. Hebei University, 2013

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