How to Use Asset Allocation Based on Market Cycles | Understanding the Merrill Lynch Investment Clock
The "Investment Clock" by Merrill Lynch is a method that links "assets," "sector rotation," "bond yield curve," and the "four phases of the economic cycle" to guide investment decisions based on the different stages of the cycle.
The concept of the economic cycle is not unfamiliar to many, as Howard Marks divided it into four stages in his book "The Most Important Thing": expansion, peak, contraction, and trough.
The cause of the business cycle is overinvestment by investors during economic expansion, resulting in market oversupply and excess production capacity, leading to economic contraction and recession. With market rebalancing and economic recovery, the economy will enter the next round of expansion.
Similar to the theory, Merrill Lynch's clock also divides the economic cycle into four stages: recovery, expansion, stagflation, and recession.
Different assets will perform differently in different stages of the economic cycle:
Recovery phase: stocks > bonds > cash > commodities
The recovery phase is characterized by economic growth and declining inflation. During this period, companies tend to achieve better profits and increase financing through stocks. Furthermore, stocks are generally more sensitive to economic conditions, making it the best time to invest in them. Interest rates are typically low during this phase, and bond prices are inversely related to market interest rates, making bonds a viable investment option as well.
As the recovery phase transitions from the recession phase, investors and consumers tend to be more cautious about commodity allocation. Tight monetary policies also hinder commodity prices, resulting in lower returns during this phase.
Expansion Phase: Commodities > Stocks > Cash/Bonds
During this phase, the economy experiences upward inflation, and commodity prices rise along with it, making commodities the most attractive asset class to invest in. Due to inflationary pressures, interest rates are often raised, causing bond prices to fall, and increasing the opportunity cost of holding cash.
Although profits for businesses continue to grow during this expansion phase, stock returns are not as high as commodity returns due to rising interest rates and liquidity issues.
Stagnation Phase: Cash > Commodities/Bonds > Stocks
During this phase, the economy experiences a downturn while inflation continues to rise. As interest rates continue to rise, cash yields increase, and companies' profit margins decrease, leading to a decrease in stock market liquidity. The bond market performs relatively better than the stock market, but is still weak. Commodities benefit from rising prices due to inflation.
Recession Phase: Bonds > Cash > Stocks > Commodities
During the recession phase, both the economy and inflation decline together. In this phase, inflation decreases, and monetary policy becomes more accommodating, leading to lower interest rates. Bonds perform well, the stock market gradually recovers, and commodity returns lose their attractiveness due to falling prices caused by declining inflation.
So how should we invest in assets based on the Merrill Lynch Clock?
In addition to the four main asset classes mentioned above, if we focus on stocks, how should we allocate them in different periods to maximize our chances of success?
Recovery Phase: Cyclical Industries
During this phase, investing in stocks of cyclical industries is optimal. These industries typically benefit from economic recovery, and their performance is likely to improve, such as:
Expansion Phase: Growth Stocks
During the expansion phase, where the economy is growing strongly, investing in growth stocks and stocks with higher beta values tend to yield higher returns. These stocks typically perform better during economic growth periods, such as:
Stagnation and Recession Phases: Defensive and Counter-Cyclical Industries
During the stagnation and recession phases, investing in defensive and counter-cyclical industries is optimal as these sectors typically perform well despite economic downturns, such as:
Of course, it's important to note that the stocks that are suitable for each phase are not set in stone, and we need to adjust our investments based on various factors such as the current situation and policies.