Highlights of this Issue The Investment Clock ML’s Investment Clock is an intuitive way of relating asset rotation and sector strategy to the economic cycle. In this report we back-test the theory using more than thirty years of data. We find that, while every cycle has unique aspects, there are clear similarities that can help investors to make money. Methodology and Results The Investment Clock model splits the economic cycle into four phases depending on the direction of growth relative to trend and the direction of inflation (Table 1). We use OECD “output gap” estimates and CPI inflation data to identify the historic phases in the U.S. since 1973. Then we calculate the average asset and sector returns for each phase, testing our results for statistical significance. We confirm that Bonds, Stocks, Commodities and Cash outperform in turn as the cycle progresses. We also find a very useful read-across to equity sector strategy and to the shape of the yield curve. See the diagram on the next page for a summary of the main results. Economic Cycle Analysis is Key We are not testing a real-time, quantitative trading rule. Rather, we are showing that a correct macro view ought to pay off in a particular way. It is striking how consistent the results are given that we pay no explicit attention to valuation, a factor often held to be of utmost importance. Economic cycle analysis, including an assessment of the aims and effectiveness of policy- makers, will form the core of our tactical asset allocation work. Based on this methodology, we still favour global “Overheat” plays:
commodities, industrial stocks, Asian currencies, Japan and the emerging markets. We would underweight Government bonds, financials, consumer discretionary stocks and the U.S. dollar. See pages 17-20 for details. Table 1: The Four Phases of the Investment Clock PhaseGrowth*Inflation Best Asset Class Best Equity Sectors Yield Curve Slope I“Reflation”BondsDefensive GrowthBull Steepening II“Recovery”StocksCyclical Growth- III“Overheat”CommoditiesCyclical ValueBear Flattening IV“Stagflation”CashDefensive Value- Source: ML Global Asset Allocation * Growth relative to trend (i.e.“output gap”) GLOBAL Contributors Trevor Greetham Director of Global Asset Allocation, Institutional Client Group (44)2079961535 Michael Hartnett Deputy Director of the RIC, Global Private Client Group (1)2124495827 10 November 2004 The Investment Clock Special Report 1: Making Money from Macro Merrill Lynch does and seeks to do business with companies covered in its research reports.As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 28. Global Securities Research & Economics GroupGlobal Fundamental Equity Research DepartmentRC60431501 The Investment Clock –10 November 2004 Refer to important disclosures on page 28. 1.The Investment Clock in a Picture n How to use the Investment Clock relative to trend, i.e. the “output gap”, and the direction of inflation. In each phase, the assets and equity sectors shown in the diagram (Chart 1) tend to outperform while those in the opposite corner tend to underperform. Cash outperforming in turn. Life is not always so simple. Sometimes the clock moves backwards or skips a phase. We will be making judgements on the future stage of the global economic cycle in our asset allocation research. Chart 1: Asset and Sector Rotation over the Economic Cycle T e le co m sInd us tr ia ls U ti lit ie s Fi na nc ia ls T e le co m sInd us tr ia ls U ti lit ie s Fi na nc ia ls In foT ech&Basic M at s P h ar m ac eu tica ls&Cons um er S ta p le s In foT ech&Basic M at s P h ar m ac eu tica ls&Cons um er S ta p le s O il & G a s Co ns u m e r D is c re ti o n a ry O il & G a s Co ns u m e r D is c re ti o n a ry Stocks Recovery G ro w th R e c o v e rs G ro w th R e c o v e rs G ro w th W e a k e n s G ro w th W e a k e n s Inflation RisesInflation Rises Inflation FallsInflation Falls Overheat ReflationStagflation Cyclical Growth Commodities Cyclical Value Bonds Defensive Growth Cash Defensive Value Source: ML Global Asset Allocation Team. Technical Note: We have tried to arrange things so the closer you are to the middle of the diagram, the stronger the statistical support from our back-testing. The model works best for broad asset rotation and explains some equity sectors (e.g. Consumer Discretionary, Oil & Gas) much more consistently than others (e.g. Telecoms, Utilities). The Investment Clock –10 November 2004 Refer to important disclosures on page 28.CONTENTS n SectionPage The Investment Clock1.A pictorial summary of our findings2 How the Model Works2.Explaining ML’s Investment Clock framework4 Back-Testing Methodology3.Using more than thirty years of U.S. data7 Market Returns over the Cycle4.Strong results for assets, equity sectors and fixed income; some intriguing patterns for foreign exchange and equity country strategyUsing the Investment Clock in Practice 5-down cycle analysis should be the starting point for tactical asset allocation; we continue to favour global “Overheat” playsStatistical AppendixI.Which results are robust and which aren’t21 The authors would like to thank Magatte Wade for his help with the numerical work in this report. The Investment Clock –10 November 2004Refer to important disclosures on page 28. 2.How The Investment Clock Works ML’s Investment Clock is a way of relating the economic cycle to asset and sector rotation. In the first section of this report, we outline the thinking behind the model. n Long Run Growth and The Economic Cycle The long run rate of growth of an economy depends on the availability of the factors of production, labour and capital, and on improvements in productivity. In the short run, economies often deviate from their sustainable growth path and it is the job of policy-makers to get them back onto it. An economy operating below potential will suffer deflationary pressure and ultimately outright deflation. On the other hand, an economy consistently above its sustainable growth path will generate disruptive inflation. Recognising Turning Points Pays Off Financial markets consistently mistake these short-term deviations for changes in the long run trend rate of growth. As a result, assets become mispriced at the extremes of the cycle, just when corrective policy shifts are about to take effect. Investors correctly recognising the turning points can make money by switching into a different asset. Those extrapolating recent history lose out. For example, many investors bought expensive technology stocks in late 1999 on the grounds that the trend growth rate of the U.S. economy was increasing and these companies stood to gain most from this “New Era”. However, Fed tightening to counter a modest rise in inflation was already well advanced. The cycle peaked in early 2000 and the dot com bubble burst. The ensuing downturn prompted aggressive Fed ease to the enormous benefit of bonds and residential real estate. The Four Phases of the Cycle The Investment Clock framework helps investors to recognise the important turning points in the economy and identifies investments to take best advantage of a change. We split the economic cycle into four phases – Reflation, Recovery, Overheat and Stagflation. Each is uniquely defined by the direction of growth relative to trend, i.e. the “output gap”, and the direction of inflation. We believe that each of these phases is linked to the outperformance of a specific asset class:
Bonds, Stocks, Commodities and then Cash (Chart 2). Chart 2:The Theoretical Economic Cycle – Output Gap and Inflation -1.1 -0.1 0.95DWH KLNHV %21&39;6672&.6 &2002&39;,7,(6&$6+ 5DWH FXWV *URZWK YV 7UHQG ,QIODWLRQ Source: ML Global Asset Allocation Team. The horizontal line re