What is Capital Flow Analysis? (Definition)
What is Capital Flow Analysis?
Capital Flow Analysis defined.
Relationship to 'flow of funds analysis'.
Relationship to Modern Portfolio Theory.
Relationship to behavioral economics.
Capital Flow Analysis as a contrarian approach to investment.
Applicability in all capital markets.
Relationship to ordinary security analysis.
How is Capital Flow Analysis useful?
Uses for individual investors.
Applications for bankers and brokers
Is Capital Flow Analysis difficult to learn?
What basic skills are required?
How long does it take to complete the training modules?
How soon will a reader be able to use Capital Flow Analysis?
Answers to FAQ |
Capital Flow Analysis defined.
Capital Flow Analysis uses national flow of funds accounts to explain supply and demand in capital markets.
The goal is to forecast price trends for broad categories of securities, such as equities or bonds, over the medium and longer term.
Relationship to 'flow of funds analysis'.
'Flow of funds analysis' is a generic term for the study of national flow of funds accounts, such as the statistics in U.S. Federal Reserve Release Z.1. There is no formal technique for 'flow of funds analysis'.
Capital Flow Analysis also refers to the study of national flow of funds accounts or similar statistics, but specifically the information regarding activities of issuers of securities and investors.
Capital Flow Analysis is a technique, with axioms and methods. The purpose is to forecast general trends in securities markets.
Relationship to Modern Portfolio Theory.
Modern Portfolio Theory is based on the observation that prices of broad categories of securities, such as stocks or bonds, tend to move together — a phenomenon called 'covariance'.
Modern Portfolio Theory assumes that price variations in securities markets are unpredictable and that the best that an asset manager can do is to arrange a portfolio is such a way that performance approximates the market averages.
Capital Flow Analysis, is based on the assumption that longer-term trends in securities markets are not random, but are the result of capital flows that can be described and, to a certain degree, predicted.
Capital Flow Analysis enhances Modern Portfolio Theory by 'explaining' price trends that would otherwise be unexplained. By combining Capital Flow Analysis and Modern Portfolio Theory, an investor may improve returns.
Relationship to behavioral economics.
Capital Flow Analysis bears some similarity to behavioral economics in that it departs from neoclassical economics assumptions regarding rational behavior. The CFA Irrationality Axiom resembles the 'bounded rationality' of behavioral economists.
Capital Flow Analysis, however, is a practical technique rather than an economic theory. It is based on market observation rather than academic economics.
Capital Flow Analysis as a contrarian approach to investment.
The axioms of Capital Flow Analysis are contrary to some popular investment theories.
For example, the Efficient Market Hypothesis is contradicted by the Irrationality and Motivation Axioms of Capital Flow Analysis.
The similarity of Capital Flow Analysis to behavioral economics and the idea of 'bounded rationality', means that the technique is contrary to some assumptions of neoclassical economics .
Applicability in all capital markets.
Although the discussion of Capital Flow Analysis on this site focuses on the U.S. capital market, the technique is applicable to other markets.
The author of the training modules on this site first employed techniques of Capital Flow Analysis in the emerging Brazilian market, without access to national flow of funds accounts.
Some countries have national flow of funds accounts that may be used for Capital Flow Analysis.
When this is not the case, similar statistics on economic sectors and instruments may serve the purpose.
Relationship to ordinary security analysis.
Analysis of individual securities in the style of Benjamin Graham and David Dodd is compatible with Capital Flow Analysis.
If portfolio performance can be enhanced by market timing and asset allocation using Capital Flow Analysis, results will be improved even more by selecting individual securities based on investment merit.
Uses for individual investors.
Individual investors often keep savings in open-end mutual funds. The primary decision in choosing a mutual fund is that of asset class. In other words, should one invest in a bond fund or a stock fund and, if both, in what proportion?
A basic use of Capital Flow Analysis is in making asset allocation decisions which is useful to investors choosing mutual funds.
Capital Flow Analysis deals with medium and longer term forecasts of market trends. This fits the long-term investment horizon of investors saving for retirement or education of children.
For day traders, Capital Flow Analysis provides insights as to the strength of the overall market, assessing the risk of a major market turn.
Fund managers are often obliged to remain fully invested by their investment contracts. When there is a major market turn, they may not be able to get out of the way.
Modern Portfolio Theory helps managers to produce performance that is comparable to that of competitors, but does little to predict broad market shifts.
Capital Flow Analysis gives portfolio managers a reasoned basis to adjust portfolios in anticipation of changes in market direction.
Applications for bankers and brokers.
Bankers and broker-dealers are in a business in which it is necessary to forecast shifts in behavior of their clients: investors and issuers.
Capital Flow Analysis is useful for this purpose, helping to suggest products to meet changing behavior of market participants.
Utility for market regulators.
Understanding the forces driving capital markets is essential for market regulators. Neoclassical economics may fail to explain fundamental shifts in market behavior. Capital Flow Analysis helps to do this.
In 2005, Federal Reserve Chairman Greenspan mentioned being 'perplexed' as to why long bond rates were falling while short-term rates were rising. As explained on this site, the answer was apparent to capital flow analysts from the Federal Reserve's own flow of funds accounts.
In 1998, Chairman Greenspan similarly misinterpreted behavior in the stock market in his 'irrational exuberance' speech, attributing over-valued stocks to speculation, rather than to corporate stock buybacks and tax deferred investment, as described on this site.
What basic skills are required?
Capital Flow Analysis does not depend on neoclassical economics or mathematics. However, a foundation in what used to be called 'a liberal education' is helpful, especially knowledge of history, human behavior, and cultural change.
A background in business and knowledge of law, taxation, financial institutions, and market instruments is useful.
The tutorials on this site do not presume any particular prior training. There are reading lists that can help to expand background knowledge.
Capital Flow Analysis does require a capacity for independent thinking and the ability to reach conclusions based on observation and commonsense.
How long does it take to complete the training modules?
The tutorials are intended for readers to proceed at their own pace. A fast read through all the modules and essays would probably take only a few weeks, if you had nothing else to do, but to get the best value, efforts should be made to engage in reading from the book lists and offsite links.
How soon will a reader be able to use Capital Flow Analysis?
The basic ideas of Capital Flow Analysis are not difficult to understand. However the method is contrary to common perceptions of rational economic behavior and efficient markets. The reader must overcome ingrained biases of neoclassical economic thinking in order to benefit from Capital Flow Analysis techniques.
