Synthesis of Final Steps: Capital Flow Analysis
Capital Flows in Context
In this learning module, we have examined the process of Capital Flow Analysis as a series of steps:
The process of Capital Flow Analysis is a series of steps.
- Using Federal Reserve flow of funds accounts, we begin with the instrument flow table for the market we are studying.
- In the instrument table, we identify motivated sectors and then examine the reasonableness of prices.
- We note the main players from the instrument table.
- We attempt to explain flows based on sources and uses of funds from the sector tables of the big players in the market that we are studying (Level One Analysis).
- We then try to explain flows better by examining institutional structures, sociology, historical background, and other factors related to this market. (Level Two Analysis).
- Next, we try to identify structural weaknesses and events that might trigger a reversal of trends.
Final Synthesis
The final and most difficult step is to synthesize a conclusion out of the observations that we have made during our analysis, using imagination and commonsense to express an opinion as to the stability and probable direction of price trends.
The result should be a succinct, coherent explanation of supply and demand.
This final synthesis should be a succinct, coherent explanation of supply and demand factors that control a particular market, along with an evaluation of the likelihood that current patterns will persist.
This final synthesis should be based on national flow of funds accounts, bringing together observations from four areas of analysis:
- Price Trends: The general movement of prices in our market segment compared to relevant capital flows over the period.
- Asset Values: The relationship of average prices in our market segment compared to the intrinsic value of the asset class.
- Flow Patterns: Net volumes of purchases and sales, and net sources and uses of funds of the players, relevant to our market segment.
- Historical Background: Information about the history, sociology, law, ethics, operations, and institutions that are related to the market and the behavior of players.
The final synthesis involves putting the pieces together.The final result should be simply expressed and characterized by consistent logic that can be understood by investors that do not have extensive technical background or familiarity with Capital Flow Analysis.
The Need for Careful Argumentation
Modern Portfolio Theory, Graham & Dodd's 'Security Analysis', and other techniques used by Wall Street professionals have been popular with two generations of market forecasters.
However, Capital Flow Analysis is still unknown to most investment analysts. As of 2005, the subject was not mentioned in the Chartered Financial Analysts' curriculum.
Many Wall Street professionals have never examined flow of funds accounts.
Many Wall Street portfolio professionals have never examined Federal Reserve flow of funds accounts.
It is likely that other market professionals will not know what you are talking about when you refer to sector tables or the Motivation Axiom.
When you present a market analysis to a client, you will not be able to use recognized buzz words or easy references to support your argument.
This means that your thesis must be backed by commonsense reasoning and argumentation that can be understood by those with no knowledge of Capital Flow Analysis.
How Scientific is Capital Flow Analysis?
We would argue that it is far-fetched to claim that any method predicting behavior of capital markets is scientific.
However, Capital Flow Analysis does attempt to construct a representation of the real world and makes use of three of the four steps in the scientific method:
- We use data collected by the Federal Reserve Bank Flow of Funds Division, as well as factual information from other sources, to build a description of supply and demand that drives securities markets;
- Based on this description, we formulate a hypothesis regarding the logical causal relationship between security prices and capital flows;
- Using this hypothesis, we try to predict the direction of prices in a particular market.
We gather data, formulate hypothesis, and make predictions.However, we do not come up with 'laws' or mathematical formulae that might be re-used in the same market for predictions six months or a year later.
We do eventually find out whether our predictions are right or wrong, and this may be useful wisdom for making future forecasts, but no economic laws are developed.
A World of Pretenders
Although Capital Flow Analysis has no scientific pretensions, the technique has a basis in observation and commonsense, and is at least as valid as some techniques that have thousands of followers in the market today:
Capital Flow Analysis is at least as valid as some techniques that have thousands of followers.
- Gann Geometry: These chartist methods are based on the assumption that only three factors determine future asset prices: price, time, and range. W.D. Gann based his 'scientific method' on the 'law of vibrations', inspired by advances in wireless telegraphy in the early 20th century.
- Elliot Waves: This chartist 'scientific method' is based on numerology and the Fibonacci sequence. Ralf Elliot claimed that, 'All human activities have three distinctive features, pattern, time and ratio, all of which observe the Fibonacci summation series.'
- Financial Astrology and Pyramidology: There are many adepts to theories that relate stock market trends to the stars, planets, and the shape of the Great Pyramid, such as James Mars Langham, F.C. Dutt, Syharial, and George Bayer.
- Contemporary Investment Theory: This is an acclaimed set of investment techniques, based on writings of Harry Markowitz, Merton H. Miller, Franco Modigliani, William Sharpe, Myron S. Scholes, Robert C. Merton, Fisher Black, and others. Much of this work relies on abstruse mathematics and unrealistic assumptions, such as perfect markets, riskless operations, free information, legal certainty, perfect knowledge, and the equivalence of capital gains and dividends. These theories are widely touted as 'scientific' because of their reliance on mathematics and because of Nobel prizes in 'economic science' awarded to their leading proponents.
People believe in a lot of things that are not based on science.The essay, 'Fallacies of the Nobel Gods', shows the extremely slim scientific basis of the most respected investment theories that dominate today's capital markets.
With this perspective, a capital flow analyst has no reason to be shy when advancing a thesis based on the Federal Reserve flow of funds accounts, solid research, and commonsense.
Before proceeding, check your progress:
Self-Test
In the final synthesis of Capital Flow Analysis, we consider:
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Which of the following is not true about Capital Flow Analysis?
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Capital flow analysts might expect:
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