Capital Flow Analysis in the Open Market: continued
Capital Flows in Context
An Open Market for 'Investment Experts'
Many of the proponents of these various theories and techniques have official claims of professional validity from associations that award certificates of competence and set standards.
- The International Federation of Technical Analysts: This group offers certification of knowledge of Elliot Waves, Kitchin Waves, Juglar Cycles, and Dow Theory (MFTA).
- The CFA Institute: This prestigious body awards certification for knowledge of contemporary investment theory, including such topics as efficient frontiers, capital allocation lines, capital asset pricing model, betas, equity risk premiums, Tobin's Q, Sharpe ratio, value at risk, and option pricing.
- Center for the Study of Cultural Astronomy and Astrology: The Bath Spa University College in England offers a Masters program in cultural astronomy and astrology, accepting federal loans from students from the U.S.
- American Academy of Financial Management: This association offers a long menu of financial certifications: CWM, CAM, CPM, MFP, FAD, CTEP, and RFS.
- Professional Risk Managers Association: In conjunction with colleges and universities, this group offers certification in professional risk management. (PRM)
- Certified Financial Planner Board of Standards: This association offers certification as a CFP.
This is just a partial list of investment professional designations.
Meeting Objections
The capital flow analyst that presents a thesis to a group of investment professionals is almost certain to be challenged by competing analysts, bearing a variety of credentials, who not only have never heard of flow of funds accounts but who are skeptical that such information could be of use, because it was not included in the curriculum of their particular institute.
This means that the capital flow analyst should anticipate objections that might be made by those holding views based on opposing market theories.
The analyst must do double duty researching, not only to make sure of the facts on which forecasts are based, but also to build counter-arguments for anticipated objections.
Most objections can be expected to based on:
- Objections to Irrationality: The Efficient Market Hypothesis and markets driven by rational investors, acting in an expected manner, are beliefs that dominate the market. The capital flow analyst is also influenced by these beliefs and needs to focus on facts so as not to fall into the 'rationality trap'.
- Unfamiliarity with Facts: The flow of funds accounts reveal patterns that are often unknown to professionals who do not study this data.
- Opinions of Market Icons: In April 2004, Bill Gross, the bond market super-pundit and boss of PIMCO, advised bond investors to 'get out of Dodge', predicting that rates on long bonds would be much higher by year end.
- It turned out that Bill Gross was wrong (primarily because his reasoning was based on 'investor rationality'), but nevertheless, pronouncements of this nature from famous players mean extra work for the unknown capital flow analyst who dares to take an opposing view.
Greenspan's 'irrational exuberance' showed he had misread investor behavior.
Capital Flow Analysis is in some ways related to Behavioral Economics in that there is a shared skeptical view regarding economic rationality. The first Nobel prize for contributions to behavioral economics was awarded to a psychologist, Daniel Kahneman, in 2002.
When we come to present a thesis regarding market trends to clients, we should keep the following in mind:
- Capital Flow Analysis is at least as 'scientific' as other techniques used by capital market professionals;
- The Federal Reserve flow of funds accounts are a respected and credible source of data, even though many market professionals may not know how to use this information.
Consequently, a prediction based on well-researched analysis of flow of funds data, succinctly presented in language that assumes that the client knows nothing about Capital Flow Analysis, is apt to be received with respect, especially if the analyst holds in reserve detailed factual justifications for anticipated objections based on commonly-held misconceptions.
Support from Long-Term Data
Let us say that it is 1999 and you, the capital flow analyst, are trying to make a forecast for the U.S. equity market.
You know that equity prices have been driven up by massive corporate buybacks for more than a decade.
You also know that equities, in historical terms, are dramatically over-priced.
Because the equity bull market is still raging on, you know that a prediction that the stock market might be in for difficulty in 2000 will be met with hoots of derision.
You run over in your mind the objections you expect to hear from those adept in Modern Financial Theory:
- Dividends are the same as capital gains, and buybacks are more tax efficient than cash dividends;
- Buybacks are in the best interest of all investors;
- There is reason to believe that buybacks will continue to boost stock prices indefinitely.
The first two objections have to do with the ethics of buybacks and are not the main determinant in your forecast, since you don't expect market perceptions of ethics to change rapidly.
However the question that is directly related to your prediction of a risky market for equities in 2000 is whether corporations can really continue the practice of buybacks indefinitely.
Here you need to know:
- Has the percentage of earnings spent on buybacks remained constant?
- Has cash retained in the corporation after buybacks and dividends remained constant?
It the answer to both of these questions is yes, then buybacks may indeed continue to support equity prices for some time.
Before proceeding, check your progress:
Self-Test
There is no assocation certifying knowledge of:
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The capital flow analyst should anticipate objections from people who :
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Capital Flow Analysis is in some ways similar to:
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