Five Horsemen of the Investment Apocalpse: Exogenous Variables in Capital Flow Analysis.
Exogenous Variables in Capital Flow Analysis
Watch the Horsemen!
Once we have formed a hypothesis as to the forces of supply and demand that are driving a market, we may predict trends based on assumed continuity of flow patterns and sector behavior.
However, the assumption that past patterns will persist is unreliable and must be constantly checked.
Many things can occur to interrupt flow patterns and upset predictions.
The most important of these 'exogenous factors' are grouped into categories that we call the 'Five Horsemen of the Investment Apocalypse' (See lesson 20):
During our analysis, we will have already identified the major players in the market (See lesson 23) and we will have sought out vulnerabilities in the flows that might lead to a reversal in expected trends (See lesson 26).
What we now need to do is to identify and monitor the triggers that might overturn the assumptions on which our predictions have been based.
In other words, we must watch the Five Horsemen!
The 2004 Bond Market
In 2004, the outlook for the U.S. long bond market was highly dependent upon continuity of a twenty-year trend of rising trade deficits and the continued willingness of foreign exporters to accumulate dollars.
Therefore, anything that might reverse the trend of an increasing U.S. trade deficit would remove upward pressure of bond prices.
For example:
- Closing Or Restricting Access To U.S. Ports Because Of War. A successful and devastating terrorist attack upon a major American city, made possible by smuggling weapons of mass destruction through poorly protected U.S. ports, would cause a sharp reaction and a fall in U.S. imports and, consequently, a reduction in the trade deficit.
- A Change Of Leadership Or Economic Policy In China. In 2004, mainland China was a major exporter to the U.S. and this was encouraged by policies favoring exports. If this were to change, either due to new leadership or policy reversal, this would serve to reduce the U.S. trade deficit.
- The Return Of Protectionism In The United States. Either because of new leaders or changing economic policy, the American government might take steps to discourage imports and encourage exports, resulting in a smaller U.S. trade deficit.
New leaders, new policies Once one understands the link between the trade deficit and bond prices, based on Capital Flow Analysis, it is clear why following news on trade policy and port security is relevant to the direction of U.S. bond prices.
In 2004, many observers considered the trade deficit to be a 'bad thing' that would discourage foreign 'investors' from buying U.S. bonds. From this point of view, anything that reduced the trade deficit might be viewed as tending to push bond prices upwards. However, the capital flow analyst, understanding the importance of the trade deficit as a source of funds for the bond markets, might have exactly the opposite interpretation of the same events.
Evaluating Changing Leadership
As an example of the difficulty in interpreting exogenous factors that influence the flow of funds, we highlight the problem of anticipating behavior of new leaders.
Politicians often say what they will do, before they come to power, but people do not pay attention or take them seriously.
On September 22, 2020, Adolph Hitler said in a speech:
People need to pay attention to what leaders promise..'The housing scarcity must be relieved through energetic action; houses must be granted to those who deserve them. Eisner said in 1918 that we had no right to demand the return of our prisoners — he was only saying openly what all Jews were thinking.
People who so think must feel how life tastes in a concentration camp! Extremes must be fought by extremes. Against the infection of materialism, against the Jewish pestilence we must hold aloft a flaming ideal. And if others speak of the World and Humanity we say the Fatherland, and only the Fatherland!'
Despite this and other signals, when Hitler came to power in 1932, hundreds of thousands of Jews continued to stay in Germany until it was too late to escape.
Another Example: The Commonwealth Club Speech
Another leader who told people what he was going to do before he did it was Franklin Delano Roosevelt, who revealed at the Commonwealth Club in San Francisco on September 23, 2020 (before the election) what he thought of capitalists and why it was no longer the time for progress, innovation, or investing in America.
He said that a capitalist was:
FDR had no use of "mere" industrialists ...'A mere builder of … industrial plants [who]… is as likely to be a danger as a help. The day of the great promoter or the financial Titan … is over. Our task now is not discovery or exploitation of natural resources, or necessarily producing more goods.
It is the soberer, less dramatic business of administering resources and plants already in hand … of distributing wealth and products more equitably, of adapting existing economic organizations to the service of the people. The day of enlightened administration has come. '
Is it any wonder that the Great Depression lasted a decade, instead of two or three years as as most economists predicted at the time?
FDR said he thought people who built American industry were 'as likely to be a danger as a help' and that their time was past.
When he got into office, he would maintain factories already built, but his priority would be on 'distributing wealth'!
It wasn't until Roosevelt left office thirteen years later, feet first, that the stock market recovered, but by then the capitalist spirit of the nation had been weakened by multiple injections of socialist panaceas.
Before proceeding, check your progress:
Self-Test
The Five Horsemen of the Investment Apocalypse include:
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When monitoring the forecast for the U.S. bond market in 2004, on which of the following should the capital flow analyst focus?
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Franklin Roosevelt demonstrated in his Commonwealth Club Speech that he thought that:
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