Covariance, Locked-in Asset Allocation, and Capital Flow Analysis

Market Covariance, Locked-In Asset Allocation, and Capital Flow Analysis Locked-In Asset Allocation : Continued

Asset Allocation

Covariance and The Great Leviathan

It doesn't take much money to improve covariance.

The average daily trading volume for an issue listed on the New York Stock Exchange is only about ten to twenty million dollars, and the median volume per issue is far less.

With 300,000 speculators running through the market seeking 'bargains' in terms of relative price, concentrating attention on this or that issue, price covariance improves.

From the point of view of the speculators, they are the 'Masters of the Universe', capable of moving markets.

Speculators are useful scavengers, playing musical chairs on the back of a Great Leviathan.

In fact, they are only useful scavengers, making a good living by straightening up the musical chairs after the Great Leviathan — the real market — shifts beneath their feet.

Although speculators are usually blamed for excessive highs or great crashes, they really do not have the leverage that many think they have.

As we have seen, the Great Bubble of the 1990s was not driven by speculation, but rather by plodding, methodical long-term investment by the 'little guys' contributing to IRAs and 401(k)s, while corporate executives used buybacks to manipulate prices to give value to stock options.

Although there were a lot of people working up a sweat in day trading, helping to improve covariance, there was no 'irrational exuberance' to blame for price levels; only the outmoded belief in the Common Stock Legend and the greed of corporate executives and fund managers lining their pockets, justifying their actions with asset-lite excuses.

The CFA Market Model

This then is our view of price determination in the securities market:

A small group of speculators, like fleas playing musical chairs on the back of a Great Leviathan, adjust spot prices, while the monster heaves and shifts beneath their feet.

Most Wall Street reporting pays attention to the antics of the speculators and their attempts at buying cheap and selling dear.

Capital Flow Analysis attends to the Great Leviathan itself.

However, Capital Flow Analysis attends to the Great Leviathan itself and the deep forces of supply and demand that cause the market to shift, rise, and fall.

Short-term market timing based on the speculators' game of musical chairs is a waste of time: too many are playing.

However, long-term market timing based on an understanding of basic supply and demand is another matter: the game is far too slow and decision points too infrequent to attract much attention among the chattering classes of the financial press.

However, the payoff can be worth the effort.

'Locked-In' Asset Allocation

In making decisions for long-term asset allocation, we must adopt a different stance from that of market timing.

'Locked-in' asset allocation decisions may be valid for ten or even fifteen years, but beyond that, we need a trustee who can make contemporaneous decisions.

'Locked-in' asset allocation, even when necessary, is not valid beyond fifteen years.

For example, we might use long-term asset allocation for setting up a trust fund for the college education of a child who was five years old, but a retirement fund for the same child should be handled at the discretion of an institutional trustee.

There are essentially three considerations for long-term asset allocation:

Unless an asset class rates favorably in each of these three categories, it should not be chosen for long-term asset allocation.

When no reasonable class of assets can be found that meet these three criteria, the only solution is to turn to an institutional trustee.

Capital Flow Analysis play a part primarily in determining the structure of supply and demand in the market for an asset class.

 

Before proceeding, check your progress:

Self-Test

When 'locking-in' a long-term asset allocation, we should pay attention to:
Choice 1 Current prices compared to intrinsic values.
Choice 3 The stability of the government.
Choice 4 The outlook for property rights.
Choice 2 Opinions of short-term traders.
In Capital Flow Analysis, we attribute major market moves to:
Choice 2 Activities of day traders.
Choice 1 Long-term sociological trends.
Choice 3 The 'buzz' among speculators.
Choice 4 Trends in underlying capital flows.
Stock market speculators tend to:
Choice 2 Improve price covariance.
Choice 3 Drive long-term price trends.
Choice 1 Attract attention of the news media.
Choice 4 Assure liquidity when all investors sell.

Learning Module: Steps in Capital Flow Analysis  learning module : continued >

Suggested Reading in Capital Flow Analysis
'All About Market Timing', Paperback, Lee Masonson

Provides investors with simple timing techniques to use on entering rising markets and exiting falling markets.

'Asset Allocation: Balancing Financial Risk', Hardcover, Roger C. Gibson

A comprehensive overview of the capital market theory behind asset allocation as well as systematic guidelines for designing and implementing appropriate asset allocation strategies.

'The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk', Hardcover, William J. Bernstein

How to assess how risk according to personal needs, and the fundamental relationship between risk and reward in financial markets.

'The Art of Asset Allocation: Asset Allocation Principles and Investment Strategies for Any Market', Hardcover, David M. Darst

A framework for using asset allocation as an investment strategy in bull, bear or non-trending markets.

'Global Asset Allocation: New Methods and Applications', Hardcover, Heinz Zimmermann, Wolfgang Drobetz, Peter Oertmann

The application of modern statistical modeling of time-varying risk and return to the study of global asset allocation, with empirical results and methodologies that shed light on the benefits of international diversification.

'Irrational Exuberance and the Illusion of Prosperity', Hardcover, Don DeVito

Published in 2000, this book warned that Americans were living in an economic dreamland, and that the long bull market and low unemployment had made people immune to economic reality.

'Reminiscences of a Stock Operator', Paperback, Edwin LeFevrestar

This Wall Street classic is a thinly disguised biography of Jesse Livermore, a remarkable character who first started speculating in New England bucket shops at the turn of the century.

'Extraordinary Popular Delusions and the Madness of Crowds & Confusion de Confusiones', Hardcover, Martin S. Fridson, Josef de la Vegastar

The excerpts of these two classics — first published in 1841 and 1688, respectively — show that the madness and confusion of crowds knows no limits, and has no temporal bounds.

'Once in Golconda: A True Drama of Wall Street 1920-1938', Hardcover, John Brooks

The stock-market boom of the twenties, the crash of 1929, the Depression, and the coming of the New Deal. Its leitmotif is the truly tragic personal history of Richard Whitney, the aristocrat Morgan broker and head of the Stock Exchange, who ended up in Sing Sing.

'Studies in Tape Reading', Paperback, Rollo Tape star

Rollo Tape is the colorful pen name of Richard D. Wyckoff. This 1910 classic on tape reading and stock market tactics is by one of its most astute students. Wyckoff for many years was a publisher of the Ticker Magazine which was later changed to The Magazine of Wall Street. He contributed more to the study of price movements than anyone else in America.

'The Art of Speculation', Paperback, Phillip L. Caret

First published in 1930, The Art of Speculation by Philip Carret has long been praised for its perceptive examination of the various ways that speculation impacts the worlds of both business and financial trading. Now, almost seven decades later, a newly updated edition proves as instructive as ever on this and related investment topics such as short selling, government regulation, options, and arbitrage. Chapters on reading a balance sheet and an income statement remain classics.

'Stock Market Technique Number One', Paperback, Richard D. Wyckoff

First published in 1933, this book contains principal articles, editorials and correspondence originally published in the magazine Stock Market Technique from March 1932 to July 1933, inclusive.

'Stock Market Technique Number Two', Paperback, Richard D. Wyckoff

This is a compilation of articles, editorials, correspondence and good sayings originally published in the magazine Stock Market Technique between August 1933 and May 1934, inclusive.

'Speculation as a Fine Art and Thoughts on Life', Paperback, Dickson J. Watts

Watts was president of The New York Cotton Exchange between 1878 and 1879, which was then one of the greatest arenas of speculation in America.

'Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages', Hardcover, Carlota Perez

Draws upon Schumpeter’s theories of the clustering of innovations to explain why each technological revolution gives rise to a paradigm shift and a ‘New Economy’

'Asset Pricing under Asymmetric Information:Bubbles, Crashes, Technical Analysis, and Herding', Hardcover, Markus Konrad Brunnermeier

An account of how bubbles and crashes and various other phenomena can occur.

'Famous First Bubbles: The Fundamentals of Early Manias', Hardcover, Peter M. Garber

Professor Garber debunks the myths surrounding tulip mania, as well as its sisters in mythology, the South Sea bubble and the Mississippi bubble.

'Wall Street: A History', Paperback, Charles Geisst

A meticulous examination of the economic cycles, legendary financiers, and monumental transactions that have shaped the fiscal structure of the United States.

'Wall Street', Hardcover, Robert Gambee

The most complete profile of the world's greatest financial center—celebrating the beauty, strength, and resiliency of an extraordinary community.

'The Collapse of Barings', Hardcover, Stephen Fay

A close look at Barings Brothers, one of England's most prestigious banks (used by the Queen) and how it went bust after a young employee working out of its Singapore office managed to 'lose' £860 million over 32 months without anyone apparently being the wiser.

'The McGraw-Hill Handbook of American Depository Receipts', Hardcover, Richard J. Coyle

What ADRs are and how they work, which companies offer them for sale, how ADRs have performed historically and how they can be expected to perform now and in the future.

'Trillion Dollar Bet: NOVA 2000', VHS Tape

One of the best NOVA productions, ever, this tape covers the 1998 financial collapse of Long Term Capital Management.

'Institutional Investors', Paperback, E. Phillip Davis, Benn Steil

A comprehensive economic assessment of institutional investment

'The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders', Paperback, Connie Bruck

The rise and fall of Drexel Burnham and Michael Milken.

'Greed and Glory on Wall Street: The Fall of the House of Lehman', Paperback, Ken Auletta

Auletta chronicles the activity at Lehman Brothers during the months between July 1983 and April 1984, immediately preceding the firm's takeover by Shearson/American Express.

'The Breaking of Nations: Order and Chaos in the Twenty-First Century', Hardcover, Robert Cooper

As terrorism grows more powerful and the 'premodern' world more unstable, sophisticated weaponry becomes more readily available to terrorist organizations. It then falls to the enlightened 'postmodern' countries to intervene militarily, taking a preemptive approach when necessary, to contain threats, root out bad guys, and defend the world.

'Present Dangers: Crisis and Opportunity in American Foreign and Defense Policy', Paperback, Robert Kagan, William Kristol

America's most significant threats come from within, rather than without.

'Practical Speculation', Hardcover, Victor Niederhoffer, Laurel Kenner

A popular, commonsense work on stock speculation.

'The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America', Hardcover, Alex Berensen

As stock options became a major element in executive compensation and the consulting role of audit firms increased while the SEC neglected to pursue fraud on any major scale, corporate executives' motives to manipulate 'the number' met with a perfect opportunity to defraud unsuspecting investors.

'The Plungers and the Peacocks: 170 Years of Wall Street', Paperback, Dana L. Thomas

Using interviews with 'old-timers' who lived through the events of the Street from the 1920s to the 40s and memoirs, and letters, the author has produced a sweeping narrative of 'the games people played' in establishing America's financial center.

'Trading & Exchanges: Market Microstructure for Practitioners', Hardcover, Larry Harris

About trading, the people who trade securities and contracts, the marketplaces where they trade and the rules that govern it.

'The Crowd: A Study of the Popular Mind', Paperback, Gustave Le Bon star

One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more.

'The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s', Paperback, John Brooks

The harrowing and humorous story of the growth stocks of the 1960s and how their meteoric rise caused a multitude of small investors to thrive until the devastating market crashes in the 1970s.

'Origins of the Crash: The Great Bubble and Its Undoing', Hardcover, Roger Lowenstein

Explains the stock market crash of 2000 and the ensuing corporate scandals. The ingredients are familiar: executive overcompensation and stock options, irrationally exuberant shareholders, friendly auditors, short-term focus by financial professionals and overemphasis on shareholder value.

'The Great Game: The Emergence of Wall Street as a World Power 1653-2000', Paperback, John Steele Gordon

The history of Wall Street and its transition from a backwater trading post to the core of global financial power.

'Stock Market Profits', Paperback, R. W. Schabacker star

Written in 1934, this is still one of the best investment books of all times.

'Psychology of the Stock Market', Paperback, G.C. Selden star

As author G.S. Selden says in his original preface, 'This book is based upon the belief that the movements of prices on the exchanges are dependent to a very large degree on the mental attitude of the investing and trading public.' Originally published in 1912.

'Asset Prices, Booms and Recessions: Financial Market, Economic Activity and the Macroeconomy', Hardcover, Willi Semmler

How economic activity affects asset prices and the financial market and how asset prices and financial market volatility feed back to economic activity

'The Boom and the Bubble: The U.S. in the World Economy', Paperback, Robert Brenner

Carefully dismantling the myths and hype that surround the US expansion, Brenner shows that transcending economic stagnation in the near future is anything but a foregone conclusion.

'Contours of Descent: U.S. Economic Fractures and the Landscape of Global Austerity', Hardcover, Robert Pollin

'1929 Stock Market Crash', Brooklyn Daily Eagle, October 24, 2020, 26 pages reprinted edition.
'Global Capital Supply and Demand: Is There Enough to Go Around?', Paperback, Zia Qureshi

World Bank economist concludes that the supply of capital will be tight in the years ahead.

'Patterns of Speculation: A Study in Observational EconoPhysics', Hardcover, Bertrand M. Roehner

Behind the bewildering diversity of historical speculative episodes it is possible to find hidden regularities, thus preparing the way for a unified theory of market speculation.

'Against the Gods: The Remarkable Story of Risk', Paperback, Peter L. Bernstein

A comprehensive history of man's efforts to understand risk and probability

'FIASCO: Blood in the Water on Wall Street', Hardcover, Frank Partnoy

According to Partnoy, a former trader at Morgan Stanley, the derivatives market is an elaborate illusion performed with smoke and mirrors, with slick deals that are just this side of outright fraud.

'Capital Ideas: The Improbably Origins of Modern Wall Street', Paperback, Peter L. Bernstein

Bernstein traces the merging of academic research with the curbstone techniques of Wall Street.

'The Money Flood: How Pension Funds Revolutionized Investing', Hardcover, Michael J. Clowes

How the pension fund industry came to dominate the financial markets and how its growth is likely to have an affect in the years ahead. Reveals what is expected once the Baby Boomers begin to cash in on 401(k) as opposed to the traditional pension managers.

'Goldman Sachs: The Culture of Success', Paperback, Lisa Endlich

An insiders view of Goldman Sachs written by a former vice president.

'Who's Afraid of Adam Smith? How the Market Got Its Soul', Hardcover, Peter J. Dougherty

Adam Smith understood that free markets could only flourish in societies with generous amounts of social capital and strong institutions of civil society.

'Civilization and Its Enemies: The Next Stage of History', Hardcover, Lee Harris

Unlike those who see the terrorist attacks of 9/11 as the outbreak of a new war between radical Muslims and modern Americans, Harris views those attacks as the decisive reemergence of an ancient cultural conflict stretching back to Sparta and Rome.

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