Basic Capital Flow Analysis: Four Behavioral Patterns of Investors and Issuers
Investors and Issuers: Behavioral Patterns
Reasonable Price
Capital flows must be judged in the light of price trends and levels.
- By noting price trends, we can see who is motivated: buyers or sellers.
- By observing price levels, we can judge the degree to which buyers or sellers are behaving as rational investors or issuers.
Four Behavioral Patterns
The combination of price trends, levels, and buying or selling action yields four distinct behavioral patterns:
- Motivated buyers taking advantage of cheap prices: This is text-book rational behavior for investors.
- Motivated buyers willing to pay high prices: This is the behavior of a speculator, market manipulator, or fool. For example, during the Great Bubble, 401(k) investors kept purchasing stocks, despite record high prices, falling into the 'fool' category. At the same time, corporate issuers were buying back their own stock, intent on manipulating the market to give value to executive options.
- Motivated sellers unloading at cheap prices: This seemingly irrational behavior is consistent with forced selling, such as liquidation of margin accounts in 1930.
- Motivated sellers in a market with high prices: This is rational behavior for investors or market manipulators selling out accumulated positions, or issuers taking advantage of low financing costs.
The Market Is Not Efficient
Despite the so-called Efficient Market Hypothesis, stocks and bonds, like anything else, become too expensive or too cheap from time to time.
Rarely, if ever, do securities sell at their intrinsic value to both buyers and sellers.
Market intermediaries usually pretend that securities are reasonably priced.
However,the business of broker-dealers is better when the public thinks tomorrow's prices will be higher than today's.
Therefore, Wall Street rarely admits that the securities they are trying to sell are expensive. This means that most published opinions on the capital market, usually paid for directly or indirectly by market institutions, tend towards the view that securities are selling at intrinsic value.
In other words, market intermediaries usually pretend that securities are reasonably priced.
How To Judge Price Levels?
The reasonableness of price is determined by comparing current prices with benchmark prices, in the light of past price history over decades, and by comparing current cash yields (dividends or interest) of competing securities (such as corporate bonds vs. treasury bills, or stocks vs. corporate bonds), and by rational analysis of expectations of cash returns.
- In the case of bonds, much research on historical bond spreads and yield curves is available on the Internet. (See James Baker & Associates for information on bond spreads.)
- Some economists claimed that stocks were under-valued throughout the Great Bubble of the 1990s, which shows there is no philosophers' stone to serve as a reliable criteria of value. An example of one economist's method of stock valuation can be found in Dr. Ed Yardeni's web page .
The U.S. Securities and Exchange Commission is silent on the question of reasonable value.
Fair value is not the same as reasonable value.
The regulator's assumption is that with sufficient disclosure of material information, markets will determine 'fair value'. However, 'fair value' is not the same as reasonable value.
Reasonable value is not a precise number. The concept is not applied to individual securities, but rather to a class of securities.
For purposes of Capital Flow Analysis, the measure has only two readings: reasonable or unreasonable.
In the case of equities, measures of reasonable value suggest how far the market may have gone astray from rational behavior, although without a precise measurement.
Measures of Reasonable Value
To help in evaluating supply and demand in the stock market, we describe three measures of reasonable value in the training module on values: 
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The values training module also covers the concept of a shortage or surplus in the supply of equities.
None of the measures of reasonable value are perfect. However, without a notion of 'reasonable value', it is impossible to perceive a possible shortage or surplus of a class of securities.
Without 'reasonable value', we cannot form an opinion as to whether investors are acting rationally.
The measures of 'reasonable value' described in the values module look back one hundred years and are based on the commonsense that ruled U.S. capital markets before the advent of workers' capitalism.
Reasonable Value: The Case of Bonds
Bonds are less likely to stray from our concept of 'reasonable price' than are stocks.
There are two reasons for this:
- Bonds are quoted in terms of yield. This means that the attention of buyers and sellers is fixed firmly on a rational investment purpose for buying bonds: that is, obtaining a return from the issuer.
- Bonds are rated by independent agencies. This establishes a standard as to the likelihood that issuers will make good on their promises to pay interest and principal. There is no comparable rating system for equities.
Furthermore, bond market players habitually refer to yield spreads when comparing different classes of bonds, maturities, and bond ratings.
In contrast, equity markets are quoted in terms of price per share, which, since the concept 'share' has no standard measure, makes it easy for stock prices to stray from value based on the return likely to be paid by issuers.
The bond market is more likely to exhibit a logical structure in pricing than the stock market.
For long periods, stock markets can be dominated by expectations of capital gains (profits from the sale to third parties) rather than by dividend yield (returns paid by the issuer of the stock).
Because of ties to rationality, the bond market is more likely to exhibit a logical structure in its pricing, and, other things being equal:
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Long-term bonds usually have higher yields than short-term bonds;
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Better quality bonds with higher ratings usually have lower yields than riskier bonds;
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Bonds with tax exemption usually have lower yields than bonds without tax exemption;
Fear of inflation and economic hard-times roil the bond markets on occasion, changing the shape of the yield curve.
The fixed-income markets are subject to government manipulation which, in terms of ordinary investor expectations and behavior, would appear to be irrational, but are long-accepted as proper by economists that are in favor of fiat money and central bank hegemony.
Reasonable Value: Summing Up
In any event, the concept of reasonable value is normally not as useful in evaluating supply and demand in bond markets, as it is in equity markets.
The point to take from this lesson is that an idea of 'reasonable value', combined with information on price movements and money flows between market sectors derived from flow of funds accounts, is the key to understanding capital market trends.
Before proceeding, check your progress:
Self-Test
The following are motivated sectors:
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We should consider price levels to be reasonable when:
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Bonds are less likely than equities to stray from our concept of 'reasonable value' because:
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learning module : continued >
Suggested Reading
'Security Analysis: The Classic 1940 Edition', Hardcover, Benjamin Graham, David Dodd The Bible of fundamental analysis, written in an age when prices were still reasonable. |
'Investment Analysis and Portfolio Management', Textbook, Frank K. Reilly, Keith C. Brown Establishment thinking on security analysis. Required reading for CFAs. |
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A detailed account of interest rates and risk management in bond markets |
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Explores every angle of this complex market. |
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Professor Damodaran (NYU Stern School) explains the various ways to value assets. |
'Interest Rate, Term Structure, and Valuation Modeling', Hardcover, Frank J. Fabozzi The valuation of fixed income securities and interest rate derivatives |
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A unique guide for valuing companies as well as equities, bonds, options, futures, and more |
External Links
| James Baker & Associates : Detailed information on bond prices and spreads. [Return] |
| Dr. Ed Yardeni's Economics Network : Well-organized site for macro-economic information. [Return] |
