Basic Capital Flow Analysis: Market Behavior of the Players: Motivation of Issuers and Investors
Motivation of Issuers and Investors
Finding Other Motivation
We expect that a 'rational' investor will try to acquire stocks that have high 'intrinsic value' as measured by growth and reliability of earnings and dividends.
We also expect that uncertainty about earnings and dividends of a specific company will lead a prudent investor to select stocks of many companies in order to diversify risk.
Proponents of Modern Portfolio Theory do not pretend to understand systemic risk.
However, no matter how many stocks the investor selects, it is impossible to eliminate all risk by diversification.
There always remains market risk, or to use the term of Modern Portfolio Theory, systemic risk.
Systemic risk cannot be eliminated by diversification.
However, by selecting stocks that, based on past behavior, are expected to react in opposing ways to market movements, systemic risk may be reduced.
Techniques for reducing systemic risk are the basis of Modern Portfolio Theory (MPT).
Proponents of Modern Portfolio Theory do not pretend to understand the causes of systemic risk.
In fact, common wisdom is that systemic risk is unknowable and unpredictable; therefore market timing that might evade market risk is considered a foolish pursuit.
Beyond Modern Portfolio Theory
Capital Flow Analysis goes beyond Modern Portfolio Theory and tries to explain systemic risk by studying national flow of funds accounts, seeking to discern the underlying forces of supply and demand.
Irrational motivation is often the elusive explanation for systemic risk.
A key concept of Capital Flow Analysis is motivation --- the reason why groups of investors or issuers act as they do.
Sometimes this motivation is 'rational', as the actions of the investor described above.
However, Capital Flow Analysis also allows for 'irrational' motivation, which is often the elusive explanation for systemic risk.
Overcoming Common Bias in Analysis
Although systemic risk is real, the financial media and Wall Street pundits almost always attribute market movements to 'rational' motives of investors.
If the market falls, the reason is something like 'investor disappointment with earnings' or 'profit taking'.
Here are some of our common biases:
A limited role of issuers:
Corporations are often portrayed as passive figures in the stock market. Their main influence on price formation is that of producing profits and paying dividends.
Buybacks of over one trillion dollars went virtually unnoticed.
The massive stock buybacks that dominated the market over the last generation, totaling over one trillion dollars, went virtually unnoticed as the primary cause for the long bull market.
Instead, the upward price trend was attributed to improved earnings and exceptional corporate growth, although not supported by fact.
The importance of foreign issuers in neutralizing buybacks by domestic corporations in 2000, one of the prime reasons for the market break, also went unnoticed.
The dominant role of speculators:
Much financial reporting is couched in terms that would be appropriate to a market dominated by short-term traders. Supposedly, prices zip up and down in response to profit taking or the ebb and flow of investor confidence.
Systemic risk is often explained not by speculation but by long-term capital flows.
The fact is, as can be verified in flow tables for U.S. households, individual investors have been net sellers of equities for a generation.
Instead, their stock purchases have been made indirectly through mutual funds, often on the 'automatic pilot' mechanism of 401(k) plans.
Mutual fund investors have been motivated by the Common Stock Legend, not by reports of improved earnings of individual companies.
These fund investors have proved remarkably constant in their belief in the market, despite market swings.
Although speculators may influence extreme short-term trading, the major market moves that account for systemic risk are best explained by examining the flow of funds accounts.
Ignoring the role of foreigners:
Foreign investment, especially in the bond market, has been an important cause of the fall in long-term interest rates over the last generation.
This money, however, comes not from individuals or institutions seeking higher yields, but from foreign exporters anxious to accumulate dollars.
The trade deficit is almost never portrayed as the driving force in the bond market, although this has been the case for a generation.
Also, foreign issuers, as mentioned above, were important in neutralizing the effect of domestic buybacks.
It is understandable why the financial media, under pressure to explain why prices rise and fall, rushes to bring out 'the usual suspects' as the cause of price movements, even though, Modern Portfolio Theory asserts that systemic risk is largely unexplainable.
Reporters can always find traders and 'experts' who will jump at the opportunity to appear on television or in the press.
Trying to Explain Systemic Risk
There are many reasons why people buy and sell securities.
The Irrationality Axiom states that these reasons are not always related to rational analysis of the intrinsic value of the securities or the investor's own self-interest.
This is consistent with Modern Portfolio Theory and the notion of systemic risk.
However, unlike followers of MPT, capital flow analysts believe that systemic risk can, in fact, be explained, if one starts by examining national flow of funds accounts.
Compulsive Behavior
Sometimes investors are compelled to buy or sell securities by law, institutional rules, custom, or life circumstances, unrelated to their understanding of the value of the securities based on merit.
For example:
Aging Baby Boomers
Baby Boomers will need to sell equities over the first three decades of the 21st century, as they liquidate assets to pay escalating costs of old age care and living expenses in retirement.
They will do this, irrespective of the value of the stocks they sell. The unforgiving laws of tax deferral and biological necessity will force this group to sell stocks for decades to come.
Faith in the Common Stock Legend
Millions of Americans buy stock indirectly through payroll deduction in 401(k) plans, with no knowledge of the stocks they are buying or any idea of the intrinsic worth of their portfolios.
They do so because of they have faith in the Common Stock Legend and because their co-workers are doing the same thing.
Margin Requirements
Following the stock market crash of 1929, banks and brokers sold equities from client's accounts in order to pay off securities loans.
Both the investors and their creditors were compelled by contract and institutional rules.
Executive Greed and Buybacks
Corporate managers bought back stocks of their own companies at increasingly higher prices during the 1980s and 1990s. In so doing, they diverted corporate assets from long-term shareholders to speculators and to executives exercising stock options.
This irrational and immoral behavior was sanctioned by market mores and winked at by the SEC.
Fund Managers Following Orders
Mutual fund managers will buy equities, no matter how high the price, as long as investors buy shares in their fund faster than shares are redeemed.
When investors are buying, as they do through 401(k) plan payroll deductions, the fund managers continue this irrational behavior because of market custom and the legal and institutional constraints on mutual funds.
Market players are bound by legal, societal, biological, political, and other constraints that force them to act in certain ways.
Their motives are often unrelated to the rational economic behavior that is taught in Economics 101.
In flow of funds analysis, we need to identify these other motives and constraints, not for individuals, but for groups of players that appear to act in concert.
Looking for Motivation
In order to find the motivation that drives sectors of the capital market, here are some guidelines:
Focus on Decision Makers:
Rather than thinking of economic sectors in abstract terms (such as 'nonfarm nonfinancial corporate business' or 'mutual funds'), think of these groups as crowds of decision makers, such as 'corporate executives' or 'fund managers'.
Pay Attention to 'Motivated' Buyers and Sellers:
Motivated sectors are those that are buying in a rising market or selling in a falling market. We presume that motivated buyers or sellers drive the market. Therefore, motivated sectors should be the primary focus of our attention.
Identify Behavior That Appears Rational:
In the case of equities, note whether motivated buyers are buying in a market that appears under-valued, and whether motivated sellers are selling in a market that appears over-valued. Just because we don't believe in the economist's Rational Man doesn't mean that market players are always irrational.
Check How Purchases are Financed and How Sales Proceeds Are Used:
An important clue to the motivation of buyers or sellers is how purchases are financed and how sales proceeds are used. This can be found by studying the flow of funds tables of the relevant sectors. In flow of funds analysis we 'follow the money'.
Find Institutional and Legal Constraints:
When behavior appears irrational and when financing of purchases or use of sales proceeds does not explain players' motivation, it is necessary to seek other reasons for behavior. Often there are institutional and legal constraints. Research on the Internet and in recommended readings often provides the explanation needed.
Supplemental Research
Supplemental research is the hardest part of analysis.
Players may go to extremes to disguise their motives with rationalizations and excuses.
Player often do not reveal the reasons for their behavior. They may go to extremes to disguise their motives, presenting rationalizations and excuses.
Unethical and selfish motives are presented in altruistic and high-minded terms, with the backing of governments, universities, and leaders of the establishment.
The practice of stock buybacks is a case in point.
Market players often do not realize why they act in certain ways, since they are bound by custom.
The essays on this site provide analyses of the market during the Great Bubble that provide ideas on how additional research might proceed.
Persistence of Motivation
Once the motivation of major sectors is determined, we need to ask how long this motivation might be sustained, both financially and culturally.
Some types of motivation have lasted for more than a generation.
This is the basis for judging the vulnerability of market prices.
Some types of motivation, such as the buyback movement or the Common Stock Legend, have lasted for more than a generation.
Other reasons for price changes are transitory, such as the chaos in the market following disequilibriums caused by programmed trading in 1987.
Just as a security analyst cannot be sure of intrinsic value, the flow of funds analyst cannot be certain of correctly identifying group motivation.
Building a 'Story'
However, to explain the market we need to have a hypothesis.
In Capital Flow Analysis, it is necessary to compose a 'story' that hangs together and makes sense.
With limited time and resources, the explanation of one analyst will certainly differ from that of the next, but as we gather more information, our story should develop and become more robust.
In this way we create an evolving hypothesis that we hope will be useful in guiding investment decisions.
Before proceeding, check your progress:
Self-Test
Modern Portfolio Theory provides a way to reduce but not eliminate:
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According to Modern Portfolio Theory, systemic risk can be:
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Capital Flow Analysis differs from Modern Portfolio Theory by using flow of funds analysis to explain:
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learning module : continued >
Suggested Reading:
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Covers the full range of theoretical perspectives and substantive topics through readings that are either classics in the field or widely discussed and debated new classics. |
'The Organization Man', Paperback, William H. Whyte, Joseph Nocera, Jenny Bell Whyte A classic in business history and sociology. Portrays American executives at mid-century. Useful to put current behavior in perspective. |
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This book, savagely attacked by the liberal establishment, points out the obvious: smarter people generally are better off than dumber people. The statistics are useful in some areas of Capital Flow Analysis. |
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A marketing approach to the geo-demographics of the United States. |
'The Hell-Fire Clubs: A History of Anti-Morality', Paperback, Geoffrey Ashe An excellent history of the Hell-Fire Club Phenomenon in 18th Century England. |
'Foundations of Social Theory', Paperback, James S. Coleman, Deepak Lal Professor Coleman attacks the economist's model of competitive equilibrium as a 'broadly perpetrated fiction'. |
'Behavioral Law & Economics', Paperback, Cass R. Sunstein Behavioral economics is useful in Capital Flow Analysis. |
'The New Golden Rule: Community and Morality in a Democratic Society', Paperback, Amitai Etzioni Etzioni contends Americans have overemphasized individual rights in recent years and seeks to restore an equilibrium between personal liberty and the common good. |
External Links
| 401(k) Plans : Investment FAQ, 401(k) retirement plans. 25 Nov 2020 [Return] |
