US Capital Market Overview: Direction of Capital Flows
US Capital Market Overview: continued
The Big Picture
Intermediaries
The three main classes of financial intermediaries in the U.S. capital market are:
| Fund Managers |
| Bankers and Brokers |
| Insurance Executives |
Fifty years ago, when the Glass-Steagall Act still governed, financial intermediaries in the U.S. capital market were divided into distinct categories.
Today, however, financial groups, such as Citibank and JP Morgan Chase, offer a wide range of financial products and services under a unified marketing structure.
These intermediaries are regulated by state and federal agencies, and by self-regulatory bodies.
The health of the capital market depends upon the ethics, morals, professional skills, and attitudes regarding risk of these intermediaries. These values are changing, not necessarily for the better.
In recent years, commercial banks have engaged in trading large portfolios of over-the-counter derivatives, giving rise to operational and market risks.
The collapse of Long Term Capital Management in 1998, holding derivatives with notional values of over one trillion dollars, was a warning as to the safety of today's banking practices.
Fixed Income and Equity Markets
Based on market value, about 70% of the U.S. securities market in December 2004 was made up of securitized debt, such as treasury bonds, corporate bonds, and mortgages.
The remaining 30% consisted of equities.
From an investor's point-of-view, contractual and legal obligations of the issuers of securities in the U.S. capital market were as follows in December 2004:
Type of Security |
Principal Receivable |
Income Receivable |
Market Value |
Fixed Income Securities |
100% |
85% |
70% |
Equities |
0% |
15% |
30% |
Although equities account for 30% of total market value of traded securities, investors in equities get nothing at all back from issuers on the principal invested and only about 15% (or less) of total payments of dividends and interest.
This distortion in stock values has been building since the 1960s with the popularization of mutual funds and the spread of the 'Common Stock Legend' — an unquestioning belief that stocks are the safest way to hold long-term assets.
In December 2004, issuers were contractually liable for about $39.1 trillion in principal on bonds and other fixed income securities, but had no obligation to pay anything whatsoever on stocks.
In other words, 30% of the total asset value of securitized financial assets in the U.S. market (about $17.2 trillion in December 2004) can be realized only by selling these assets to someone else. There are no buyers with sufficient funds to acquire this volume of securities.
In December 2004, investors held about $17.2 trillion dollars in equities (at market value), but on the basis of pre-1960 valuation customs, this was from $7 to $10 trillion over-valued. [See the 
training module].
Like the dikes and levees that protected New Orleans from Hurricane Katrina, over-valuation of equities is a weak point in the U.S. capital market that will be tested over the next decades as Baby Boomers retire.
Sources of New Investment Funds
The primary sources of new investment money in the U.S. capital market (other than the reinvestment of business profits) is the personal savings of domestic households and net capital transfers and trade deficits with the rest of the world.
Price levels in the U.S. market are dependent upon the trade deficit and the prestige of the dollar among foreign investors and exporters.
The flow of money available for the capital market flowing from domestic households and foreign investors was as follows in 2004:
| Household savings from income | 100.8 |
| Foreign exporters and investors | 642.6 |
The flows of capital from abroad, mainly related to the U.S. trade deficit, dwarf domestic savings and show how dependent the U.S. has become upon globalization and the supremacy of the dollar as the international trading currency.
Foreign investors prefer to hold dollar balances in fixed income securities. As the trade deficit has grown over the last twenty years, the interest rate on bonds has fallen, due primarily to this massive inflow of foreign capital.
Any serious impediment to international trade or globalization, or anything that weakened confidence in the dollar or in U.S. financial intermediaries, would have a profound effect on the U.S. capital market.
Direction of Capital Flows
In school, we are trained to think of the capital market as a mechanism whereby savings flow from investors to corporations through financial intermediaries.
Corporations invest these savings producing jobs and dividends for the investing public.
This diagram shows the conventional expectation of the 'normal' direction of capital flows:
The national flow of funds accounts show that in the U.S. equity market this 'normal' flow has been inverted for over a decade.
Since the mid-1980s, households (individuals) have been net sellers of equities, while corporations have been net buyers.
Over the last two decades, U.S. corporations have redeemed (bought back) more than one trillion dollars of their own stock, net of new issues.
In contrast, in the bond markets, capital has flowed in the normal direction, form investors to issuers.
By repurchasing more of their own stock than they have been issuing, domestic corporations have inflated equity values over twenty years, causing values to exceed instrinsic worth.
Corporations may not be able to continue to be net buyers of their own stocks indefinitely.
When this practice changes, and fund flows in the equity market will resume the traditional pattern and the price of equities may be expected to fall.
Securitization and Institutional Investors
Flow of funds statistics over the last fifty years show two other significant trends:
- Securitization: In the mid-1970s, starting in the mortgage markets, asset-backed securities have been created, securitizing everything from home mortgages to credit card debt to accounts receivable. This has increased the size of the fixed income market.
- Institutional Investors: Over three decades, pension funds have become the largest asset held by households, even surpassing home equity. Because of this trend and the mass-marketing of open-end mutual funds, corporate control has shifted from individual investors to intermediaries.
These long-term changes show that the structure of capital markets is in constant evolution.
Shifts in market structure have significant effects on security prices.
For example, the shift of corporate control from individual investors and family groups to fund managers and professional executives, has given rise to a stock option-buyback phenomenon that has caused an extraordinary rise in stock prices.
Changing Flows, Changing Structures
Capital Flow Analysis presents a view of financial markets that focuses on long-term shifts in the flow of funds, as well as on the continuing evolution of market structures.
Although the U.S. market is large and complex, by following flow of funds accounts over time, changes in patterns and practices that are reflected in price trends become discernible.
On this site, information on the major players and securitized instruments can be found using the tabs 'players' and 'instruments' at the top of each page.
Before proceeding, check your progress:
Self-Test
A potential weakness in the U.S. banking system is:
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The largest category of financial securities in the U.S. capital market is made up of:
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Significant changes in the U.S. capital market over the last fifty years include:
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learning Module : end
