Graph: US Stock Market Flow of Funds Flow of Funds Graph: US Stock Market

Case Study (Continued)

Flow of Funds Graph: US Stock Market: the Great Bubble

Graphing the Flows

In order to better see the relationship between supply and demand in the equity market, we have taken the raw data from flow table F.123 , and after arranging the sectors in groups with similar motivation, have plotted the net purchases and sales from 1985 to 2003 (see the graph, below).

Three groups of players stand out:

On the graph, there are several things to note.

The first is the sharp fall in the net buying action of corporations and mutual funds in 2001 and 2002 (the green bars).

Domestic corporations had become constrained by the natural limits on buybacks relative to profits, while foreign issuers were stepping up new issues.

Another highlight is the massive withdrawal of 'smart' institutions from equities in 1999 (light blue bars).

By 2000, rising stock prices had become dependent upon the doubtful ability of domestic corporations to finance buybacks in ever larger amounts and the willingness of foreign individuals to continue to pour record amounts into U.S. equities.

The graph shows that prior to 1993, although traditional flows from investors to issuers had been reversed by the buyback movement, prices were still reasonable and flows showed a more or less even pattern.

After 1993, prices began to enter the realm of the unreasonable and the net buying and selling flows progressively increased.

By 1995, the 'smart' institutions were bailing out of the market.

An Abundance of Signals

A  strong bull market must be fed by an ever-increasing buying volume from motivated purchasers.

When this volume begins to fall, so does the market.

The graph (above) shows that this is what happened during the Great Bubble.

From 1992 to 2000 the amount of buybacks and mutual fund purchases steadily increased until the volume could no longer be sustained and the market collapsed.

Capital Flow Analysis provided an abundance of signals that it was time to get out of the stock market in 2000:

Flow of funds accounts, of course, gave no forewarning that the peak would come precisely in the summer of 2000.

However, by that time there was enough capital flow information published by the Federal Reserve that a prudent investor would have known that, once the market turned, to continue to hold stocks was not a wise course of action.

A Long Ways Down

Despite the great loss of wealth, the Crash of 2000 did not send stock prices down so far that the S&P 500 index was again at the long-term average of fifteen.

The Great Bubble had definitely burst, but, in historical terms, stock prices were still high, suggesting that there was reason to be wary of further weakening, even as late as 2005.

The Crash of 2000 showed that corporate buybacks cannot push prices up indefinitely. Sooner or later, the accumulation of options in the hands of executives, plus the attraction of low capital costs on foreign issuers, causes buybacks to be neutralized and the market to fall.

By 2005, although buyback/option behavior continued, the market was beginning to enter the earliest years of the period when Baby Boomers will retire, putting new selling pressure on stock prices.

This suggests that, although prices did not drop to fifteen times earnings after the Great Bubble, this could still happen.

The market still had a long ways down to reach the historical level of fifteen times earnings.

No 'Paradigm Shift'

Despite the crash, the underlying motivation of market movers remained unshaken and unquestioned.

Attitudes of the market players that dominated the Great Bubble were not transitory or subject to sudden change.

The crash occurred not because corporate or mutual fund managers repented their short-term ways or because mutual fund investors had given up on the Common Stock Legend.

The market turned simply because stock prices had gotten so high that foreign corporations were persuaded to issue new stock, 'smart' institutional investors were convinced that intrinsic value had been exceeded, and stock option holders became afraid that if they did not sell, they would forego substantial profits.

A point had been reached when it simply not possible for domestic corporations to come up with enough buyback money to overcome the volume of new issues by foreign companies and the exercise of accumulated options by executives.

The reasons for the Great Bubble and the subsequent crash were generally not understood, and blame was directed to the usual suspects — speculators and a few bad apples among corporate managers.

The Common Stock Legend was still strong in the hearts of mutual fund investors.

Corporate buybacks escaped criticism as regulators were distracted by Enron, corporate accounting scandals, and illusions that 'independent directors' would somehow solve problems of corporate governance.

Instead, corporations continued their buyback programs, giving value to executive stock options, while mutual fund sales, although somewhat reduced in 2001 and 2002, were strong again in 2003.

However, although patterns of behavior continued, the proportions had changed. The ability of buybacks to drive the market forever upwards had been tested.

The market was now evolving to into a new configuration.

learning Module Capital Flow Analysis: Learning Module: Steps : End

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