Investor Irrationality and Motivation in Capital Flow Analysis Irrationality and Motivation in Capital Flow Analysis

Are Prices Reasonable?

In lesson 21 you learned how to get access to the particular instrument flow table that relates to the market that you are trying to understand.

You also learned how to use this site to conveniently organize the research resources that you will need.

The last lesson also covered the basics of reading flow and level tables.

Now your analysis can begin.

Paying Attention to the Motivation Axiom

The essence of Capital Flow Analysis is to read instrument flow tables in the context of price trends over a period that may vary from three months to decades.

Instrument flow tables on this site show, at the top of each column, price trends for equities and corporate bonds over each period.

In lesson 2, we covered the Motivation Axiom:

Motivation Axiom (top brace)
Unequal Motivation Controls Market Price

In investment transactions with respect to a class of securities, the intensity of motivation of buyers and sellers is rarely the same.

When sectors that are buying are more motivated than sectors that are selling, the price of the class of securities will rise, and the opposite occurs when selling groups are more motivated than buying groups.

Motivation Axiom (bottom brace)

Using this axiom and the information about the direction of prices shown at the top of each column in the instrument tables, we can determine which sectors represent motivated buyers and sellers.

Having identified the sectors that are driving prices, our analysis may now be directed to determining the nature of motivation in the important sectors.

We focus on entire market segments, not individual securities

In either case, we are focusing on entire market segments, not individual securities, or even sub-sectors within a market.

Our analysis is limited to sectors and instruments reported in the Federal Reserve flow of funds accounts.

Using the Irrationality Axiom

In lesson 6, we presented the Irrationality Axiom:

Irrationality Axiom (top brace)
Market Players Are Often Irrational

Market players have reasons for buying and selling investment assets, but these reasons are not always ‘economically rational’ and change from time to time.

People have many motives for trading in the capital markets that are not related to maximization of financial wealth, the choice between consumption and spending, or logical expectations of future returns.

Irrationality Axiom (bottom brace)

The reason that this axiom is important is that most of what we read in the financial press tries to explain price trends in terms of rational economic behavior of investors.

Most financial reporters explain price trends in terms of rational economic behavior

We become accustomed to thinking the same way and fall into the 'rationality trap'. For example, it seems natural to us that:

These are all 'economically rational' reasons that we normally associate with behavior of issuers and investors. These are motivations that we automatically attribute to corporate managers and investors because we have been taught that these actions are consistent with the proper economic role of these players.

On the other hand, we do not normally expect investors and issuers, as a group, to do things like:

When stock prices fall, the financial press is likely to assign the cause to 'lack of investor confidence' or 'profit taking', rather than say that the reason is 'old people raising cash to pay medical bills'.

Issuers and investors may buy and sell securities, often over long periods, for reasons that are not related to the idealized patterns of behavior that we think of as 'rational' reasons that we attribute to these groups as normal behavior for issuers and investors.

Focusing On True Motivation

The Irrationality Axiom reminds us that markets may be, and often are, irrational, sometimes for long periods.

For example:

In 2004, the Federal Reserve announced that it would follow a policy of increasing short term interest rates throughout the year. At the same time, many highly-visible market analysts were predicting that increasing fiscal and trade deficits, likely improvement in business activity, and weakness of the dollar against the euro, indicated that long term bond rates would be higher at the end of the year than at the beginning.

Long bond rates fell in 2004, rather than rise as most professionals expected

This expectation was based on the supposed rationality of the market. The common wisdom was that bond investors would cut back on buying bonds because of the negative bond fundamentals mentioned.
However, this did not happen.
Long term bond rates actually fell throughout 2004, rather than increase as many market professionals expected.
The reason, obvious to a capital flow analyst, was that foreign investors were driving bond prices and that these investors were accumulating dollars because of the ever-larger trade deficit. The crucial investment decision was that of foreign exporters, particularly in Asia and Latin America, who were anxious to keep factories running by selling goods to the United States, thereby accumulating dollars.
Once they had added dollars to their assets, foreign investors sought the bond market, because this was their customary long-term preference.
Analysts who were predicting a rise in bond rates in 2004 turned out to be wrong because they failed to understand that a rising trade deficit would lead to more dollars in the hands of foreigners and that these dollars would then, inevitably, be invested in U.S. bonds.
As demand for bonds increased, prices rose, and yields fell. The supposed 'rational' reasons for not buying U.S. bonds (the fiscal and trade deficit, Federal Reserve intervention, and so forth) had nothing to do with the actual motivation of the sector that was driving bond prices.

The analysts who were 'puzzled by the bond market' included Alan Greenspan, Chairman of the Federal Reserve Board. In mid 2005 he publicly confessed that he was baffled by the behavior of the bond market.

Of course, Alan Greenspan was not using techniques of Capital Flow Analysis, but rather was relying on the economists' traditional assumption of rational markets.

This was not the first time that Chairman Greenspan was egregiously wrong in his market expectations:

In 1996 he made his famous 'irrational exuberance' speech, that suggested that individual investors were driving the bull market. This was simply not true. The bull market in stocks had been force fed for years by corporate executives who were manipulating prices upwards through buybacks that gave value to their stock options and remuneration contracts.
This market manipulation was granted safe harbor from prosecution by the SEC and was avidly supported by Wall Street brokers who profited on handsome commissions and increased investor activity.

Again, the economists' assumption that markets are driven by rational investors' reasonable expectations of intrinsic value proved wrong.

Conquering The Presumption of Rationality

Any difficulty that we may have in reading and interpreting flow of funds tables pales in comparison to the difficulty that we have in overcoming our own biases regarding the presumption of rational behavior of market players.

In this respect, we should note the admonition of the 1950s cartoon character, Pogo:

'We have met the enemy ... and he is us!'

It is our own presumption of rationality that is the greatest barrier to correct interpretation of capital flows.

Every capital flow analyst is a member of a society dominated by economists claiming that investment behavior is driven by reasonable men making rational choices based on intrinsic value of securities.

The presumption of rationality is the greatest barrier to correct interpretation of capital flows

Almost everything we read in the Wall Street Journal, in brokers' reports, or on the financial cable channels is based on this presumption.

Even when we convince ourselves otherwise, we still face the arduous task of convincing others, equally deluded.

This becomes serious, and perhaps fatal, when the purpose of Capital Flow Analysis is not to guide our own investment decisions, but those of others.

When the 'others' that we must convince included clients and bosses, the temptation to abandon our insistence on 'irrationality' may be irresistible in light of the possibility of losing our jobs.

Nevertheless, the monetary rewards for properly interpreting market behavior are tremendous.

Because of the Irrationality Axiom, capital flow analysts are often market contrarians.


Before proceeding, check your progress:


Which are motivated buyers or sellers?
Choice 1 Sectors buying in a falling market.
Choice 2 Sectors buying in a rising market.
Choice 3 Sectors selling in a falling market.
Choice 4 Sectors selling in a rising market.
In Capital Flow Analysis, we assume that:
Choice 1 Investors are always rational.
Choice 2 Investors are never rational.
Choice 3 Issuers are sometimes rational.
Choice 4 Issuers are always rational.
In 2004, long bond prices rose primarily because:
Choice 1 Issuers were redeeming bonds.
Choice 2 The trade deficit increased demand.
Choice 3 Bond ratings were improving.
Choice 4 The Fed was buying corporate bonds.

Investment Tutorial: Practical Capital Flow Analysis  Irrationality and Motivation : continued >

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