Investment Time Horizon for Asset Allocation in Capital Flow Analysis

Investment Time Horizon for Asset Allocation in Capital Flow Analysis Asset Allocation and Capital Flow Analysis

Investment Time Horizon for Asset Allocation

The end product of Capital Flow Analysis is a medium or long-term forecast for a general class of investments, based on national flow of funds accounts or equivalent statistics.

Capital Flow Analysis is constrained by the data.

Such a forecast would include identification of the major players, behavior patterns, and triggers that might cause a reversal of current trends.

The scope of Capital Flow Analysis is limited by the data:

Generally, Capital Flow Analysis provides an expectation of general price levels of a class of securities that is based on an instrument table in the flow of funds accounts.

Such an expectation usually would be with respect to prices a year or so in the future.

Although a full revised forecast can be made only upon publication of the latest flow of funds accounts, interim news of changes can lead to immediate changes in expectations.

Time Horizons and Expectations

As discussed in lesson 25, the expectations for the corporate bond market in 2004, based on flow of funds analysis, was for higher bond prices by year end, based primarily on the long-term correlation between the trade deficit and bond prices.

Short term fluctuations are beneath the radar of Capital Flow Analysis.

The graph shows the trend in bond prices, represented by the Lehman Aggregate Bond Index, from 1995 to 2004. The blue circle shows the range for the year 2004.

Capital Flow Analysis is relevant to the places where the graph enters and leaves the blue circle, but not for much within the circle.

Examining the bond index over the long-term, we see monthly and quarterly fluctuations that do not change the long-term trend.

If the graph were to show weekly, daily, or hourly fluctuations, there would be even greater variations, equally irrelevant to Capital Flow Analysis.

Asset Allocation Decisions

There are various financial products that attempt to mimic the Lehman Aggregate Bond Index.

Capital Flow Analysis of the bond market would be a useful tool for making longer-term investment decisions on such products.

There are also a host of bond funds whose performance is correlated with the Lehman Aggregate Bond Index.

Capital Flow Analysis can guide investment in index or asset category funds.

With regards to index funds, or asset category funds that have relevant correlations to indices of stock or bond prices, Capital Flow Analysis is a useful tool for deciding whether to invest in such funds for periods of one year or more.

Furthermore, because Capital Flow Analysis produces information regarding factors that might trigger the reversal of a trend, the technique may give warnings as to the advisability of holding a certain category of assets.

For example, when bond prices are correlated to the expanding trade deficit, and an event occurs that might sharply reduce the trade deficit, Capital Flow Analysis would provide the background information that supports a decision to get out of the bond market, even before the statistics are compiled by the Federal Reserve.

An attack on U.S. ports that shuts down international trade would be such an event.

Kinds of Allocation Decisions

In the allocation of investment assets, we are limited to the asset classes described in the Federal Reserve flow of funds accounts.

Based on Capital Flow Analysis, we might justify allocation of funds to, say, corporate equities or corporate bonds, but not to utility stocks or steel stocks.

Types of asset allocation decisions that might be enhanced by Capital Flow Analysis are:

Capital Flow Analysis is useful even to an investor who knows the market to be over-priced.

Although Capital Flow Analysis may not result in signals for day to day trading, the value of being able to forecast major market turns is evident.

For example, an investor who agreed with Chairman Greenspan that equities were over-priced in 1996, could have held on for three more years, waiting for the signal from Capital Flow Analysis to get out in 2000.

Long-Term Allocation

Sometimes decisions to invest or not to invest in a specific asset class for the long-term must be made in circumstances in which reconsideration may be impractical or impossible.

An example would be the establishment of a trust in which the grantor wishes to limit the scope of investment of the trust assets.

Capital Flow Analysis can be used in setting restrictions for a 'locked-in' portfolio.

Since 1994, over 80% of U.S. states have adopted the Uniform Prudent Investor Act icon-pdf-1 which abrogates all categorical restrictions on trustees regarding types of investment, unless the grantor specifically writes such restrictions in the trust agreement.

This means that a trustee, unless restricted in the deed, can invest in anything that seems to be prudent: stocks, bonds, real estate, or derivatives.

In times when the Common Stock Legend, the Fallacies of the Nobel Gods, and the Efficient Market Hypothesis are taught in universities, and when memories of Long Term Capital Management still linger, we might wonder what might be considered imprudent in a relativistic world.

Problems With Fiduciaries

To further aggravate the problem, costs of professional fiduciaries may be too high for a modest portfolio and a grantor may have difficulty in finding someone trustworthy with reasonable financial skills and who will not charge so much that the yield on the investment is seriously depleted.

Trustees may die or go mad; banks may be closed.

Moreover, no matter who the original trustees may be, they may die or go mad, banks may be closed, and the problem of an unknown successor looms.

A reasonable solution might be for the grantor to specify in the deed that the trustee may invest only in a certain class of assets, such as, say, 'a diversified portfolio of closed-end funds that invest in taxable bonds with a Morningstar rating of at least four, or equivalent rating'.

This would help avoid the pitfalls of the Uniform Prudent Investor Act.

The decision for this long-term asset allocation could be based on Capital Flow Analysis at the time the trust was established.

Fundamental Analysis Is Necessary

Capital Flow Analysis does not substitute fundamental analysis of specific investment opportunities.

Capital Flow Analysis doesn't invalidate Graham and Dodd.

Using Capital Flow Analysis, I might decide that it would be appropriate, say, to invest in bonds, but then I still would have to perform studies to determine in which bonds to invest.

Allocation based on Capital Flow Analysis should never override commonsense evaluation of investment merit of specific securities.

Covariance, CFA, and MPT

Modern Portfolio Theory (MPT) is a technique for controlling covariance of a portfolio relative to performance of a market index.

Covariance is a statistical measure that attests to the common observation that security prices tend to go up and down together.

Covariance makes Capital Flow Analysis useful.

The popularity of the beta coefficient in Modern Portfolio Theory is the result of this observation.

Beta is a measure of the degree to which the price of an individual security will vary relative to the price index of many securities.

Without a high degree of covariance for securities in an asset class, we could not use Capital Flow Analysis for market timing and asset allocation.

There are many reasons to believe that prices, for a certain class of securities, will move in tandem.

Enforcing Covariance

Spot security prices are influenced by a tiny fraction of security holders.

On any day, less than one-half of one percent of all stocks in circulation are traded in the U.S. market.

Many trades are done by the same people, day after day, while most stockholders stay off the market.

Active traders represent less than one-half of one percent of all shareholders.

Of the roughly 80 million people that own stocks directly or indirectly, active traders represent less than one-half of one percent.

However, active traders play an important role in setting prices from day to day, especially with respect to the covariance of stock prices.

Speculators are the enforcers of covariance.

Speculators are, in essence, the tail that wags the dog.

They are the enforcers of covariance.

John Maynard Keynes, in this famous passage, describes the motivation of these active traders as they try to outsmart each other:

'This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional — it can be played by professionals amongst themselves.

Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.

These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.'

Covariance: The Dominant Few

Securities markets are run by relatively few people.

With the principal exchanges in New York City, the U.S. equity market is highly centralized.

The top ten broker-dealers account for more than half the volume.

Brokerage and investment banking is handled by less than 300 firms; the top ten firms account for more than half the volume.

Securities data is published by a few large companies: Standard and Poor's, Moody's, Morningstar, and some others.

Financial news is dominated by the Wall Street Journal, Barrons, and a handful of competitors.

A half dozen cable shows make up most of the financial news market.

Training at Ivy League schools and some other prestigious institutions, like Stanford, produce a high degree of group-think among Wall Streeters.

Those at the center of the market have resources and ability to sustain market myths, legends, and illusions that match their world-view.

One of the greatest illusions is that the price determined on Wall Street is the approximate value at which all investors may exchange their securities for cash.

This, of course, is true only when a small percentage of investors attempt to sell their securities at the same time; if all investors prefer cash, the value goes to zero.

As long as the illusion of value is maintained, most security holders will stay away from the market.

Buying and selling by a relatively small group of active traders playing Keynes's game of musical chairs, ensures a high degree of covariance in security prices.

Covariance: Comparison Shopping

Speculative psychology and comparison shopping dominates the market.

Wall Street makes most of its money by catering to speculators, not long-term investors.

Both bulls and bears are interested in short-term price swings.

With 300,000 speculators dancing to the tune of 300 brokers and with dealers row-on-row at crowded trading desks, starting each morning with group-think blaring over the company bull-horn, markets are bound to move together.

Perceptions of relative strength and comparison shopping lead speculators to run in packs.

The most popular form of speculation is simple comparison shopping: buying what seems to be cheap relative to other securities and selling what seems to be comparatively expensive.

Second by second the market is judged by measures of central tendency in raw prices: the S&P 500, the Dow Jones Average, the Russell 5000, and other indexes.

Great interest is paid to the 'leaders and laggards', the advance-decline index, and relative strength measures for every stock.

The central idea of chart reading is to 'go with the flow' and 'the trend is your friend'.

When average price-earnings ratios are fifteen, speculators will move in and buy laggards with ratios of ten (unless there is something wrong with the issue).

When stock averages have improved ten percent, speculators will pay attention to sluggards that have risen only one percent.


Before proceeding, check your progress:


Capital Flow Analysis is most relevant to forecasting market trends over a period of:
Choice 1 One day.
Choice 3 One week.
Choice 4 One quarter.
Choice 2 One year.
Capital Flow Analysis would be most applicable to investment decisions regarding asset allocation to:
Choice 2 Specific utility stocks.
Choice 1 Specific municipal bonds.
Choice 3 Index funds.
Choice 4 Grain commodity futures.
Capital Flow Analysis can be used for asset allocation decisions because of:
Choice 2 Covariance.
Choice 3 Cohesion.
Choice 1 The Efficient Market Hypothesis
Choice 4 The Fibbonacci Effect.

Learning Module: Steps in Capital Flow Analysis  learning module : continued >

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