Basic Capital Flow Analysis: Knowing What Questions to Ask
Basic Capital Flow Analysis
Knowing What Questions to Ask
The outcome of any serious research can only be to make two questions grow where only one grew before.
Good questions outrank easy answers.
If we know why groups of investors and issuers buy and sell securities, and if we can predict how long these reasons might persist, we have a basis for anticipating security price trends.
There are important forces that drive capital flows over the long term, even decades.
- Trends are often institutional and cultural, resisting change.
- Customs become hard-wired into institutions.
- Changes in motivation may happen so slowly as to be difficult to perceive in months or years.
However, to discover what these forces might be, we have to ask the right questions. There is no simple formula that tells us what questions to ask.
Capital Flow Analysis: A New Technique
Flow of funds accounts have been around for half a century, and the U.S. government spends millions of dollars preparing these tables every quarter.
However, this valuable resource has had remarkably little impact on the common understanding of capital markets.
For example, the fact that U.S. corporations have been buying back more stocks than they issue for a generation --- in a net amount of more that one trillion dollars --- is hardly ever mentioned in the press.
In this sense, Capital Flow Analysis is a brand new technique, little understood, barely recognized, and with extremely sparse literature. In the first decade of the 21st century, most of those practicing Capital Flow Analysis will be pioneers.
Because the field is so new, there are, as yet, no cookie-cutter recipes that tell us what questions to ask when studying flow of funds accounts.
Thinking Outside The Box
One problem may be that economists are trained with biases that make it difficult to ask the simple, obvious, commonsense questions that are necessary for Capital Flow Analysis.
Unless we know what to look for, the flow of funds tables might be a meaningless blur of numbers.
In this lesson, there are examples of questions might be useful, but the list is not exhaustive.
The challenge is to come up with useful questions; in this lies the secret of good analysis.
Some Possible Questions
To detect and understand the trends that move capital markets, there are certain things we may look for when reading flow of funds tables.
Here a few lines of inquiry, some of which are discussed in detail in other lessons:
When reading instrument tables:
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Who are the buyers and sellers and what is their relative importance?
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Which group is more motivated: buyers or sellers? (Lesson 2).
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Is there a shortage in the supply of securities? (Lesson 5).
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What are issuers doing? (Lesson 9).
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How do current flows compare to past flows? (Lesson 27).
When reading sector tables:
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How are buyers financing their purchases and how stable is their source of funds?
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What are sellers doing with the proceeds of their sales and is this a temporary or permanent pattern?
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Is reallocation of assets temporary or is it part of a long-term trend? (Lesson 27).
When researching the market for a class of security:
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Have there been changes in tax law that make these securities more or less attractive?
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Have there been regulatory changes that affect the interests of certain sectors in these securities?
When researching market sectors (players):
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What is the principal investment goal of the sector?
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Do players have short- or long-term horizons?
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Do they seek capital gains or cash return?
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Do fiduciaries or agents control investment decisions and, if so, what conflicts exist?
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Which aspects of players' behavior are built into the institutional structure?
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How do changing social patterns in the U.S. capital market effect player behavior? (See Lessons 11 to 20).
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Have there been tax changes that influence the behavior of certain sectors?
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Have there been regulatory changes that effect the actions of players?
Developing a Working Hypothesis
By viewing the flow of funds tables by instrument and by sector in the light of price trends, and by examining the cultural, institutional, and fiscal/regulatory context of each security and player group, it usually is possible to develop a cogent 'story' or hypothesis that seems to explain capital flows.
Although it takes a lot of work to develop a useful hypothesis about capital flows and price trends, the institutional, cultural, and fiscal/regulatory frameworks of markets and players often persist for long periods. There are certain themes or patterns of behavior that may serve for years or even decades.
Once we have a working hypothesis, this may continue to be valid for quite some time. We don't necessarily have to redo our research that often, but instead can focus on certain items to be followed or studied in greater depth.
By maintaining a long-term view of capital flows, we are more likely to interpret correctly short-term changes.
Capital Flows Must Be Seen In A Larger Context
Reading to expand our understanding of society, history, and the many technical aspects of capital markets pays off when trying to interpret flow of fund accounts.
Just as a security analyst knows what questions to ask when looking at a balance sheet or income statement, the capital flow analyst must have similar insights when reading flow of funds tables.
Much of the information on this site is intended to provide examples of the kind of questions and issues that are relevant in Capital Flow Analysis.
However, the goal is to stimulate the student into developing new questions, constantly improving the quality of analysis.
Before proceeding, check your progress:
Self-Test
In the first decade of the 21st century, Capital Flow Analysis was:
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In order to extract meaning from national flow of funds accounts, you must:
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Many forces that cause price movements in capital markets and that are reflected in national flow of funds accounts, can be expected to:
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learning module : continued >
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