Capital Flow Analysis () Overview Concept Capital market is made up of groups of players (sectors) such as: Households Non-financial

al corporations Commercial banks Insurance companies Capital flow analysis uses statistics on the net exchange of assets between sectors. Sectors trade classes of instruments such as: Corporate bonds Corporate equities Mutual funds Municipal bonds Motivation The reason of net flow of a certain class of financial instrument from one sector to another is called motivation. As each sector operates under different rules, customs, and constraints, the motivation behind a sector buying certain types of assets is often different from the motivation of other sectors buying the same classes of instruments. In capital flow analysis, it is assumed that some sectors are more motivated than others to buy/sell certain classes of financial assets. Price Trends Capital flow analysis is based on Motivation Axiom that price trends are caused by one sector being more motivated than another about the purchase/sale of a particular type of instrument. One objective of analysis is to discover the reason (motivation) that explains why a sector is buying/selling particular types of assets. Irrationality Axiom states that the reasons that motivation is not always based on rational expectations. Example Since the end of gold standard in 1971, there has been a worldwide habit of accumulating savings in dollars. This has led to trade deficit and in international players having an increasing amount of dollars to invest. Foreign holders of dollars have long shown preference for fixed income investments over equities. Increasing volume of dollars held by foreigners has put upward pressure on bond prices. The long up trend in U.S. bond prices since the 1980s is directly correlated to increasing foreign trade deficits. Basis for Trend Prediction Capital flow analysis is used to predict price trends in categories of instruments. It is based on: Predicting the continuity of patterns of net flows of instruments between sectors Predicting persistence of the current motivation of sectors about each instrument class Information Sources U.S.: FRB, National Flow of Funds Accounts: Release Z.1

Big Picture Categories: 7 Sectors, 6 Instruments Sectors (Players) Households Fund Managers Bankers and Brokers Corporations Foreign Investors Government Officials Insurance Companies Total (Tr. US$) U.S. Capital Market 2004 Q4 % Securitized Instruments 36.3% 16.0% 14.6% 12.9% 9.1% 5.4% 5.2% 101.1 Corporate Equities Agency Securities & Mortgages Fund Shares Corporate Bonds Treasuries and Open Market Municipal Securities Total (Tr. US$) % 30.5% 29.7% 12.9% 12.8% 10.2% 3.6% 56.3

Primary Players It is useful to think capital market is composed of primary players and intermediaries. Primary Players Households Corporate Foreign Investors Government Intermediaries Fund Managers Bankers and brokers Insurance Executives Fixed Income and Equity Market Type of Security Fixed Income Securities Equities U.S. Capital Market 2004 Market Value Principal Receivable 70% 30% 100% 0% Income Receivable 85% 15%

Sources of New Investment Funds New Money for Investment 2004 Households savings: $100.8 trillion Foreign Exporters and Investors: $642.6 trillion Direction of Capital Flows Usually, the next diagram is the conventional expectation of the normal capital flows. But in U.S. equity market, this trend has been inverted for over a decade. Since mid-1980s, households have been net sellers of equities, while corporations have been net buyers through repurchase. Since creation of ASB in mid-1970s, great securitization has increased the size of fixed income market. Due to rise of pension funds and mutual funds, corporate control has shifted from individuals to intermediaries.

Training Module: How to Read National Flow of Funds Accounts Data Description FRB Quarterly Release Z.1, Flow of Funds Accounts of the United States contains about 172 tables in 125 pages. Historical tables date back to 1945. About 80% of them refer to the flow of funds among various financial instruments and economic sectors. Remaining tables are about macro-economic statistics. Tables of interest to capital flow analysis are sector and instrument tables. Terms

Flow: (Level)t (Level)t-1 Level: Outstanding balance of an asset/liability at the end of a period Sector: a.k.a. Player. An economic group as designated in the national flow of funds accounts. Instrument: a.k.a. securities. An economic asset/liability as designated in the flow of fund accounts. NIPA: National Income and Product Accounts. Macro-economic statistics included in the flow of fund tables.

Table Code System Flow Tables: Coded with F such as F.100, F.213, etc Level Tables: Coded with L such as L.100, L.213, etc Sector Tables: Coded in 100 series such as F.102, L.123, F.114, etc Instrument Tables: Coded in 200 series such as F.208, L.217, etc Official Guide Federal Reserve Board, Guide to the Flow of Funds Accounts ($20) Note: Net and Gross Flow of funds accounts doesnt show total transactions. Instead, it shows only net transactions. From the point of view of capital flow analysis, it is the size and direction of net change in sector holdings of instruments that is important in explaining capital market supply and demand. Understanding Tables Sector Tables Sector tables show net transfers of financial assets and liabilities for a particular economic group over a specific period. They describe allocation change of financial assets for a particular sector over a period. They are divided into 3 sections from top to bottom: NIPA Data: Macro-economic data related NIPA. Financial Applications: Net changes in holdings of various categories of financial assets. Liabilities and Equity: Net changes in sector liabilities and net worth. Instrument Tables Sector tables show net shifts in ownership among sectors for a particular type of financial instrument over a specific period. They describe net purchasers/sellers of a particular financial instrument over a period of time. They are divided into 2 sections from top to bottom: Issuers: Net issues of the instrument by sector. Purchasers: Net purchases of the instrument by sector.

Selection of the Most Relevant 29 Tables by Center for Capital Flow Analysis Sector Tables Individual Investors F.100 Households and Nonprofit Organizations Nonfinancial Business F.101 Nonfinancial Business F.102 Nonfarm, Nonfinancial Corporate Business Government F.105 State and Local Governments F.106 Federal Government F.124 Government Sponsored Enterprises International Players F.107 Rest of the World Bankers and Brokers F.109 Commercial Banking F.114 Savings Institutions F.126 Issuers of Asset-Backed Securities F.129 Securities Brokers and Dealers Insurance Companies F.116 Property & Casualty Insurance Companies F.117 Life Insurance Companies Funds F.118 Private Pension Plans F.119 State and Local Government Employee Retirement Funds F.120 Federal Government Retirement Funds F.121 Money Market Mutual Funds F.122 Mutual Funds F.123 Closed-End and Exchange-Traded Funds F.128 Real Estate Investment Trusts (REITs) This selection represents a comprehensive picture of the major players in the U.S. capital market. Instrument Tables Fixed Income Securities F.206 Money Market Mutual Fund Shares F.208 Open Market Pager F.209 Treasury Securities F.210 Agency Securities F.211 Municipal Securities and Loans F.212 Corporate and Foreign Bonds F.217 Total Mortgages Equity Instruments F.213 Corporate Equities F.214 Mutual Fund Shares This selection represents the primary categories of securities that are bought and sold in U.S. capital market.

Note: Statistical Discretionary In principle, flow tables must agree with difference between the balances in sequential level tables. But it is not always the case because: Some balances are not shown at historical value but at market value. (Case for corporate equities) There are statistical discontinuities between sequences of level tables. Sector tables are a combination of NIPA statistics, while other tables are derived from accounting data. Color-code System for Easy Read by Center for Capital Flow Analysis Depending on whether a table refers to a sector or instrument, and the position of data in the table, positive and negative numbers have different meanings. Color-coding is a way for easy reading of the data. Meaning of Positive/Negative Numbers in Each Table and Color-Code Suggestion Tables Section Positive Numbers Negative Numbers Investment section Use of Funds Source of Funds Liabilities section Source of Funds Use of Funds Issuers section Seller of Securities Buyer of Securities Instrument Tables Purchasers section Buyer of Securities Seller of Securities Capital flow analysis is a way to find out significant flows (changes in holdings) of an instrument for a sector. Therefore, flows of more than 10% in net uses/sources of funds or purchases/sales of securities are shown in bold numbers. Capital flow analysis assumes concept of motivated flows. Therefore, buyers in bull market and sellers in bear market are underlined. Bull/bear market is determined by S&P 500 and Moodys AAA Corporate Bond. Sector Table: Motivated buyers\sellers are shown in underlined green/red numbers. Instrument Table: Motivated purchases/sales are indicated by underlined numbers, only in F.213 Corporate Equities and F.212 Corporate and Foreign Bonds, but no other instrument tables. Sector Tables

Training Module: Basic Analysis Questions to Be Asked Capital flow analysis attempts to explain not only for what happened in the market, but also why it happened. It is very important to ask questions for reasonable explanation as below; How significant are the net purchases/sales compared to the total wealth of each sector? How do current flows compare to past flows? What sectors are buying/selling a particular class of securities? How are the buyers financing their purchases? Are the sources stable? What did the sellers do with the proceeds? Is it a temporary use or long-term trend? Have there been regulatory/social changes that affect capital markets or players behaviors? Basic Readings See a level and flow for a security A below. L.2XX is one of the possibilities of background of F.2XX.
F.2XX Security 'A' Year 1 Issuer: Investor: 200 200 Issuer: Investor: L.2XX Security 'A' Year 0 5000 5000 Year 1 5200 5200

To find the motivation behind these transactions, see sector tables below.
F.1XX Issuer Year 1 Income Fixed Assets Bank Deposits Issue Security 'A' 100 200 100 200 Savings Consumer Durables Security 'A' Security Credit F.1XX Investor Year 1 50 150 200 300

From the tables above, we can explain the transactions; Issuer sold their stock and spent their income for fixed assets for long-term business and bank deposits. Investor purchased the stock A and a durable with security credit (margin transaction) and savings. Basic Steps Step 1: Start with the instrument table for the market that interests you. Step 2: In the instrument table, choose sectors that appear to play a major role in the market. Step 3: Study flow table of that sector to see the sources and uses of funds. It helps find out the motivation. Step 4: Finally, return to the initial instrument table and choose other sectors to repeat Step 3. 4 Behavioral Patterns Here are basic behavioral patterns behind the market movement and capital flows. Motivated buyers taking advantage of cheap prices: Rational behavior for investors. Motivated buyers willing to pay high prices: Investors doing speculations, or corporations buying back their own stocks to give higher value to stock options. Motivated sellers unloading at cheap prices: Seemingly irrational, but consistent with forced selling. Motivated sellers in a market with high prices: Issuers benefitting from low financing cost, or investors selling out accumulated positions.

Themes: What to Be Careful about for Market Analysis Common Biases on the Market Limited Role of Issuers: Corporations are often understood that they could affect the market only by dividends and earnings. But it should be noted that massive stock buybacks by domestic corporations and new issues by foreign corporations which neutralize buybacks are extremely important in major market moves. Dominant Role of Speculators: Although speculators may influence short-term fluctuations, the major market moves that account for systemic risk are best explained by examining the flow of funds accounts. Ignoring the Role of Foreign Investors: In any country, foreign investors have been an extremely important factor, especially in bonds market. Compulsive Behavior Aging Baby Boomers: They will need to sell equities over the first 3 decades of 21st century to pay escalating costs of old age care and living expenses in retirement. Corporate Stock Options Fund Managers: Mutual fund managers are required to invest in equities no matter the price when investors buy their funds faster than stock prices, through 401K or individually. Social Changes Changes in Investment Patterns: Changes in how households save and invest their money is an important market mover. See a table below. Investment Patterns of U.S. Households 1950s 1960s 1970s 1980s 1990s 27.5% 22.7% 26.1% 27.7% 20.4% Equity in Home & Durables 21.2% 22.1% 22.9% 23.4% 20.2% Deposits & Credit Securities 17.3% 23.6% 12.7% 9.9% 19.5% Stock & Mutual Funds 5.0% 4.3% 3.3% 2.0% 2.0% Life Insurance Reserves 3.8% 6.4% 9.0% 14.1% 21.4% Pension Reserves 25.1% 20.3% 22.5% 20.0% 13.6% Non Corporate Equity 0.0% 0.6% 3.6% 2.8% 2.9% Bank Personal Trusts Regressive Income Tax: Usually, income tax plays an important role in widening inequalities. See below. Distribution of U.S. Income % of Population % of Financial Assets (1998) % of National Income (1998) Ratio of Income/Assets % of Income Tax (1996) Min. Family Wealth (1998)

1 47.1 16.6 0.35 31.7 $3,350,000 Super-Rich 9 32.4 24.6 0.75 30.3 $475,000 Rich 90 20.5 58.8 2.86 38.0 Negative Non-Rich Job and Industrial Changes: Leaving the family farm, deindustrialization, rise of MBA, changes in population composition, are the main factors. Decline of Agricultural Workers and Deindustrialization

Rise of MBA and Population Decomposition

Decline of Entrepreneurship: Small new businesses are critical to job creation, and they are sources of new securities that feed the equity market. Decline in entrepreneurial income (proprietorship and corporate profits) to rental income (interests and rents) over the decades raises questions about long-term prospects for not only the stock market, but also the economy.