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Against the Flow

“The use of flow-of-funds analysis for capital market forecasts is simply inappropriate. The process assumes that we can forecast flows of funds. We cannot.”
Peter L Bernstein.

One of the more confused areas of commentary and analysis in the world of financial markets is that surrounding the discussion of flows of money. On a daily basis there are stories in the media about who’s buying and selling particular assets, across national borders and between asset classes and in many cases the commentary hints at how these flows may impact future prices. In 2013 there were several headline grabbing stories in particular around emerging markets and the impact of capital flows. For example, in August 2013 India imposed capital controls, described by The Economist to “stop cash flowing out of the country and stem the decline of the rupee.” At the time India was widely criticized for these measures as they reversed the gradual liberalization of the balance of payments that had taken place over the past decade and the authorities planted a seed of doubt in the minds of investors that they might ‘Do a Malaysia’ if things got even worse. Malaysia imposed strict currency controls after the Ringgit collapsed in 1997, pegging the Ringgit to the US dollar and enabling interest rates to come down within the domestic economy.

Similarly the story on capital flows in China is never far from the headlines. The combination of a current account surplus and capital controls in place to keep capital in the country has led to massive reserve accumulation. In August 2012 The Economist reported that China had experienced a net capital outflow in Q2 2012, which diminished the country’s huge international reserves by $11.8bn (or just under 0.4%). But this was a blip and not the start of a new trend. A lively debate takes place about what will happen if and when these capital controls are eased – The Economist concludes that: “If China’s firms and households buy more foreign assets, its central bank could buy fewer” which perfectly illustrates the point that the balance of payments must by definition add up to zero and any analysis of one part of the account which ignores the off-setting impact can never hope to reach a sensible conclusion. This does not stop some economists predicting that Chinese financial sector reforms will allow private sector outflows, which will have to be financed by the central bank selling reserves – typically treasuries, which will push Treasury yields up.

So what is the value of this kind of analysis? Do prices respond to flows? Can flows be forecasted in the future?

A good starting point is the classic by Peter Bernstein that appeared in the Journal of Portfolio Management in 1990, in which the author makes several bold statements:

  • “The use of flow-of-funds analysis for capital market forecasts is simply inappropriate. The process assumes that we can forecast flows of funds. We cannot.”
  • “Prices in capital markets move in response to changing expectations, or to events that differ from expectations.”
  • “Flows of funds are the dependent variable and prices the independent variable, not the other way round.”
  • “Prices in the capital markets can and do move without a single dollar changing hands.”

Bernstein, of course, was not the first economist to comment on the use of flows of funds analysis. Keynes himself, in chapter 15 of the General Theory stated:

“Only, indeed, in so far as the change in the news is differently interpreted by different individuals or affects individual interests differently will there be room for any increased activity of dealing in the bond market. If the change in the news affects the judgment and the requirements of everyone in precisely the same way, the rate of interest (as indicated by the prices of bonds and debts) will be adjusted forthwith to the new situation without any market transactions being necessary.”

In his July 2013 profile: The US Bond Market Bubble: A Novel Explanation of What Happened, Woody Brock of Strategic Economic Decisions explained that while the laws of supply and demand work for commodities, they do not work in a straight forward way for stocks, bonds and real estate, where there is both a flow and stock variable. Stock effects generally dominate flow effects, implying that issuance of new bonds to fund a greater government deficit may not lead to rising yields if, at the same time, the expectations of existing bond holders lead to a re-pricing of bonds reflecting lower inflation expectations, for example.

There are many examples of situations that can be understood more easily in the light of the Bernstein / Keynes view of the world.

Probably the best recent example of Bernstein’s point that prices can move without a single dollar changing hands is that of Wall Street at the time of the 9/11 event. The S&P500 had closed on 10th September at 1092.54 and then remained closed for the rest of the week. When it reopened for the first time on 17th September it was priced nearly 5% lower and no trades had taken place. It then continued to fall, down to a low of 965.80 on 21st September (on higher than average trading volumes) before then recovering to 1161.02 by the end of the year.

Other crisis events have taken place when huge volumes of trading have occurred:

  • On 11th March 2011 Northern Japan was hit by an earthquake and tsunami. This time there were huge volumes of trading taking place and the market fell 16% in 2 days.
  • During the Asian crisis the Thai baht fell 60% between June 1997 and January 1998 and the stock market in Thailand more than halved – this took place with normal volumes of trading activity.
  • When Lehman’s filed for bankruptcy on 16th September 2008, the S&P500 subsequently fell 44% down to a low of 676.53 on 9th March 2009 and this time on huge volumes of trading.

In each case it makes more sense to think of the change in price being due to changing expectations of future cash flows and the discount rate rather than being due to flows of money. We know that changing beliefs and perspectives on the risks of ownership of an asset can sometimes cause violent shifts in the required discount rate embedded in asset pricing. It is sometimes possible to observe that there are huge volumes of trading taking place sometimes due to a collective panic and desire for safety assets on the part of investors. In these examples there are often comments made along the lines of ‘everyone is selling’ and at other times ‘everyone is short’ of an asset. But on closer examination these comments make little sense. They raise more issues – who are they selling to? Why are they selling? Is it possible for ‘everyone’ to be short of an asset – surely someone owns it? Do they live on another planet?

Not everyone agrees with the view that the analysis of flows is unhelpful. Human beings prefer simple explanations of what causes prices to move in financial markets and flows stories are popular as a convenient answer. In the extreme, there may be a case for huge flows to influence pricing for a period of time. Central bank purchases of bonds or flows driven by regulatory change are more complex to analyse, since they are not directly due to changing beliefs or investors’ perspectives on risk, so could provide a temporary distortion to market pricing.

For the purpose of this blog we’d prefer to focus on the reasons for the flows of money – whether that is changing expectations about changing fundamentals or a changing preference for risk – rather than talk about the flows themselves. As Bernstein so neatly states: “After the fact, flow-of-funds can tell us who bought and who sold capital markets assets and at what prices. Hence, the only way we can forecast what the pattern of money flows will look like is to forecast the prices at which those assets will trade. But if we could do that, who would need flow-of-funds data to begin with?”


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.