google.com, pub-2431335701173086, DIRECT, f08c47fec0942fa0 Flow Theory of the Stock Market - MarchéEconomics

Flow Theory of the Stock Market

March 6, 2017

google.com, pub-2431335701173086, DIRECT, f08c47fec0942fa0

Flow theory is about the flow of money into and out of stocks, economic sectors, and the overall stock market. I am going to focus on the overall stock market. Flows into and out of the stock market occur for different reasons in the longer-run period (greater than 1 or 2 years) versus the shorter-run period (less than 1 or 2 years). In the long-run money flows depend on:

1. Demographic trends
2. Long-run economic growth.
3. International portfolio capital flows.

As for demographics, millennials moving from unemployed to employed or from being under-employed to fully employed will form households and add more and more income toward retirement funds. Since millennials actually outnumber retiring baby boomers, this represents a net inflow of money into the stock market. Moreover, outflows from Baby Boomer retirees are not taken completely out of the market. At 70.5 years of age they must take minimum required distributions but many don’t need the money to live on and just put the money back into the market through different accounts. This suggests a long-run net inflow of money into the stock market.

Another contributing factor to long-run stock market inflows are higher interest rates in the US coupled with a strong dollar. Both of these increase the returns to foreign investors. Higher returns cause an inflow of foreign portfolio capital into US stock and bond markets. This inflow bids up the dollar while keeping interest rates lower.

This net inflow of portfolio capital influences economic and stock market growth. Growth can continue until the real interest rate (the nominal interest rate minus the inflation rate) becomes too high and begins to crowd out private sector growth. This probably will not happen. There are two ways real interest rate can increase and crowd out private sector growth.

1) If domestic growth causes nominal interest rates to rise faster
than inflows of foreign portfolio capital can keep them from rising,

and

2) If the bid up dollar value from portfolio inflows can limit
inflation to a greater extent than domestic economic growth
increases it.

Because of these two offsetting forces, the real interest rate cannot rise too fast and cause a recession by crowding out private sector economic activity. In other words, the long-run economic growth that underpins the stock market is likely to continue for some time.

Sounds like a happy scenario . . . right? The problem is that there is one more factor influencing interest rates. This is the ever-growing level of government debt which is now greater than 106% of GDP (Gross Domestic Product). Rising debt levels push interest rates higher.

Driving the increasing level of outstanding US government debt are mandatory entitlement outlays such those for social security, Medicare, Medicaid, and military and government pensions. Because of demographics, these outlays are ever-increasing. To finance these growing expenditures, government borrowing must increase, which forces up nominal interest rates faster. Increased borrowing will occur even if we cut all discretionary Federal government expenditures, including military expenditures, from the Federal budget entirely. GAO (Government Accounting Office) and CBO (Congressional Budget Office) estimates show that this will occur around 2030.

To keep the real interest rate in check, the Fed must increase its balance sheet by buying the government debt and pumping money into the economy. This puts increased pressure on inflation and downward pressure on the dollar exchange rate, which is also inflationary. If the Fed does this, increases in the nominal interest rate will be less and inflation more, causing the real interest to stay in check for longer.

What about money flows in the short-run? Those who wait out short-term corrections, or who buy into the market after a correction, are fine. Of course, some want to time the market. This is tricky. Although he risk of some type of correction or sell-off is always present, which suggests a pay-off to correctly timing the market, corrections always come as a surprise or they would already be priced into the forward-looking market.

On the other hand, consumer or investor expectations play a role in short-run corrections, suggesting a degree of predictability. Predictability results from self-full filing expectations on the demand side of the market. For example, if consumers expect prices to fall they tend to make that happen by not buying now and waiting for the expected lower prices. Inventories build up and sellers must lower prices to clear out the excess inventory. Thus, expected price declines become self-full filing. Same for expected price increases. Consumers buy now at lower prices, which then drives up prices as expected.

Expectations effect money flows into and out of the stock market similarly. For example, more and more investors expecting a correction and declining stock prices will hold larger portions of the portfolios in cash. Financial markets exhibit herding behavior when others see this and do the same. Herding amplifies the outflow of cash from stocks and causes prices to fall as expected. Those that hold on longer and engage in panic selling increase the rate of outflow and deepen the plunge. The reverse occurs when some buy back into the market after the panic and when everyone else is fearful. The expected increases in stock prices becomes self-full filing as others join in (herding behavior) on the buying side.

Those that want to time the market without having correctly predicted the stock market correction risk exiting the market too late (already fallen) or entering too late (near its top). These same stock market investors might then complain that unpredictable market volatility contributed to their poor investment performance and go on to suggest that the market and its investors be regulated, or even licensed.

I suspect that most investors prefer a less regulated and competitive economy and stock market. Moreover, I don’t think that most investors and business persons support those that function poorly in the market and then try to drag everyone else down and into a quagmire of market socialism (i.e., too much government regulation and interference). This suggests that the flow of “rational exuberance” resulting from being freed from eight years in a socialist quagmire is an additional reason to expect the economy and stock market to grow throughout the next several years.

More about Gary Marché

I have a PhD in economics with emphasis in International Economics, Comparative Economic Systems, Open Economy Macroeconomics, Public Finance, and Policy Analysis and Program Evaluation. I am also a successful life-long investor . . . and hope to continue to be.