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Flow of Funds
• When aggressive investors or traders become nervous about the
stock market, they usually sell stocks and place the funds into
money market mutual funds.
• Margin debt, the amount of funds that customers at brokerage
houses borrow for commitments in stocks, has historically been
considered a sentiment indicator.
• The theory was that when markets became speculative and
attracted the less-sophisticated and less-knowledgeable
investors and traders, who began to trade on margin, the market
was near a top.
• Today’s speculator, instead of borrowing from his brokerage
firm, can purchase and sell various highly leveraged derivatives
such as options and futures that avoid being reported to the
exchanges as margin debt.
•It uses a 15-month rate of change as the indicator of margin debt
excess. When, over this period, the indicator crosses above –21%, a
buy signal is generated, and when it crosses below 57%, a sell
signal is generated. Eighteen months after a buy signal, the stock
market has advanced on average 47.2%, and on sell signals it only
advanced 2.0%. This has worked well in the period from 1970
through 2010, but potential change in the parameters must be
considered for the future.
Flow of Funds
A secondary offering is the offering of additional shares of stock in a
company that is already publicly traded, as opposed to a primary
offering which occurs when stock in a newly publicly traded company is
offered. This is usually a bearish sign for two reasons.
First, it is a sign that more supply is coming into the
marketplace, soaking up available funds. Following the basic
principles of economics, as the supply of stock increases, the
price of stock will fall.
Second, the sellers, usually insiders, are liquidating. These
insiders will try to sell stock at times when they think the price
is relatively high.
Thus, an increase in public offerings is directly related to supply and
demand for stock and is also a sentiment indicator.
Household Financial Assets
Money Supply
Bank Loan
•Households, like corporations and governments, have different kinds of
assets. They have both physical assets, such as cars and houses, as well
as financial assets, such as stocks, bonds, mutual
funds, and banking accounts.
•Some of their financial assets are liquid and some are not.
•Liquid assets can be converted to cash quickly; cash, bank deposits,
money market mutual funds, U.S. Treasury bonds, notes, and bills are
liquid financial assets.
• Other financial assets cannot always be converted to cash quickly;
stocks generally are considered to be more liquid than other financial
assets, such as pension funds, retirement accounts, profit-sharing
accounts, unincorporated business ownership, trusts, mortgages, and
life insurance.
• A ratio of liquid financial assets to total assets shows how “liquid”
households are—in other words, how easily they can raise cash if they
need it. Generally, the more liquid households are, the more able they
are to invest in stocks. When household liquidity is high, it is, therefore,
favorable for the stock market, whereas low liquidity is negative for the
stock market.
The data presented in above Figure shows a substantial decline in
household liquidity in the 1990s. This is one reason why consumer
debt rose so strongly and why households were unable to withstand
the severe economic contraction. During severe economic
contractions, one major source of funds for cash-strapped households
is the stock market. Thus, this indicator, although it does not give
mechanical signals, does measure the potential funds for stock
demand or supply.
• Expansion in the money supply is a measure of potential demand for
stock, as well as other assets, and is, thus, a rough measure of the
potential for business and stock market expansion.
• Increases in the money supply have been historically associated with
increases in economic growth and productivity.
Ned Davis Research has found that when this ratio exceeds 143, the
amount of money available is large, and, consequently, the stock market
tends to rise on average 13.0% per year versus an average 5.3% buy-
and-hold average annual increase. On the other hand, when the ratio
dips to 89 and below, money is scarce, and the stock market tends to
decline. This relationship is highlighted in Figure below.
Flow of Funds
Generally, an increase in loan activity, the amount of loans being
created and existing, is a sign of increased business activity. It can also
be a sign of increased speculation and/or a particular period when
banks, because the yield curve is so much in their favor, become less
prudent in their lending policies.
Ned Davis Research found that since 1948, a year-to-year rise
in bank loans (and leases) greater than 13% indicated an overheated
economy and a high likelihood of a stock market decline. When bank
loans only expanded at 5.5% or lower, the economy was healthier, and
the stock market rose on average 11.5% per year on average.
Flow of Funds
Short-Term Interest Rates
Long-Term Interest Rates
The theory behind using short-term interest rates as stock market
signals is based on two assumptions.
First, interest-bearing investments are alternatives to stock
investments. In other words, savers make choices about placing
their investment funds in interest-bearing securities or the
stock market. When interest rates are relatively high, the
interest-bearing securities look relatively more enticing.
Second, interest rates directly affect costs for corporations and,
thus, corporate earnings.
The interest rate itself is important because the expected rate of return
in the stock market must be greater than the short-term interest rate
for investors to invest.
Federal Reserve policy indicators and short-term interest rates are
generally very accurate, though often early, as a predictor of stock market
direction. Figure on next slide shows the relationship between short-term
interest rate movements and the S&P500. During the speculative bubble in
1998 to 2000 and its collapse into 2002, however, interest rates had little
effect upon the market’s direction. Emotion had overcome logic, and the
relationship between short-term interest rates and the market was
abandoned for greed to make easy money and fear of missing the next
upward wave in stock prices. Again, in the period between 2007 and 2009,
when the stock market collapsed to a new 10-year low, lower short-term
interest rates had no positive effect on the stock market. Financial jargon
calls this behavior “pushing on a string,” when short-term rates do not
cause incentives to buy stocks. The last time rates did not work was in the
1920s speculative bubble and early 1930s collapse. They were reliable for
more than 50 years thereafter.
As a rule, long-term bonds have tended to move in the same direction
as the stock market. In other words, long-term interest rates have
tended to move in the opposite direction from the stock market. As the
bond market makes a major bottom, the stock market often makes a
major bottom also. At tops, the bond market tends to lead the stock
market and is, thus, very often, an early indicator of trouble ahead for
the stock market. As in short-term interest rates, this relationship
broke down during the period of the speculative bubble and collapse
between 1998 and 2002 and between 2007 and 2009. Prior to those
periods, the relationship had been steady for over 50 years and will
likely return.
• The velocity of money is a measure of how fast money turns over in the
economy. It is calculated as a ratio of personal income to M2.
• Historically, money velocity is related to inflation, as the faster money
circulates, the more pressure exists on prices, and as a leading indicator
of long term interest rates, again because it reflects inflationary pressure.
In terms of being an indicator for the stock market, Ned Davis Research
has found that when money velocity (a monthly figure) rises above its
13-month moving average, the stock market has advanced 3.4% per
annum on average. When money velocity declines below its 13-month
moving average, the stock market has advanced 10.1% per annum. This
relationship is shown in Figure 10.9. Clearly, inflationary pressures from
increased money velocity put a damper on stock market prices.
Flow of Funds
The Misery Index is a universal index that can be calculated for any
country by simply summing the country’s inflation and unemployment
rates together. The original Misery Index has been modified to create the
American Misery Index. The American Misery Index is calculated by
adding the inflation, unemployment, and interest rates. Figure 10.10
shows how the level of the American Misery Index has related to the
performance of the DJIA since 1966. This figure shows the results of
buying the DJIA whenever the American Misery Index falls by 0.3 points
and selling the DJIA whenever the index rises by 3.2 points. The trading
accuracy of this system is 75% favorable, and its gain per annum is
greater than the buy-and-hold gain per annum by over 4%. Because the
calculation of the Misery Index is easy and low-cost, the profitable results
of this trading system appear valuable.
Flow of Funds
The Federal Reserve has three main tools for adjusting the money supply:
1. Changing the amount of reserves that banks are required to hold,
2. Hanging the discount rate, and
3. Buying and selling U.S. Treasury and federal agency securities through
its open market operations. The third tool (open market operations) is
the one that the Fed most often uses.
Iowa Electronic Markets
Whenever the Federal Reserve raises either the federal funds target rate, margin
requirements, or reserve requirements three consecutive times without a decline,
the stock market is likely to suffer a substantial, perhaps serious, setback.
This simple rule is still relevant. Although it tends to lead a market top, it is
something that should not be disregarded. As shown in Figure on next slide the
rule has been followed by a median decline of 17%. Only two possible incorrect
signals were given since 1915: The 1928 signal, prior to the 1929 crash, was
possibly too early, and the 1978 signal was probably too late. Thus, this signal
has an accuracy record of at least 87.5%.
The Two Tumbles and a Jump indicator was first mentioned in Fosback’s 1973
edition of Market Logic. It is essentially the opposite of Gould’s Three-Steps rule.
Although it uses changes in the Federal Reserve funds target rate, margin
requirements, and reserve requirements, it looks for two consecutive declines, or
tumbles, in any of these policy variables. It has an excellent history of predicting
the stock market rises. As Figure 10.13 demonstrates, the percentage of accuracy
since 1915 is 84%, with some of the errors considered questionable.
Flow of Funds
Banks traditionally practice maturity intermediation, borrowing short-
term funds and lending to corporations or individuals over longer
periods. Thus, they are said to “borrow short, and lend long.” Their profit
depends on the spread between the cost of funds, the short-term
interest rate, and the return from loaned funds, the long-term interest
rate. As short-term interest rates rise, presumably from Federal Reserve
policy action and long-term interest rates remain steady or decline, the
yield curve becomes flatter and the banks are unable to profit as much
from the spread. The yield curve, therefore, is a crude measurement of
bank potential profitability. Bank profitability affects interest rates, and
interest rates affect the stock market. Thus, the yield curve is a
forecaster of stock market direction, and, historically, it has had an
acceptable record of anticipating major turns in the stock market.
Flow of Funds

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Flow of Funds

  • 2. • When aggressive investors or traders become nervous about the stock market, they usually sell stocks and place the funds into money market mutual funds. • Margin debt, the amount of funds that customers at brokerage houses borrow for commitments in stocks, has historically been considered a sentiment indicator. • The theory was that when markets became speculative and attracted the less-sophisticated and less-knowledgeable investors and traders, who began to trade on margin, the market was near a top.
  • 3. • Today’s speculator, instead of borrowing from his brokerage firm, can purchase and sell various highly leveraged derivatives such as options and futures that avoid being reported to the exchanges as margin debt. •It uses a 15-month rate of change as the indicator of margin debt excess. When, over this period, the indicator crosses above –21%, a buy signal is generated, and when it crosses below 57%, a sell signal is generated. Eighteen months after a buy signal, the stock market has advanced on average 47.2%, and on sell signals it only advanced 2.0%. This has worked well in the period from 1970 through 2010, but potential change in the parameters must be considered for the future.
  • 5. A secondary offering is the offering of additional shares of stock in a company that is already publicly traded, as opposed to a primary offering which occurs when stock in a newly publicly traded company is offered. This is usually a bearish sign for two reasons. First, it is a sign that more supply is coming into the marketplace, soaking up available funds. Following the basic principles of economics, as the supply of stock increases, the price of stock will fall. Second, the sellers, usually insiders, are liquidating. These insiders will try to sell stock at times when they think the price is relatively high. Thus, an increase in public offerings is directly related to supply and demand for stock and is also a sentiment indicator.
  • 7. •Households, like corporations and governments, have different kinds of assets. They have both physical assets, such as cars and houses, as well as financial assets, such as stocks, bonds, mutual funds, and banking accounts. •Some of their financial assets are liquid and some are not. •Liquid assets can be converted to cash quickly; cash, bank deposits, money market mutual funds, U.S. Treasury bonds, notes, and bills are liquid financial assets. • Other financial assets cannot always be converted to cash quickly; stocks generally are considered to be more liquid than other financial assets, such as pension funds, retirement accounts, profit-sharing accounts, unincorporated business ownership, trusts, mortgages, and life insurance. • A ratio of liquid financial assets to total assets shows how “liquid” households are—in other words, how easily they can raise cash if they need it. Generally, the more liquid households are, the more able they are to invest in stocks. When household liquidity is high, it is, therefore, favorable for the stock market, whereas low liquidity is negative for the stock market.
  • 8. The data presented in above Figure shows a substantial decline in household liquidity in the 1990s. This is one reason why consumer debt rose so strongly and why households were unable to withstand the severe economic contraction. During severe economic contractions, one major source of funds for cash-strapped households is the stock market. Thus, this indicator, although it does not give mechanical signals, does measure the potential funds for stock demand or supply.
  • 9. • Expansion in the money supply is a measure of potential demand for stock, as well as other assets, and is, thus, a rough measure of the potential for business and stock market expansion. • Increases in the money supply have been historically associated with increases in economic growth and productivity.
  • 10. Ned Davis Research has found that when this ratio exceeds 143, the amount of money available is large, and, consequently, the stock market tends to rise on average 13.0% per year versus an average 5.3% buy- and-hold average annual increase. On the other hand, when the ratio dips to 89 and below, money is scarce, and the stock market tends to decline. This relationship is highlighted in Figure below.
  • 12. Generally, an increase in loan activity, the amount of loans being created and existing, is a sign of increased business activity. It can also be a sign of increased speculation and/or a particular period when banks, because the yield curve is so much in their favor, become less prudent in their lending policies. Ned Davis Research found that since 1948, a year-to-year rise in bank loans (and leases) greater than 13% indicated an overheated economy and a high likelihood of a stock market decline. When bank loans only expanded at 5.5% or lower, the economy was healthier, and the stock market rose on average 11.5% per year on average.
  • 15. The theory behind using short-term interest rates as stock market signals is based on two assumptions. First, interest-bearing investments are alternatives to stock investments. In other words, savers make choices about placing their investment funds in interest-bearing securities or the stock market. When interest rates are relatively high, the interest-bearing securities look relatively more enticing. Second, interest rates directly affect costs for corporations and, thus, corporate earnings. The interest rate itself is important because the expected rate of return in the stock market must be greater than the short-term interest rate for investors to invest.
  • 16. Federal Reserve policy indicators and short-term interest rates are generally very accurate, though often early, as a predictor of stock market direction. Figure on next slide shows the relationship between short-term interest rate movements and the S&P500. During the speculative bubble in 1998 to 2000 and its collapse into 2002, however, interest rates had little effect upon the market’s direction. Emotion had overcome logic, and the relationship between short-term interest rates and the market was abandoned for greed to make easy money and fear of missing the next upward wave in stock prices. Again, in the period between 2007 and 2009, when the stock market collapsed to a new 10-year low, lower short-term interest rates had no positive effect on the stock market. Financial jargon calls this behavior “pushing on a string,” when short-term rates do not cause incentives to buy stocks. The last time rates did not work was in the 1920s speculative bubble and early 1930s collapse. They were reliable for more than 50 years thereafter.
  • 17. As a rule, long-term bonds have tended to move in the same direction as the stock market. In other words, long-term interest rates have tended to move in the opposite direction from the stock market. As the bond market makes a major bottom, the stock market often makes a major bottom also. At tops, the bond market tends to lead the stock market and is, thus, very often, an early indicator of trouble ahead for the stock market. As in short-term interest rates, this relationship broke down during the period of the speculative bubble and collapse between 1998 and 2002 and between 2007 and 2009. Prior to those periods, the relationship had been steady for over 50 years and will likely return.
  • 18. • The velocity of money is a measure of how fast money turns over in the economy. It is calculated as a ratio of personal income to M2. • Historically, money velocity is related to inflation, as the faster money circulates, the more pressure exists on prices, and as a leading indicator of long term interest rates, again because it reflects inflationary pressure. In terms of being an indicator for the stock market, Ned Davis Research has found that when money velocity (a monthly figure) rises above its 13-month moving average, the stock market has advanced 3.4% per annum on average. When money velocity declines below its 13-month moving average, the stock market has advanced 10.1% per annum. This relationship is shown in Figure 10.9. Clearly, inflationary pressures from increased money velocity put a damper on stock market prices.
  • 20. The Misery Index is a universal index that can be calculated for any country by simply summing the country’s inflation and unemployment rates together. The original Misery Index has been modified to create the American Misery Index. The American Misery Index is calculated by adding the inflation, unemployment, and interest rates. Figure 10.10 shows how the level of the American Misery Index has related to the performance of the DJIA since 1966. This figure shows the results of buying the DJIA whenever the American Misery Index falls by 0.3 points and selling the DJIA whenever the index rises by 3.2 points. The trading accuracy of this system is 75% favorable, and its gain per annum is greater than the buy-and-hold gain per annum by over 4%. Because the calculation of the Misery Index is easy and low-cost, the profitable results of this trading system appear valuable.
  • 22. The Federal Reserve has three main tools for adjusting the money supply: 1. Changing the amount of reserves that banks are required to hold, 2. Hanging the discount rate, and 3. Buying and selling U.S. Treasury and federal agency securities through its open market operations. The third tool (open market operations) is the one that the Fed most often uses. Iowa Electronic Markets
  • 23. Whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback. This simple rule is still relevant. Although it tends to lead a market top, it is something that should not be disregarded. As shown in Figure on next slide the rule has been followed by a median decline of 17%. Only two possible incorrect signals were given since 1915: The 1928 signal, prior to the 1929 crash, was possibly too early, and the 1978 signal was probably too late. Thus, this signal has an accuracy record of at least 87.5%. The Two Tumbles and a Jump indicator was first mentioned in Fosback’s 1973 edition of Market Logic. It is essentially the opposite of Gould’s Three-Steps rule. Although it uses changes in the Federal Reserve funds target rate, margin requirements, and reserve requirements, it looks for two consecutive declines, or tumbles, in any of these policy variables. It has an excellent history of predicting the stock market rises. As Figure 10.13 demonstrates, the percentage of accuracy since 1915 is 84%, with some of the errors considered questionable.
  • 25. Banks traditionally practice maturity intermediation, borrowing short- term funds and lending to corporations or individuals over longer periods. Thus, they are said to “borrow short, and lend long.” Their profit depends on the spread between the cost of funds, the short-term interest rate, and the return from loaned funds, the long-term interest rate. As short-term interest rates rise, presumably from Federal Reserve policy action and long-term interest rates remain steady or decline, the yield curve becomes flatter and the banks are unable to profit as much from the spread. The yield curve, therefore, is a crude measurement of bank potential profitability. Bank profitability affects interest rates, and interest rates affect the stock market. Thus, the yield curve is a forecaster of stock market direction, and, historically, it has had an acceptable record of anticipating major turns in the stock market.