Flow of Funds Analysis: Technical Primer

BALTIMORE (Stockpickr) -- Chances are, "flow of funds" doesn't enter into most investors' analysis of the markets. But traders who don't fully grasp how cash impacts stocks are doing themselves a major disservice. Flow of funds analysis isn't just a key to market mechanics -- it's also incredibly relevant to this summer's volatile market conditions.

In today's Technical Primer, we'll take a look at how the flow of funds impacts market prices and how you can analyze this meaningful metric to figure out what's happening next for your portfolio.

Simply put, "flow of funds" refers to the movement of money in the market. It's arguably the single most important concept that bridges the gap between that ethereal thing we call "the market" and the place where the rubber meets the road in technical analysis. At the end of the day, fundamentals, economic factors and news stories don't move stock prices; the flow of funds into and out of the market is the only thing that matters.

Let me explain.

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How Fund Flow Impacts Share Prices

Back in high school, just when my attention was starting to turn to the stock market, I thought that when companies made money, their share prices simply increased as well. It was a logical assumption -- and one that many casual market observers still hold. But it's got a serious flaw. Increased earnings don't actually drive increases in share prices; it's the buying interest that comes from those earnings that physically drives prices higher.

That's why stocks can fall even in the face of a strong earnings release. The flow of funds has everything to do it.

Just like any other dealer or auction market, cash flowing into stocks results in increasing prices, while cash flowing out of stocks results in falling prices. That's because the flow of funds is just the physical manifestation of the supply and demand forces that drive technical analysis. As demand for stocks increases and cash flows into the stock market, for example, eager buyers outbid each other and sellers become less inclined to part with their shares, causing prices to rise. That flow of funds is absolutely required to move share prices.

In the real world, prices can't move on forever -- they're subject to very real constraints. On the down side, those constraints are fundamentals. If a stock becomes so absurdly discounted that it's out of whack with reality, buyers can come in and acquire the company, either selling off its assets for a quick arbitrage gain or hanging on to pocket its earnings at a bargain price.

On the up side, the biggest constraint is cash. If investors run out of money to keep lofting share prices, they'll eventually fall as the supply demand balance shifts lower.

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Flow of Funds Analysis

If money ultimately drives stock prices, then it makes sense that "following the money" can reveal a lot about what's going on in stocks. Generally, investment dollars come from a few sources. They can come from cash on hand (in a savings, brokerage, or money market account, for instance), they can be borrowed from brokers as margin, or they can be borrowed from other places (think home equity loans and credit cards).

When you're analyzing the flow of funds, you want to see how much cash investors can deploy to boost stock prices.

It's also worthwhile to think about the flow of funds when looking at the relationships between different assets. There's a reason that treasuries rally when stocks move lower - it's because people are selling off their stocks and using that money to buy treasuries. Remember, money is finite. That means that for an asset class to rally (or even just to hold price levels), there needs to be money flowing into it.

The flow of funds between different assets comes down to what looks attractive to market participants. Whenever "safer" alternatives (like bonds or treasuries) can provide returns similar to stocks, cash is going to flow out of the equity market, and stock prices will fall.

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How to Gauge Flow of Funds

Now that you know how the flow of funds works in a market, it makes sense to figure out how to put that knowledge to work for your portfolio. To do that, you'll want to take a look at a metric that counts up how much money is out there. These are a few popular flow of funds indicators:

1. Mutual Fund Cash Levels: You can't just go around asking investors how much cash they have sitting around. But you can ask mutual funds. Mutual fund cash levels tell investors how much cash institutional funds can deploy to buy stocks; low levels of cash mean that funds can't put more money to work and that any sort of reallocation will require selling in assets that the funds already own; those are two bearish indications for any market. More important, mutual fund cash levels indicate how much cash other investors hold as well.

It's important to note that mutual fund cash levels are only a useful indicator in the shorter term. As NDR's Ned Davis pointed out in a recent presentation, mutual funds have dramatically increased their allocations to stocks in recent years as lower market exposure led to underperformance versus index funds in the bull markets of the last two decades. When your time horizon is measured in years (not decades), they're still a very valid indicator of how much "dry powder" investors still have.

Mutual fund cash data can be found at www.ici.org, or through professional services like Bloomberg.

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2. Margin Debt

The idea behind measuring margin debt is very much the same. As bull markets become overbought, irrational exuberance sets in, and investors pile everything they have in to the market. That's when margin debt levels are at their highest (the same can be said about strong bear markets, albeit to a lesser degree). NYSE Euronext ( NYX) maintains a database of margin debt and portfolio cash numbers at its NYSE Technologies Factbook website.

3. Anecdotal Flow of Funds Observations

One of the most powerful sources of flow of funds data actually comes from outside the market in the form of anecdotal observations. Other measures of consumer financial health (such as consumer debt, savings rates, and home equity data) can give a good view of how much cash retail investors have available to them (and available to buoy stock prices).

Looking at the day-to-day movement of prices is another important anecdotal way to get a handle on the flow of funds. As an example, if stocks are moving lower and treasuries are moving higher, it's clear that investors are actively taking risk off the table by selling their stocks, and buying risk-free treasuries. If all assets are rising, on the other hand, suddenly we have a situation where the net cash available to the markets is increasing -- and rising tides have the potential to lift all boats. Keeping an eye on those intermarket relationships can tell you quite a lot about where the money's going.

However you choose to implement it, flow of funds analysis is the cornerstone of how markets move -- and why technical analysis works. Understanding how flow of funds impacts stocks is guaranteed to make you a more effective trader and a more market-conscious investor. Next time, we'll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.

In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.

-- Written by Jonas Elmerraji in Baltimore.


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Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.

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