Flow of Funds

Section 4, Lecture 6
Lesson 3 - Flow of Funds The flow of funds plays a vital role in determining stock market
valuation. Hence, understanding the flow of funds can help us in the assessment of the stock
market.
There are four important topics that we need to know in this lesson.
1. The fund that is available within the financial marketplace
2. The fund that is outside the financial markets
3. The cost of funds
4. The influence that central bank policy has on all of these variables

1. Funds Within the Financial Marketplace

Let us understand how money flows in the financial system and what it indicates.

Money Market Funds: When investors or traders feel edgy about the stock market,
they move their money from the stock market to the money market. And when the situation
improves again money market fund is reinvested back into the stock market. Hence, the
level of money market fund assets can be a contrary opinion sentiment indicator.

Margin Debt: When the market became speculative it attracts the amateur
investors and traders, who begin to trade on margin, thus higher margin debt indicates that
the market is near peak. However, with the development of new financial instrument, new
age speculators have started using highly leveraged derivatives such as options and futures
instead of margin debt. Thus, the market debt figures based indicators are dynamic and
hence it should be continually adjusted.

Secondary Offerings: A secondary offering is the offering of additional shares of

stock in a company that is already publicly traded. Secondary Equity Offerings is a leading
indicator of an imminent market downturn. At one hand, it is a sign that more supply is
coming into the marketplace to soaking up the available funds. On another hand, it indicates
that the sellers (i.e. corporate), are liquidating. These corporate will try to sell the stock at
times when they think the price is relatively high. Thus, an increase in secondary public
offerings is bearish in nature.

2. Money Outside the Security Market

The funds outside the security market also play a crucial role in determining market
conditions. Let us understand it in detail.

Household Financial Assets: Households have different kinds of assets. They have
both physical assets as well as financial assets. Financial assets are either liquid or illiquid.
While liquid assets can be converted to cash quickly whereas illiquid asset cannot be
converted to cash quickly. The more liquid households are, the more they can invest in
stocks. High liquidity ratio of household is favourable for the stock market while low liquidity
is negative for the stock market.

Money Supply: The money supply is positively correlated with the growth in the
economy. Measuring money supply can be a good indicator for the stock market. Money
supply is measured by taking in account M1 (Currency in circulation + Travellers checks +
Demand deposits + Other checkable deposits ) and M2 ( M1 + Small-denomination time
deposits + Savings deposits including money-market deposit accounts + Retail money
market mutual fund shares). Money supply determines the purchasing power and therefore
potential demand for products and services. Hence, Stock prices tend to move higher when
the money supply in an economy is high.

Bank Loans: When loan demand increases, it puts upward pressure on interest
rates. Conversely, a decrease in loan demand puts downward pressure on interest rates.
Hence, it can be said that the growth and contraction of bank lending has a bearing on
interest rates and the stock market. An increase in loan activity is a sign of increased
business activity. But, the rise in credit can also be a sign of increased speculation. Thus, the
increase in bank loans indicates an overheated economy and a high likelihood of a stock
market decline.
3. Cost of Funds
The cost of funds is the cost that borrowers have to pay to use the money. It is also the
reward that lenders receive for letting someone borrow their money. While determining
portfolio allocation to different market Investors compare their expected return with the cost
of funds to see does it make sense to invest in stock market or not at current cost.

Short-Term Interest Rates: Investors make a decision to place their investible

funds either in interest-bearing securities or the stock market. Interest-bearing securities
look attractive when interest rates are high, Conversely, when interest rates are low, then
stock market seems more appealing.To know when a major switch in the direction in shortterm interest rates has occurred is critical knowledge as to a probable switch in stock market

direction. The Central Bank policy indicators and short-term interest rates are usually very
accurate as a forecaster of stock market direction.

Long-Term Interest Rates: Long-term interest rates and stock prices are inversely
related. When long-term interest rates rise, stock prices fall, and when long-term interest
rates fall, stock prices rise. Long-term interest rates basically move in the opposite direction
to the stock market.

Money Velocity: The velocity of money indicate how fast money is moving in the
economy. It is calculated as a ratio of Nominal GDP to M1or M2 . Money velocity is positively
correlated with inflation, the faster money circulates, the more pressure exists on prices, and
as a leading indicator of long-term interest rates, and hence it reflects inflationary pressure.
Evidently, higher inflationary pressures a damper for the stock market.
4. Central Bank Policy
Fed Policy: The Federal Reserves policy has a crucial bearing on all the variables discussed
earlier in this lesson. The federal policy tells the public whether the Federal Reserve is
pursuing a restrictive or expansionist policy.
It is important to be aware of Fed policy as Fed policies primarily impact short-term interest
rates. And short-term interest rates are important to the stock market.
The Federal Reserve or Fed uses three main tools for adjusting the money supply
First, the Fed can change the amount of reserves that banks are required to hold
Second, Fed can change the discount rate
Third, Fed can buy and sell U.S. Treasury and federal agency securities in its open market
operations. The Fed uses this tool to achieve a federal funds rate target (The federal funds
rate is the interest rate at which banks borrow from each other).
Although the federal funds rate is not set by the Federal Reserve, Fed action significantly
impacts this rate. If the Federal Reserve makes open market purchases, banks will have
more money in reserve. Fewer banks will need to borrow reserves from other banks, and
more Banks will have excess reserves that they want to lend. This action pushes the federal
funds rate down. Similarly, when the Fed sells securities, bank reserves decrease, and as
bank reserves decline, more banks want to borrow, and fewer banks wish to lend in the
federal funds market. Thus, the federal funds rate will rise.

By keeping a close eye on the Fed's move, one can understand where the short-term
interest rates are heading and thus can predict the stock market movement.