Philosophically, money flow analysis takes its lead from the market. Instead of relying on fundamental ratios to assess value, money flow analysis looks to what the market itself is signaling about a stock, sector or market. This signal may be about interest rates, commodity prices, earnings expectations, future sales or takeover activity. Money flow analysis rests on the classic economic principles of how supply and demand imbalances affect prices. The complication is that the stock market is a market in which there is not normally an outside supply of stock (company issuance of new stock or repurchase of stock for cancellation are the exceptions to this). Therefore, the stock market operates as a closed system with all investors playing a zero-sum game: one group of investors supply the stock to fulfill demand from another group of investors. Money Flow analysis seeks to measure the excess of demand over supply in a stock, sector or market. It also seeks to establish whether trading is led by buyers (excess demand over supply) or by sellers (more supply than demand), and from this determine future price performance.
Constructing and interpreting money flows is done by monitoring every single trade in a stock. Although for every trade there is always a buyer and a seller, it is very important which comes first - the buy order or the sell order. For example, many buy orders cumulating up one after the other will eventually lead to upwards share-price performance as sellers of the stock require higher and higher price to sell their positions. Birinyi Associates monitors every trade for the major stocks not only in the US, but also in 36 markets worldwide to determine money flow. Although price and volume data on every trade is available, whether the trade is originated by a buyer or a seller is not, so an assumption has to be made. The key assumption of our analysis is that if the trade in question is at a higher level than the previous trade (that is, an up-tick) then it is deemed to be as a result of buying interest. A down-tick is deemed to be a sell led trade.
The next step is to construct the Money Flow for the trade in question: this is the volume of the trade multiplied by the price of the transaction. A buy-led transaction (up-tick) is treated as positive money flow, while a sell-led transaction (down-tick) is treated as negative money flow so that a cumulative picture of Money Flows can be built up. The longer the time period associated with any trend of buying or selling identified by the cumulative money flows, the more statistically accurate it is. Thus Money Flow is equivalent to the net buying or selling interest in a stock, or sector or market. Net interest because any trade that is 'crossed' without changing the prevailing market price is discarded in this analysis (as it should be, because it does not affect the stock price).
Money flow thus gives a picture of the balance between buying and selling interest (that is, net demand/supply). As no new stock usually enters or leaves the market, classic economics would argue that the stock price will react to these imbalances: sustained buying (selling) interest leads to rising (falling) stock prices. In most cases this is the true, much like the Media sector example below, where money flows and the stock price move in parallel.
Clearly this relationship can change at any time given that the tightness with which stocks are held depends on sentiment but chart to the left shows that the Media sector has been treated consistently by the market in 2002 both in the bullish times early on, and the bearish times thereafter. However, in around one in five examples, a stock is marked higher or lower, contrary to the direction of the real trade. This divergence in money flows from stock prices is the most interesting signal in our analysis as it is a lead indicator of future performance.
Given the strong correlation between money flows and share-price performance the path of a stock, sector or market should follow the ellipse shown schematically in
Deviations into positive money flow/negative return and negative money flow/ positive return are possible as price and money flow are only loosely coupled in the short-run.
There are two main ways to use money flow analysis. Continuations show that the market is continuing to buy/sell a stock and that the stock price movement is reasonable. Following this trend is not predictive because flows can always change but it substantially lowers risk as the investment is following the prevailing market logic. Divergences signal when price and money flow have decoupled. This often happens at a turning point in a stock, sector or market. This situation is predictive as stock prices ultimately follow the direction of money flows.
Don't fight the tape is a prominent cliche throughout Wall Street and we hope to highlight what the tape is saying through our research.
The following is a link to a complementary copy of a white paper we penned, Money Flows: Mr Market Speaks.