Talking to John Schroy

John Schroy

As many of you know, when I like a person’s ideas or research I’ll generally try to call them and talk about whatever the topic is that they are expert on. John Schroy is no different, he is a man whom I first came across via his excellent site ‘Capital Flow Analysis‘ which has tutorials on how to examine the Federal Reserves Capital Flow statistics.

He is also a really experienced practitioner – I have a soft spot for people who have been in the trade with lots of experience – who was in the trade across several continents and with a divergent mix of developed and developing markets at the same time.

I spoke to him in his Florida home last week….

KD: Hi John, so, what exactly is the ‘flow of funds analysis’

JS: Flow of funds analysis is a technique of interpreting capital market trends, using flow of funds accounts. The most useful set of these accounts internationally is published in the US by the Fed, but you can use the concepts elsewhere, [He started focusing on the idea when doing  security research in Brazil where he worked for 23 years as a banker/broker dealer/market maker].

KD: What are you finding from it?

JS: Some data shows what is really going on, while things that may be headlined as the cause of a market trend may not be. Generally you are looking to find out the motivation that drives different sectors of the market.

For example, in the US stock market, for many years the prime upward force came from corporations that were buying back their own stock. This amounted to over $5 trillion dollars in buying pressure over the last 20 years. The primary sellers show up in the table for the household sector, but are actually corporate executives cashing in stock options. Since 1982 when the SEC granted ‘safe harbour’ for this practice, stock buybacks have driven the market.

KD: So the long secular bull market wasn’t the powers of deregulation unleashed?

JS: Partially, but not the way we hear it. What happens with buybacks is that a company uses its cash in lieu of paying dividends to buy back its own shares on the market.  This drives up the price. Previously, the company will have issued share options to its executives for free.  In time, the executives exercise these options below market price by buying directly from the company, and they then sell the stock on the market, where the company is keeping prices up by a buyback program. Because of a SEC safe harbour exemption and the fact that transactions take place on the market, rather than directly between executives and the company, the direct link can’t be traced. But, If you didn’t have the buybacks, prices wouldn’t go up as steadily. Options are issued by the company directly to their executives who pay nothing for them and who, after a holding period, when market prices have risen, take up the stock from the company and sell the shares into the market, while the company supports the price.

KD: Is that a rip off?

JS: Yes, a tremendous one, you could argue that it is basically a fraud, in 1982 the SEC issued a rule that gave safe harbour allowing companies to manipulate prices by buying back their own stock.  This has been the driving force in US equity markets ever since. The federal reserve  doesn’t seem able to figure this out, such as when Alan Greenspan made his famous “irrational exuberance’ remark, essentially blaming speculators for the rise in equity prices, rather than the well-documented buyback movement.  Many use the flow of funds accounts only to pick out isolated numbers or trends, but what is really going on is not obvious unless you know how to connect flows from the different tables and have a working theory on how to do this.

KD: When is the flow of funds data published?

JS: The flow of funds accounts come from the Fed. The data is published as Release Z.1 every quarter. The data is generally 3-6 months late. To understand these tables, you have to know how to read the accounts and have a method for connecting data from one table to the next. I publish free tutorials on how to do this. Go to There are also links to the tutorials on the Capital Flow Watch blog.

KD: You spent many years in Brazil? How was that? I heard that back in the 60’s and 70’s Brazil was spoken about the way people presently speak about China?

JS: Well, Brazil is now an industrial power, the private sector there does quite well, whereas government has always been pretty bad, I’d move back but I feel that crime has gotten out of hand. The people are wonderful, and industry and banking are first rate, but things look better on the surface than they really are.

KD: Would you move to Natal or some less populated area?

JS: Crime is everywhere, and it isn’t just the favelas, I left Brazil in 1980. Up to then you could walk around at night and be safe. Now its dangerous in Ipanema in the daylight. There are criminals picking people off with sniper rifles from the surrounding hills. Unless you stay there for a time, speak the language, have friends who can tell you what’s going on, and read the local newspapers, you don’t always get it.  The government does what it can to paint a rosy picture for tourists.

KD: Did drugs play a big role in the development of crime?

JS: Drugs and crime are a symptom, not the cause. There always were a lot of poor people in Brazil, in fact most of the population is still poor.  What you see now in Brazil in terms of progress is mainly due to the ‘economic miracle’ that took place between 1965 and 1980.  During those years, the military kept crime under control, and focused on economic progress.

When I first went to Rio in 1956, I lived in a house right next to a favela, People were friendly and you felt safe. Only a few places in the city were considered to be trouble spots, like any big city.

In the 1980s, after the military turned the government back to civilian politicians, things went to hell quickly. Extreme left wing politicians brought on fifteen years of civil unrest and economic confusion. These were the years of the ‘death-squads’, hyper-inflation, drug wars, and explosive growth of the favelas.

Unfortunately, the leftists also rewrote history and many Brazilians today, who were not alive in those years, have a distorted and negative impression of the ‘Brazilian Miracle’.

The ‘Brazilian Miracle’ is really a period that deserves serious study. When I first arrived in Brazil, the country had few manufactured goods. There had been a textile industry since the 19th century, and a few steel mills, cigarette makers, breweries, and such.  But stores in Copacabana had little to offer of local origin. The few cars on the street were old rattling jalopies. Most manufactured goods had to be imported at extreme prices, and even then were often not available. Anyone traveling abroad went with a list of things to bring back for friends.

But by 1980, after the ‘economic miracle’, Brazilians were making and exporting air-planes! They were producing cars, from the paint to the steel, to the windows, motors, parts, components, with hundreds of sub-industries that had been created from scratch in fifteen years. The speed and degree of industrialization was simply astounding, although many today can’t really put this in context.  In the 1950s, Brazil was the ‘land of the future’, but most Brazilians were pessimistic that the future would ever come.  How could a country with massive poverty, illiteracy, a drastic shortage of capital and know-how, no capital market to speak of, and rampant inflation, ever hope to catch up to the United States as an industrial power?  That this happened is a tribute to good government in the years of the “Brazilian Miracle”.

KD: So did military dictatorship work?

JS: Yes, although the term ‘dictatorship’ is largely an invention of the radical left and the communists. In fact, throughout these years, regular, contested democratic elections were held. The military had taken over only to put down a communist coup d’etat staged by Goulart in 1965 and expected to hold power only for a short time.

The military held only a few positions at the top. None of them got rich. They all left office after their term. No one was clinging to power. The technocrats that ran the ministries were almost all civilians, many educated in the United States.

I lived through those years and was quite plugged in. I never saw or heard of any instances of people being taken out of their homes in the middle of the night or being thrown out of airplanes into the Atlantic as happened in Argentina. In fact, the leftists have been trying to research and discover atrocities under the ‘dictatorship’, but have come up with a stunningly short list of names, mostly criminals who robbed banks or kidnapped ambassadors.

Brazil had always been a close friend of the United States; the military had fought along side with the Americans in Italy in World War II.

Unfortunately for Brazil, when Jimmy Carter became president, he adopted a policy of forcing an immediate return of the corrupt politicians, including communists who were exiled in Portugal and elsewhere.  The military, who didn’t want to hang onto power anyway, said OK and peacefully turned the government back to ‘democracy”.

The communists came back and brought with them the ‘lost decade’ of the 1980s, and the hyper-inflation of the early 1990s.  Today, high school children are told to write papers on the ‘military dictatorship and its evils’.  History is written by those in power.

Eventually in the mid-1990s, a conservative government was elected. Things got back in line.  Inflation was controlled by high taxes, fiscal prudence, high interest rates, and high tariffs that allowed exporters to  build up a dollar surplus. A relatively stable currency, combined with currency options and swaps, and a vast differential in interest rates gave rise to the carry trade that made Brazilian investment appear attractive abroad.

But back to your question, it isn’t drugs  or crime that caused the favelas;  the problem has always been with education.  While Brazil does have excellent schools and universities, there are simply not enough of these institutions to serve the vast populations of poor people spread across an area greater than the continental United States.

I lived ten years in Indonesia where you could go into the villages in Java and Sumatra and see children walking along the side of the road, in scouting uniforms, going to school  even on Saturdays.  I never saw this in Brazil, even during the years of the “Economic Miracle”.

The favelas grew rapidly during the ‘lost decade’ of the 1980s, when leftists encouraged immigration from other parts of the country. Internal migrations have always been a factor in the growth of the favelas, but the situation has worsened over the last twenty years.

KD: Brazil is the same size as the continental USA, and 1/3 of the population, why isn’t the miracle continuing?

JS: People in the private financial and industrial sectors are really good, Bradesco and some other local banks were exceptionally well run during the years of the Brazilian Miracle. However, the technocrats that made the Miracle possible were only a thin layer at the top of government.  The rank and file of government workers were notoriously inefficient. Furthermore, the military only expected to be in office for a short time.

The “Miracle” was driven by a series of five year plans, when to undertake permanent reforms, like education, as occurred in Singapore and South Korea, a twenty year plan is needed.  Five year plans worked for industrialization, but even the technocrats that ruled during the ‘Miracle’ years, recognized that failure to address education was a big mistake and a major lost opportunity.

KD: What are your thoughts on Gold?

JS: Gold…. The big thing and risk to the dollar, is inflation. Government in the States has gone mad, in particular on spending.

The rise of gold is obviously 99% driven by inflation fears. Those fears are justified. The threat to the dollar now is the current government.  The hope is that they get kicked out in time to save the situation. There is an extreme level of uncertainty. On top of bad government, there are problems on Wall Street, not yet resolved and that have spread across the world.

The banking system has serious unresolved problems. [he worked in Citi many years ago]. In the banks, many of the decision makers don’t seems to know what they are doing any more. Banks have become too big and too complex. The lesson of 2008 was that nobody seemed to know what to do.

KD: What about Volcker’s thoughts on banking then?

JS: Volcker’s idea of getting the commercial banks out of proprietary trading would be a good start, but there are other problems. For example, to have sound banking you need a government guarantee on deposits.

Today, one of the problems is that a lot of what are essentially demand deposits are not in banks, they are in money market funds [mutual funds that invest in short term commercial paper]. There are no reserve requirements on these funds. The Fed can’t control money supply by adjusting reserve requirements of money market funds. You can write a cheque on a money market fund and it clears just like a regular bank!

KD: What is the attraction of money market funds?

JS: Money market funds were invented in the 70’s  The US government saw them as securities, so they were outside of banking regulations, and fell under the supervision of the  SEC, who were only interested in disclosure.

Because, the money market funds had no reserve requirements or limits on interest rates, and very low fixed costs, they could pay 12% in the Carter years. Back then, there were limits on interest paid by Savings Banks and their deposits had 10-20% set aside as reserves. They were not free to pay market rates of interest like the money market funds.

KD: So it’s a short term bond market that you are funding but it acts like a current account?

JS: It is like a mutual fund but the money market fund maintains a par value at $1 by declaring a stock dividend every day.  Its all done by computer. The distribution is done automatically, one day you have 1 share the next day you have 1.01 shares. if you know that the par value is $1 and you now have 1.01  shares, then you have $1.01 in the ‘bank’, so to speak, instead of $1.

Money market funds act just like a bank account in which you get dividends every day. The cheques you can write are used to redeem a certain number of shares. They redeem the fractional shares necessary to cover the  amount on the check.

The problem is that differential treatment causes a distortion of the market.

Nowadays, even commercial banks run money market funds, if you have a deposit, they’ll sweep it into a money market fund that they run.  It is a way to get out of the reserve requirements and banking regulation.

[John set up a money market fund in the 70’s in Brazil. The Brazilian regulators were a lot smarter than the Americans and one day they ordered him to stop marketing his fund  too aggressively, because of competition with the commercial banks.]

KD: How did Brazil handle inflation?

JS: During the years of the “Economic Miracle”, inflation ran 20-30% a year.  Nevertheless, the country still experienced tremendous economic progress.

In 1965, there was no mortgage market because of the extreme inflation. However, the technocrats  invented ‘monetary correction bonds’ and this brought the mortgage market to life. There also were government bonds with monetary correction that were extraordinarily successful until the 1980s.

The government would publish the rates for monetary correction, based on inflation.  The government bonds also had the option of correction in terms of dollars.

KD: John, I’ve gotta dash, but that last comment will definitely form the foundation of our next call! Many thanks for taking the time out to speak to me.

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