ECONOMICS IS ABOUT supply and demand—just not in financial markets. A building block of asset-pricing theory is that the value of stocks and bonds is determined by their expected future payoffs rather than by ignorant trades. If an investor unthinkingly throws money at, say, shares in Apple, opportunistic short-sellers are supposed to line up to take the other side of the bet, keeping the share price anchored to where it ought to be, given Apple’s likely profits. Free money gets picked up and dumb money gets picked off. Markets are efficient, in that prices come to reflect genuine information about the future.
At this point your columnist may be in danger of provoking guffaws. It has been a bad year for the textbooks. Retail investors have driven up the prices of meme stocks such as GameStop and AMC. Cryptocurrencies, the fundamentals of which cannot easily be analysed, have soared too. Even America’s bond market is a puzzle: the ten-year Treasury yield is only 1.4% even though annual consumer-price inflation has reached 5.4%. So-called “technical” explanations for market movements—“where you put things that you can’t quite explain”, according to Jerome Powell, the chairman of the Federal Reserve—are in fashion. So it is apt that an emerging theory of how markets work says that even random financial flows may matter a great deal to asset prices.
In a recent working paper Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago study how the aggregate value of America’s stockmarket responds to buying and selling. Researchers have studied flows before, typically finding noticeable effects as investors sell one stock and buy another. Messrs Gabaix and Koijen are interested in whether this finding scales up to move the market as a whole—a thesis that is consistent with the smaller-scale findings, but more provocative.
The first challenge is getting definitions straight. The financial press often writes about money flowing into stocks, but for a security to be bought, it also has to be sold. The authors’ definition of inflows relies on the fact that investment funds often promise to maintain a fraction of their portfolio in equities (a retirement fund offered by Vanguard, say, might offer investors 80% exposure to stocks and 20% to bonds). A flow into stocks is defined as an investor using fresh cash, or the proceeds of selling bonds, to buy funds that hold at least some equities. The higher the share devoted to equities, the larger the “flow”. The amount of securities in existence does not change—for every buyer, there is a seller—but their price is forced up until the value of the market is sufficient to satisfy each fund’s mandate to hold the target fraction of its portfolio in stocks.
Using statistical wizardry the authors isolate flows into stocks that appear unexplained (by, for example, GDP growth) over the period from 1993 to 2019. They find that markets respond in a manner contrary to that set out in the textbooks: they magnify, rather than dampen, the impact of flows. A dollar of inflows into equities increases the aggregate value of the market by $3-8. Markets are not “elastic”, as textbooks say they should be. Messrs Gabaix and Koijen therefore call their idea the “inelastic markets hypothesis”.
Does inelastic mean inefficient? A trader who could see flows coming would get rich quickly. (It has long been known that the so-called “front-running” of big trades, which is usually banned, is profitable.) But flows are hard to predict, says Mr Koijen. A true believer in markets might argue that unforeseeable flows are the mechanism by which the right price is reached, and reflect new information coming to the fore.
Even if flows are ill-informed, though, the opportunity to profit from them is small once they have already moved the price, says Mr Gabaix. And the arbitrageurs who are meant to keep the whole market anchored to fundamentals do not seem to exist. The authors note that at the onset of the global financial crisis hedge funds owned less than 4% of the stockmarket, and that their trades tended to amplify market movements, not dampen them. Funds are constrained by limits on leverage and by the fact that they must cope with the investments and redemptions of underlying investors. Different parts of the market do not trade much with each other, as would be necessary for markets to be elastic.
The paper will surprise the typical economist, who, according to the authors’ surveys, believes that flows do not affect prices. It also threatens associated financial theories. One is the Modigliani-Miller theorem, which says that it does not matter whether a company finances itself with equity or with debt. In inelastic markets, by contrast, a firm that issues debt to buy back its stock will find that it drives up both its own share price and the broader market. The authors look only at stocks, but other research suggests that bond markets are inelastic (albeit to a lesser degree). As a result, central banks’ quantitative-easing policies, under which they buy bonds, will affect bond yields—something that many traders take as given but that purists say should not happen.
Messrs Gabaix and Koijen hope to inspire research that explains market movements using the granular, observable choices of investors, rather than attributing gyrations in markets to unobservable changes in beliefs. And portfolio managers who typically try to forecast future business conditions might find it productive to try to predict flows into and out of investment funds instead.
There may be an irony here. The authors do not study whether markets have become less elastic over time, but in recent decades funds that passively allocate fixed percentages to indices have grown in popularity, making their theory more plausible. The trend is a vote of confidence in markets’ efficiency, which should make the returns to active stock-picking low. Yet passivity may breed inelasticity—and therefore create opportunities for a canny investor who is ahead of the crowd. ■
This article appeared in the Finance & economics section of the print edition under the headline “The fundamentals of finance”