August 14, 2021
E.CONOMICS is about supply and demand – just not on the financial markets. One building block of asset pricing theory is that the value of stocks and bonds is determined by their expected future payouts, not by ignorant trades. If an investor thoughtlessly tosses money on, say, Apple stock, opportunistic short sellers should line up to take the other side of the bet and keep the stock price where it should be given Apple’s likely profits. Free money is picked up and stupid money is picked up. Markets are efficient in that prices reflect real information about the future.
At this point, your columnist could be in danger of provoking laughter. It’s been a bad year for the textbooks. Retail investors have propelled the prices of meme stocks like GameStop and AMC. Cryptocurrencies, the fundamentals of which cannot be easily analyzed, have also skyrocketed. Even the American bond market is puzzling: the yield on ten-year government bonds is only 1.4%, even though annual consumer price inflation has reached 5.4%. So-called “technical” explanations of market movements – “where you put things that cannot be fully explained,” said Jerome Powell, chairman of the Federal Reserve, are trending. It is therefore true that a new theory about how markets work is that even random financial flows can have a major impact on asset prices.
In a recent working paper, Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago examine how the total value of the American stock market reacts to buying and selling. Researchers have studied flows before and have typically seen a noticeable impact when investors sell one stock and buy another. Messrs. Gabaix and Koijen are interested in whether this finding scales in order to move the market as a whole – a thesis that agrees with the smaller findings, but is more provocative.
The first challenge is to make definitions clear. The financial press often writes that money goes into stocks, but in order for a security to be bought, it must also be sold. The authors’ definition of inflows is based on the fact that mutual funds often promise to hold part of their portfolio in stocks (for example, a pension fund offered by Vanguard might offer investors 80% exposure to stocks and 20% to bonds). An inflow into stocks is defined as an investor who uses fresh cash or the proceeds from the sale of bonds to buy funds that hold at least some stocks. The higher the share of shares, the greater the “flow”. The number of securities in existence does not change – there is a seller for every buyer – but their price is forced until the market value is sufficient to fulfill each fund’s mandate to hold the target portion of its portfolio in stocks.
Using statistical wizardry, the authors isolate flows in stocks that appear inexplicable from 1993 to 2019 (e.g. from GDP growth). than dampen the effects of currents. One dollar of inflows into stocks adds $ 3-8 to the total value of the market. Markets are not “elastic” as it is said in textbooks. Messrs. Gabaix and Koijen therefore call their idea the “inelastic market hypothesis”.
Does inelastic mean inefficient? A trader who could see currents coming would get rich quick. (It has long been known that “front running” of large trades, which is normally prohibited, is profitable.) But the flows are difficult to predict, says Koijen. A true believer in the markets might argue that unpredictable flows are the mechanism by which the right price is reached and reflect new information that comes to the fore.
Even if flows are ill-informed, the chance of benefiting from it is slim if they have already moved the price, says Gabaix. And the arbitrageurs who are supposed to keep the entire market on fundamentals don’t seem to exist. The authors note that when the global financial crisis began, hedge funds owned less than 4% of the stock market and that their trades tended to increase, not dampen, market movements. Funds are subject to leverage and the fact that they must handle the investments and redemptions of the underlying investors. Different parts of the market do not trade much with each other, which would be required for elastic markets.
The paper will surprise the typical economist who, according to the authors’ surveys, believes that flows do not affect prices. It also threatens related financial theories. One of them is the Modigliani-Miller theorem, which states that it does not matter whether a company finances itself with equity or debt. In inelastic markets, on the other hand, a company that issues bonds to buy back its stocks will find that it drives up both its own stock price and the broader market. The authors only look at stocks, but other research suggests that bond markets are inelastic (albeit to a lesser extent). As a result, the quantitative easing policies of the central banks through which they buy bonds will affect bond yields – something that many traders take for granted but purists say it shouldn’t.
Messrs Gabaix and Koijen hope to stimulate research that explains market movements based on the granular, observable decisions of investors, rather than attributing the fluctuations of the markets to unobservable changes in beliefs. And portfolio managers, who normally try to predict future business conditions, might find it productive to try instead to predict inflows into and out of mutual funds.
There may be an irony here. The authors do not examine whether markets have become less elastic over time, but over the past few decades, funds that passively assign fixed percentages to indices have grown in popularity, which makes their theory more plausible. The trend is a vote of confidence in the efficiency of the markets, which should reduce the returns on active stock selection. However, passivity can create inelasticity – creating opportunities for a savvy investor who is ahead of the crowd. ■
This article appeared in the Finance & Economics section of the print edition under the heading “Fundamentals of Finance”