Is aggregate U.S. stock market value sensitive to flows of new funds (inelastic)? In their October 2020 paper entitled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis”, Xavier Gabaix and Ralph Koijen analyze aggregate stock market fluctuations in relation to flows of money into and out of stocks by different investor categories. They key on difficulties in satisfying demand for stocks/cash when money enters/exits the market. For example, institutions have reasonably rigid equity allocations, many individuals exhibit strong buy-and-hold inertia and hedge funds are not large enough to accommodate large inflows. In other words, households and their institutional proxies require considerable incentive to deviate from established equity allocations. As a result, relative modest flows have large impacts on prices (are inelastic). They further analyze how key tenets of macro-finance change if, in contrast to conventional belief, markets are inelastic. Using data on money flows to/from U.S. stocks across different investor categories as available during 1993 through 2018, and contemporaneous U.S. stock market level, they find that:
- Modeling suggests that adding $1 to the stock market increases aggregate market value by about $5. This model connects historical time variation in market volatility to flows and demand shocks of different investor categories.
- Results are robust to changes in model specifications, with price impact multiplier in the range of 3 to 8.
- Impacts of money flows into/out of the stock market are persistent, not because they carry information about future fundamentals, but simply because permanent shifts in demand for stocks changes equilibrium prices.
- Money flows drive over one third of all stock market fluctuations, with 54% of the effect from U.S. household accounts, 30% from mutual funds and exchange-traded funds, 14% from foreign accounts and 7% from private pension funds.
- Stock market inelasticity means than government purchases of equities and corporate share buybacks have a persistent material impact on aggregate market volatility and growth.
- Findings refute conventional beliefs. Two pre-publication online surveys via Twitter and an online seminar at VirtualFinance.org reveal a median belief that incremental investment in the stock market has no effect on aggregate market value.
In summary, the inelastic markets hypothesis and limited empirical support suggest that flows of money into and out of financial markets, not fundamentals, are preeminent for understanding stock market fluctuations.
Cautions regarding findings include:
- The sample periods for empirical support are short in terms of economic/market cycles.
- The empirical support is largely explanatory rather than predictive. The study does not address potential for investment strategies to exploit the hypothesis.
