What determines stock market prices? here’s a new theory

Specifically, a dollar of cash from outside the stock market that is invested in equities would increase the combined market cap of all stocks by about $5, while a dollar taken out of the market would have the opposite “multiplier effect.” .

This does not mean that each individual stock will go up when new cash comes into the market. Some stocks and sectors will move higher than others. But overall, according to the study, investors as a group are reluctant to sell their equities when cash comes in from outside the market. Their price insensitivity can be understood intuitively by imagining a market in which there are only two investors: if the first wants to buy the stock with cash from outside the market, and the second wants to continue holding the stock, the price will be very high. have to go. persuade others to sell.

This multiplier effect is not present when the cash used to buy the stock comes from inside the market — in other words, from the proceeds of selling another stock. Any increase in market cap resulting from such purchases will be offset by a decrease due to sales.

In contrast, hitherto academic theory of the market has asserted that investors are extremely price sensitive, very willing to sell when prices rise. As a result, market flows that have no relevance to a company’s fundamentals should play no role. This is why the academic stereotype up to now has been that the flow-based multiplier should be zero.

The new study that finds the opposite, titled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” was authored by Javier Gabax, a professor of economics and finance at Harvard University, and Ralph Koijn, a finance professor. University of Chicago Booth School of Business.

They are not denying that traditional forces related to earnings, dividends, cash flow and risk appetite also play a role, Prof. Gabex says. One of the contributions of his new research is to show that flows also play an important role in explaining market volatility, although he does not yet have an estimate of how important this role is.

Another contribution is to show that not only does a flow-based multiplier exist, but it is quite large.

Cash and Basics

According to the professors, one reason why investors are collectively price-insensitive is that large institutional investors typically operate with a mandate specifying their equity-exposure levels. Most are constrained to maintain a more or less stable ratio of their portfolios in equities. Therefore, contrary to what would have been expected if these investors were price sensitive, they do not reduce their risk when new liquidity comes into the market and prices rise.

Another reason is investor psychology: We become more bullish as prices rise—not less. An example is how much the stock market timer’s recommended equity-exposure levels have risen since the March 2020 low. According to my tracking of about 100 such timers, when the Dow Jones Industrial Average was below 19000, they were on average completely out of the market at that bottom. Today, with the DJIA almost double where it stood, the average exposure level is 63%. If these timers were more price-sensitive, you would expect their equity-exposure levels to be much lower today.

Earlier researchers failed to detect the larger role played by flow, Prof. Gabex argues, because it is surprisingly difficult to measure flows in and out of the stock market as a whole. After all, for every buyer there is a seller, and it makes a big difference whether the cash used to buy a stock comes from the sale of another stock or from outside the stock market. A comprehensive accounting of flows is required to exclude those that are intramarket, and most of the research effort of the professors was devoted to developing such accounting in the period 1993 to 2018.

Many on Wall Street already pay attention to the individual pieces of the flow puzzle. For example, some focus on inflows and outflows into US-equity funds (mutual funds and exchange-traded funds). But, Prof. Mutual fund flows themselves can be confusing, says Koizen. Other important sources of inflows include foreign investors, insider transactions, dividends and share repurchases, contributions to 401(k)s and pension plans, etc. A useful avenue for future research, he added, would be to examine whether flows can be predicted across the market as a whole.

explain the event

In the meantime, this new research provides a fresh perspective on several market phenomena that have so far been a source of controversy, including:

• Share repurchases. While many on Wall Street already believe the buybacks are bullish, others say they have no price effect. The professor explains why buybacks can have a multiplier effect on the combined market cap of all stocks.

• Government incentives. This new research identifies a potentially powerful tool that governments can use to stimulate the market: the outright purchase of shares, which can raise the combined value of the stock market by up to five times the dollar amount allocated for such purchases. Is. Although the US government has yet to employ such a tool, it would not be surprising – especially in light of this new research – that the government is seriously considering it.