Revenge of the dumb money

Capital flows affect stock prices. This basic proposition aligns poorly with conventional wisdom in finance. It’s also easy to dismiss – after all, for every buyer there is a seller, right? Duh!

As it happens, though, this is the subject of a growing number of interesting research efforts. They revolve around the perhaps somewhat nebulous concept of stock market elasticity.

In basic economics, we talk about price elasticity. If a price rise of 1% lowers the volume of goods sold by 5%, demand is highly elastic – meaning it is very sensitive to changes in price.

In finance, the concept is somehow turned on its head: We want to know the sensitivity of the stock price to changes in capital invested in the stock market through mutual funds, pension funds etc. If the market is elastic, it can absorb this supply of capital without really changing the price. Given a price elasticity of 5 (or, conversely, a multiplier of just 0.2), an inflow of 5% would only increase the price level by 1%.

In standard models, the market is even more elastic. When prices rise, more investors find stocks expensive, and decide to sell. We’re taught that stock market returns are a function of the risk-free rate and a perhaps inexplicably high risk premium. Capital flows don’t enter into it. There’s perfect competition and a given price in a perfect market.

Not so in real life.

This acute insight has started to make inroads into financial research too. Here’s the crux: What if investors don’t find the new price level expensive? What if they actually don’t care about the price?

This is the case for investors with a fixed mandate, most notably passive investors like index funds. If they have an inflow of a billion dollars, this capital must be invested in the index. If that makes prices rise, so be it.

And they certainly do. According to research now gaining traction in the financial community, the stock market is highly inelastic: 1 dollar invested in the stock market makes the aggregate market value rise by as much as 5 dollars (a multiplier of 5). The rising share of passive investment means that fewer investors now find the new price level too high. There are simply more investors for whom the price level is irrelevant.

See the implications?

• Passive investment contributes to stocks being permanently higher priced. Pundits have claimed for years that the market is overvalued. It just might stay that way.
• This applies primarily to index stocks, which explains why many active investors have struggled over the past 15 or so years. Large fund flows into passive funds have pushed up the prices of index stocks.
• Several papers, like this one, find that the effect is disproportionately more powerful for larger stocks; their price appreciation is not corrected by active investors. This then explains the growing concentration in a small number of index stocks like “the Magnificent Seven”.
• It also makes it easier for retail traders to move prices in smaller stocks. Remember the GameStop frenzy, where Reddit users contributed to pushing up the price from $17.25 to roughly $500 in January 2021? One important reason, apparently, was that over 60% of the company’s shares were held by perfectly inelastic (passive) investors.

I dare say it’s getting harder and harder to explain why conventional wisdom fails to explain such features of the stock market.