Inelastic Market Hypothesis
The inelastic markets theory states that price changes can correct stock market supply and demand mismatches. In order to preserve their target allocation, funds with rigorous investing strategies must sell stocks when extra money flows into those funds. Even in the lack of rising earnings or other indicators of fundamental value, this can raise stock prices. This theory aids in explaining market behaviour that places supply and demand above underlying economic worth as the primary drivers of stock prices.
The market has become less diverse as a result of the growth of target-date funds and passive investment funds, making it more vulnerable to supply and demand imbalances. Although some claim that passive funds do not yet control the market, their behaviour, not their moniker, is what matters. Passive funds are likely to react similarly in the event of a demand shock, which could exacerbate the shock’s impact.
The “Inelastic Markets Hypothesis” (GK) by Gabaix and Koijen (GK) focuses on the connection between stock supply and demand. According to their argument, households fund institutions, which have a limited capacity to adjust to shifting market conditions. Therefore, the majority of investment institutions only have a limited degree of freedom in their investment approaches. The limitation on their capacity to react to changes in the market is a major contributor to volatility in the value of money.
It doesn’t take a rocket scientist to realise that this image might be flawed. A highly convincing answer is offered in a recent work by Xavier Gabaix and Ralph S.J. Koijen titled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.” A helpful summary of it is provided by The Economist:
“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. Thus, markets are not ‘elastic,’ as textbooks say they should be. Messrs Gabaix and Koijen, therefore, call their idea the ‘inelastic markets hypothesis.”
The aggregate stock market has a low degree of demand elasticity, which means that even tiny changes in the amount of money flowing into and out of the market can have a big impact on stock prices. As an illustration, if a fund wants to purchase $1 worth of stocks, it might not be able to do so because many funds have mandates that limit them from making sudden changes to their holdings. This lack of adaptability can cause market imbalances and influence price swings.
The stability of stock shares over time for many investors and the absence of institutions capable of arbitraging away mispricings brought on by inelastic demand are further variables that contribute to inelasticity. Target-date funds’ introduction, which encouraged investors to keep equity allocations comparatively steady, has also contributed to this occurrence. It is therefore conceivable that there is not enough capital available to absorb shocks in stock demand.
According to the inelastic markets theory, even slight changes in the demand for and supply of stocks can have a significant effect on stock prices. This is so that they can’t swiftly modify their portfolios in response to shifting market conditions because many investment funds have strict mandates. Target-date funds’ introduction, which encourages investors to hold onto relatively steady stock holdings, has contributed to this issue. The lack of organisations that can arbitrage away mispricings brought on by inelastic demand, according to the authors, further worsens the effects of supply and demand imbalances. The market is more vulnerable to price changes because it lacks flexibility and diversity.
Investing Ramifications on Inelastic Market Hypothesis
According to the inelastic markets hypothesis, rather than more conventional metrics of value like balance sheets, profitability, dividends, and cash flows, the main driver of stock prices is the flow of money. While this might be the case in the near future, value investors like Schloss, Klarman, and Buffett have highlighted the importance of fundamentals over the long run. Fundamental shifts can significantly affect stock prices over the long run. In fact, studies have shown that one basic component alone can account for more than 30% of market swings over the course of a year. This implies that, even while fundamentals may not always be reflected in the market in the short term, they are still crucial for comprehending long-term changes in stock price.
While the inelastic markets hypothesis contends that the short-term major driver of stock prices is the movement of capital, fundamentals are likely to have a greater impact in the long run. “Over the long term, investment returns are perfectly connected to business fundamentals,” famously remarked Warren Buffett. However, figuring out the actual length of the long term and how it stacks up against the short term can be challenging. Comparing the market capitalisation of bonds and stocks globally and using research on the influence of fundamentals on market swings are two ways to evaluate the likelihood of future stock price growth. Regardless of our beliefs regarding the current fundamental situation, our study implies that stock prices have the ability to increase by a factor of two or even beyond their current levels in the future.
What’s in for bonus?
There are several arguments in favour of inelastic markets, many of which are both important and beneficial. Let’s look at them one by one:
- Since markets are inelastic, capital flows account for around one-third of all stock market fluctuations. The ability to replace the “invisible hand” steering the markets with something tangible has important consequences for how markets should be seen.
- There is no seller for every buyer!
- Changes in stock market prices can be attributed to flows with certain investors. Our currency is essential since households and individual investors make up the majority of the investors in this situation.
- Government participation is crucial. Governments don’t often consider this when deciding on policies and taking actions in the market, but if they increase flows, this has a big impact on markets.
- Corporate buybacks have a measurable impact; as investors, we should be able to understand that impact and, consequently, the value that it delivers to shareholders based on the flows in relation to the specific elasticity of the security.
- Their models defy both recognised wisdom in their industry as well as standard theoretical models, and for us individual investors, this should be considered when making investment or policy decisions.
