That's not what I learned in junior financial economist class but if true it would explain some things.
From Verdad Advisors, September 15:
The Butterfly Effect
The Price Impact of Fund Flows in Inelastic Markets
How much does the aggregate value of equities change if an investment fund allocates an additional $1B to stocks? A survey of 300 economists found that the consensus answer was “zero.”
Most financial economists believe that the idea that fund flows might impact market prices is “sadly illiterate,” according to one recent paper. This is because the efficient markets theory presumes that markets are highly elastic—that is, demand is highly reactive to prices and thus stock prices shouldn’t diverge from fundamental value just because large investments flow in or out of the security.
But in a controversial new paper, Harvard’s Xavier Gabaix and Chicago’s Ralph Koijen propose an unorthodox and even heretical idea: that the stock market is so inelastic that $1 invested in the stock market increases aggregate valuations by $5. Their “Inelastic Markets Hypothesis” presents structural inelasticity as the answer to the long-debated excess volatility problem.
The paper is so controversial relative to academic consensus that we decided to replicate the authors’ methodology to better understand the empirical support for their hypothesis. Replicating the paper’s methodology was no simple task. The paper is chock-full of phrases like “intuitively, we use the sector-specific, or idiosyncratic, demand shocks of one sector as a source of exogenous price variation to the demand elasticity of another sector,” and when we emailed the authors to ask their advice, they replied that we’d need a graduate-level course in econometrics to understand their logic. Not a promising start, especially given our skeptical view of ideas that require complex models or academic degrees to understand. But, after substantial effort, we think we understand their empirical argument well enough to discuss it in simple terms and to conclude that we find the argument credible but are not yet willing to say the empirical support is substantial enough to be definitive.
To replicate the study, we compiled the flows and the aggregate levels of equity from 1990 to the present from the Federal Reserve’s Flow of Funds database. The database records the purchase of and the aggregate prices of corporate equities owned by different sectors of investors (households, pension funds, mutual funds, the federal government, etc.). We then compared flows into equity markets to the returns on the S&P 500 index to attempt to understand the relationship between flows and prices.
Since elasticity captures how price responds to demand, intuition would direct us to simply regress returns onto flows. If stock market demand is elastic, the multiple by which flows drive up prices should be no greater than 1. To support the broadest version of the inelasticity hypothesis, we must get a multiple above 1 that is statistically significant.
A regression of the total market value versus aggregate inflows and outflows yields a multiple of 2 but an r2 of 0. By lumping all the investor sectors together, we lower the statistical significance of the multiple. Some investor sector flows do not predict changes in aggregate prices and thus should be excluded from the regression. So we broke flows down by sector, as Gabaix and Koijen do in their paper....
....MUCH MORE
