A dispassionate scientist once joked, “If economists wanted to study horses, they wouldn’t go and look at horses. They would sit in their studies and say to themselves: ‘What would I do if I were a horse?'” But at least horses are spared this kind of attention; Not the finance type. And an economic idea is especially liable to make them fill with impatience and ask whether the person citing it has been near any trading floor.
Retail traders clamor for meme stocks, raising prices only to shock short-sellers
This is the efficient-market hypothesis, the formal version of which states that investors, in the aggregate, fully and immediately incorporate new information into asset prices. Those who invoke it may often have an even stronger meaning: markets therefore provide the best possible forecast of fundamentals such as corporate earnings. In other words, the price is always right, as it certainly would be if economists went around and made all the decisions.
Right now this Platonic ideal seems especially remote. Retail traders clamor for meme stocks, raising prices only to shock short-sellers. Shares of GameStop, an ailing video-game seller that was singled out for such gains in 2020, are still worth 20 times more than they were then. They’ve done the same thing as Nvidia, by far the biggest beneficiary of the artificial-intelligence revolution. Nvidia’s fellow tech giants are rushing to issue new stock and sell it to the public – a sure sign that they believe the bull market is nearing its peak. Yet investors are still happily investing.
Financial economists who visit the stables have known for nearly half a century that markets are far more volatile than they would be if only new information would motivate them. Robert Shiller, who won the Nobel Prize in 2013, showed this for bond yields in a paper published in 1979 and for stock prices in 1981. In over a hundred years of data they studied, stock prices fell several times more than could be justified even by a Depression-scale recession. This made it implausible that investors were valuing stocks based solely on dire forecasts of their dividends.
More recently Mr. Schiller’s intellectual heirs have helped to explain why – other than people’s occasional tendency to run away and engage in stampedes. The most inspiring theory, which is gaining momentum among both researchers and academically minded investors, is the “inelastic-market hypothesis”, coined by Harvard’s Xavier Gabaux and the University of Chicago’s Ralph Koijen. Its essence is that share prices, rather than being determined by the dividends (or earnings) expected by investors, are significantly and permanently influenced by capital flows. Messrs. Gabex and Coigen estimate that someone who buys a $1-worth of shares with fresh cash increases his total stockmarket value by $3-8.
To see why, let’s illustrate three types of investors. One is the return-chaser, who buys more shares when they are in bad shape and sells when prices are falling (think retail traders or trend-following hedge funds). The second maintains a real estate allocation: 60% in stocks and 40% in bonds, say (think pension plans). The third is a value investor, who is interested in buying stocks only at the lowest levels after a decline (think Warren Buffett). Squint, and this stylized mix looks like the groups that dominate real-world markets. Crucially, any arbitrageurs – who efficient-market enthusiasts imagine can remove distortions and revalue assets according to fundamentals – are few, and strictly prohibited.
Now imagine a retirement saver who wants to buy stocks in a bull market. They cannot kill the return pursuer, who himself wants more. Fixed allocators can only sell when prices rise, as they must maintain their 60/40 split. Value investors will also sell only when shares become more expensive and, therefore, less attractive to them. So capital inflows send stock prices up, regardless of what one thinks about future earnings.
If the elites working the trading desks get frustrated with economists preaching about efficient markets, they might smile at this explanation. After all, it sounds like “prices rise to match supply and demand”, without explaining why demand increased to begin with.
That absence may actually be a strength. Ordinary savers who buy stocks each payday don’t typically base their purchases on spectacular corporate earnings forecasts. Nor, necessarily, do institutional investors who are asked to aim for a set return target and give a few better shots. Yet their actions cause share prices to rise. Betting that the future can be predicted seems like a good way to lose your shirt.
