These positions, the researchers argue, are often in large part passive, stable, and price insensitive—or inelastic. Much of, but not all of the money they point to is essentially restricted from trading by mandates. Such limited response can also lead to inelastic markets. Koijen argues that fund flows have an important effect on asset prices. Fund flows can also affect bond yields—and may explain part of the EU debt crisis in Southern Europe, research suggests. Read more. In , as the European Union was trying to claw its way out of a sovereign debt crisis, Greece teetered on the edge of solvency.
Its debt crisis was so severe that the country seriously flirted with leaving the eurozone and readopting the drachma. A sizable spread developed between the yields on long-term bonds in Germany and those in the countries in Southern Europe.
Comparing Germany with Greece, Italy, and Portugal, the researchers determine that macroeconomic variables accounted for 64 percent of the variance in spreads. Long-term debt levels accounted for another 14 percent. And demand had about the same weight. But when the researchers reconstructed what happened by country, separating the outcome for Greece from the fortunes of its neighbors, they saw investor demand at work.
In Greece, fundamental problems weighed on bond yields. This investor fear driven by perceived risk had real consequences. It caused a wider borrowing crisis throughout Southern Europe and forced the European Central Bank to act. The ECB cut interest rates and extended low-cost loan facilities to banks that might purchase these bonds. The ECB also purchased bonds directly.
In retrospect, if the ECB had known at the time that investors were panicking, was there an alternative? Could the crisis have played out differently? Not necessarily, Koijen says. Ralph S. Gabaix and Koijen calculated the effects of fund flows on individual prices as well as on the market in aggregate. They used a variety of data sources—piecing together a picture using various public filings and reports containing information on holdings and flows in stock and bond markets, generally covering the years to The prevailing view, held by just over half of respondents, was that it would have no price effect.
But in the inelastic markets hypothesis, money that flows into the stock market leads to stronger price effects because there are essentially a set number of available shares, and many of those are not being actively traded.
Moskowitz estimated the price impact one large trader had on prices. He calculates that the multiplier for dollars invested can be even higher for volatile stocks—or lower for companies for which a smaller fraction of the market cap is actively traded. Day traders might like meme stocks, they write, while some pension and sovereign wealth funds have mandates to invest in sustainable, more environmentally friendly companies. Many hedge funds, meanwhile, look for arbitrage opportunities. The researchers developed a framework that starts with a simple model they applied to data to identify the characteristics that determine demand and ultimately prices.
They then divided investors into eight groups according to investor size and strategy—from huge, passive investment advisers to smaller, actively managed advisers and hedge funds. Then they imagined a world in which the assets of one of those groups flows to all other institutional investors.
Performing this portfolio thought experiment leads to many observations, among them that certain small, active investors have the largest influence on valuations. Hedge funds hold less than 5 percent of the equity market, Koijen, Richmond, and Yogo find—and yet, controlling for size, they are the most influential players in the market, more so than far larger pension funds and insurance companies. With international holdings data, Koijen and Yogo performed a similar decomposition exercise, applying the idea to international stock, bond, and currency markets.
Many other forces can move markets, including government and monetary policies, volatility, sovereign debt ratings, and macroeconomic conditions. To tease apart the various forces at work, they developed a model to study what moved exchange rates, long-term yields on bonds, and stock prices across 36 countries between and They find that fundamentals such as macroeconomic variables, foreign exchange reserves, short-term rates, and long-term debt levels were influential.
In exchange rates, fundamentals accounted for 55 percent of the price movements, and macro variables were the primary drivers of stock prices, responsible for 57 percent of the variation. The inelastic markets hypothesis raises questions, one of which is: If flows have a larger impact on prices than standard theories allow, how many of those flows are still made on the basis of fundamentals?
Still, the conversation about the hypothesis has leapt pretty quickly from academic workshops to a public discussion. For example, as Gabaix and Koijen note, central banks have bought trillions of dollars of bonds to support markets.
If it turns out that the multiplier effect exists, and is stronger in stock markets than in bond markets, this could imply that a central bank seeking to influence the economy should buy stocks instead of bonds. If the inelastic markets hypothesis sticks around, it may also have implications for corporate buybacks.
By how much do those affect prices? The idea that market flows matter has skeptics and fans, and perhaps could be the future. Koijen says the new model provides a framework to start exploring the elasticity of the aggregate market and related questions.
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