Danger of mushrooming ETFs: How "Inelastic Markets Hypothesis" changes everything

Key topics:Stock markets are far less liquid than traditional theory suggests.$1 investment can move market value by $5 due to inelastic flows.Passive funds now drive prices more than fundamentals or earnings..Sign up for your early morning brew of the BizNews Insider to keep you up to speed with the content that matters. The newsletter will land in your inbox at 5:30am weekdays. Register here.Support South Africa’s bastion of independent journalism, offering balanced insights on investments, business, and the political economy, by joining BizNews Premium. Register here.If you prefer WhatsApp for updates, sign up to the BizNews channel here..By Alec Hogg.In the world of investing, there are certain bedrock beliefs we cling to. We believe in the efficiency of the stock market. We believe that although Mr Market can temporarily distort the picture, in the long term, share prices reflect the collective wisdom of millions of rational actors, all processing information instantly. We also believe that markets are deep, liquid oceans where a single stone — or a single dollar — causes barely a ripple.But what if the pool of funds we believe to be an ocean is actually just a puddle?A groundbreaking paper by Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago (attached) concludes as much. It is titled the "Inelastic Markets Hypothesis," and for anyone who manages money or worries about their pension, it makes for startling reading.The "Mystery Multiplier"Their central thesis challenges the very liquidity thesis of stock markets. For decades, theory has taught us that the demand for shares is "elastic." In plain English, this means if the price of a company’s shares deviates from its fundamental value, the smart money will swoop in to buy or sell - arbitrage the pricing gap and, in time, profit accordingly. In this theoretical world, a large buy order shouldn't move the price much because there’s always a willing seller at the "right" price..Read more:.FT: Emerging markets roar back with biggest stock rally in 15 years.The conclusion reached in their research led Gabaix and Koijen to argue the opposite. They calculate that the market is remarkably "inelastic", something they quantify. The headline number is a fivefold multiplier. According to their research, investing $1 in the stock market increases the market's aggregate value by approximately $5. Conversely, selling $1 destroys $5 of value.That sounds crazy. How is it possible for $1 of inputto have $5 of impact? That seems to defy the laws of physics, let alone economics.Who is really holding the bag?The answer lies in the way the market has changed, and who actually “owns” the modern stock market. It’s not the money managers, hedge funds or private investors of the past. The authors point out it is now dominated by institutional mandates — pension funds, mutual funds, and, increasingly, Exchange Traded Funds. All of which have strict mandates. Rules they must follow in a robotic fashion. Think about the typical "60/40" balanced fund. It must hold 60% equities. If the market rises, these funds don't necessarily sell to realise profits; they are compelled by their mandate to hold. ETFs are even more rigid; they buy blindly regardless of price because they must follow strict mandates to fulfil their promise of tracking an index. These massive, strictly conformist players are directed by rules, not price. Their decisions are "inelastic" — so there is remarkably little "give" in the system. The weight of old-fashioned ‘smart money’, such as hedge funds and active unit trust managers, which we assume will correct mispriced equities, is now too small to really matter. With the mushrooming of ETFs - and other institutionalised passive mandates - those who make their investments based on experience or their own research - active mandates - now constitute an ever-declining slice of the market. So when there is a net inflow into the pool of cash heading for the stock market, most of it has no choice where to go: as a result, prices must rise disproportionately to induce a sale from the few remaining flexible holders (ie active managers or private investors).Why markets detach from realityThere are profound implications for South African investors. Rational thinkers often scratch their heads, wondering how the JSE or, more obviously, the S&P 500 can detach so violently from what we regard as economic reality. Why do markets keep rising when they are already overpriced relative to past history? Why the buoyancy when the economy is limping? On the other hand, why does a bit of bad news lead to a crash?The Inelastic Markets Hypothesis by Gabaix and Koijen offers a compelling answer: valuations no longer hold the key - it’s all about the flow of money.If households or foreign investors allocate more capital to equities, prices must rise significantly to accommodate that capital, regardless of earnings or GDP growth. There’s a five-to-one multiplier. It explains last year’s market "melt-up" that Magnus Heystek referred to in our discussion earlier this week. Ditto when liquidity is pumped into the system by central banks. On the other hand, it also warns us to prepare for terrifying volatility when liquidity dries up. Something stock market investors have experienced, albeit briefly, a couple of times in the past half-decade. This "multiplier effect" driven by the way strict mandates dominate when invested money is allocated, turns the market into a far more fragile beast than we ever imagined. It suggests that boom-and-bust cycles are not driven primarily by news flow or earnings reports, but by the mechanics of capital inflows and outflows within a rigid system.For the BizNews community, the takeaway is clear: Flow matters much more than we thought. In a world where $1 of buying translates into $5 of market capitalisation, observing the flow of funds — especially into and out of passive giants — might be just as important as reading balance sheets and income statements. The market is no longer a weighing machine as Benjamin Graham famously told us; it has become a flow machine. And right now, the pipes are narrower than we think. We’ve been warned.

Danger of mushrooming ETFs: How "Inelastic Markets Hypothesis" changes everything

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