The traditional view of finance is that the stock market is price elastic, meaning that the amount of demand for an individual stock or the entire market is inversely responsive to market prices. In an elastic market, if the price of a stock increases, the demand decreases proportionally. However, the recent massive gains in stocks, particularly the Mag-7, seem inconsistent with an elastic market. More recent academic research suggests that stock prices are inelastic, meaning that higher stock prices do not meaningfully reduce demand. Stated another way, investors (particularly passive ones) are not wary of buying or owning expensively valued stocks.
The “Inelastic Markets Hypothesis” posits that cash flows in and out of the stock market have a significant impact on stock prices. According to the hypothesis, positive flows into the equity market, such as from 401(k)s, may be creating more upward pressure on stock prices than classic market theories would forecast. 1.
Other research indicates that stock market price sensitivity has decreased in tandem with the rise of passive investing. Intuitively this makes sense. Active managers often display elastic behavior, selling expensive stocks and purchasing cheaper ones. However, index managers display inelastic behavior, as they buy stocks based on their index weight without consideration of price. The large growth in passive assets helps explain both the increasing inelasticity of markets and the concentration of gains into a narrow group of mega-cap stocks.2.
Beyond helping to explain the current state of stock prices, the Inelastic Market Hypothesis is well suited to help explain the strong price appreciation in Bitcoin and Gold and the outperformance of stocks buying back their shares.
While some research highlights the undesirable structural impacts caused by the growth of indexing, overall, the positives of passive investing, including low fees, transparency, diversification, and strong past performance, outweigh the negatives. Thus far, the inelastic equity price movements have been beneficial to investors, but large prices movements due to inelasticity can be both positive and negative.
- Xavier Gabaix and Ralph Koijen, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis”
- Valentin Haddad, Paul Huebner & Erik Loualiche, “How Completive is the Stock Market?”
Chart Source: Bloomberg