When the pandemic hit and spread in 2020, stock markets in the European Union, Japan, and the United States plummeted up to 30 percent. The implications of the virus for public health, the global economy, and numerous aspects of everyday life were uncertain, and dire. But to financial researchers, the extent of these market reactions was still perplexing. “For the stock market to decline by 30 percent only due to revised growth expectations, the shock to future dividends needs to be large and highly persistent,” wrote Chicago Booth’s Niels Gormsen and Ralph S. J. Koijen that fall. “It would be, for instance, inconsistent with a V-shaped recovery.”
Stock markets were being volatile, yes, but they were acting more volatile than could be explained by looking at the underlying fundamentals. And there have been other examples of extreme volatility, including the stock run-ups in video-game retailer GameStop and movie-theater chain AMC. The dynamics extend to different types of markets too. A single bitcoin has no future earnings or cash flow, and should therefore be worth nothing, according to traditional models. So why pay tens of thousands of dollars for one? And why should their value swing so wildly in response to a tweet from billionaire Elon Musk?
The conventional wisdom, embodied in the efficient-market hypothesis, holds that market prices reflect the fundamental value of the underlying asset. But increasingly, research is identifying another force as being important: investor demand that may or may not be informed. Chicago Booth’s Samuel Hartzmark and Boston College’s David H. Solomon, in a study of data from 1926 to 2020, find that the stock market tended to rise more on days with heavier dividend payouts, as investors took cash hitting their accounts and reinvested it in the market. (For more, read “Dividend payouts lead to stock-price bumps.”) “There’s no reason we should see anything like we do,” Hartzmark says, unless the conventional wisdom is wrong—or missing something.
Harvard’s Xavier Gabaix and Booth’s Ralph S. J. Koijen are among those who say that it is. And their inelastic markets hypothesis lays out an argument for why financial models need to include the long-ignored forces of supply and demand. They calculate that every $1 flowing into the market pushes up aggregate prices by $5, and that these forces also amplify volatility, explaining why stock returns are more than twice as volatile as fundamental information implies they should be.
At the heart of their argument is a new description of the stock market, which has been transformed over the past few decades by the rise of index funds and other large, slow-moving investors.
“What we’re suggesting is that a large fraction of the market is restricted by mandates, therefore not necessarily reacting to new information. And in some cases, investors may be having a hard time assessing expected returns, in which case they’re also not acting much on prices,” says Koijen. With so much money essentially sitting on the sidelines, prices are more sensitive to what trading does happen. “As a result, shocks to flows and investor demand have an outsize effect on prices, leading to volatile markets.”