The Puzzle That Won't Go Away
The stock market moves in ways that make no sense if you only look at the companies behind it.
Take the 2020 pandemic crash. The broad market fell about 30% in weeks. Niels Gormsen and Ralph Koijen, both researchers at Chicago Booth, pointed out that a drop that big would require an enormous and lasting shock to future dividends.
A quick V-shaped recovery would not produce that kind of decline. Something else had to be driving prices.
That something, according to Koijen and Harvard's Xavier Gabaix, is the way money actually moves through markets. Their theory, called the inelastic markets hypothesis, is gaining traction fast.
The Hidden Multiplier
Here is the core idea. A huge and growing chunk of stock market money is held by investors who do not trade much. Index funds, pension funds, endowments, and other investors tied to benchmarks are largely passive.
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They buy and hold. They do not jump in and out based on news.
According to Morningstar Direct, index funds alone managed $12.5 trillion in assets. Hedge funds, by contrast, own less than 5% of the equity market. So when money does flow into or out of the market - from regular investors, for example - there are not enough active traders on the other side to absorb it smoothly. The result is a multiplier effect.
Real-world examples back it up. During August 1998, Hong Kong's government purchased 6% of its domestic stock market as a defensive measure.
Prices surged 24%. The Bank of Japan owned about 5% of its market in 2018. China indirectly owned 5% in 2020.
Small ownership shares produced outsized moves.
This phenomenon stems from the fact that stock demand is relatively inelastic - meaning that investors do not significantly adjust their holdings in response to price changes. When large, passive pools of capital flow in or out, the limited number of active traders cannot absorb the orders without causing large price moves. This contrasts sharply with the efficient-market hypothesis, which assumes that demand is highly elastic and that prices reflect all available information instantly.
Why does it matter? It means the market's wild mood swings are not random. They are driven by flows - the sheer weight of money moving in and out.
What This Means for Your Portfolio
The inelastic markets hypothesis challenges a bedrock idea in finance: the efficient-market hypothesis, pioneered by Nobel winner Eugene Fama. That old model says prices reflect all available information instantly. The new model says prices also reflect investor demand that has little to do with fundamentals.
Samuel Hartzmark, another Chicago Booth researcher, put it bluntly: "There's no reason we should see anything like we do." Dividend payouts alone can bump stock prices, which should not happen in a perfectly efficient market.
So what does this mean for your portfolio? First, the volatility you see is not a sign that markets are broken. It is a sign that large, slow-moving pools of money - your pension, your index fund - have more influence than anyone realized.
Second, that influence is not going away. Index funds keep growing.
The catch: if prices are driven by flows rather than fundamentals, events like the GameStop and AMC surges make more sense. So do sharp drops that seem out of proportion to the news. The theory is still being tested, but it offers a clearer lens.
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