Every Day-Trader Dollar Is Worth Five in a New Theory on Stocks

  • New research sets out to explain equity market fluctuations
  • ‘Mystery’ of random moves best tackled by understanding flows

Day traders claiming bragging rights for this year’s $9 trillion U.S. equity rebound can find some supporting evidence in the latest research.

Even as retail trading has grown to represent 20% of daily volume, Wall Street has struggled to figure out how much this modest-sized contingent actually influences prices. After all, the market is teeming with algorithmic funds, long-only managers and more.

But a fresh way to understand stock fluctuations via academics at Harvard University and the University of Chicago makes the effort a little easier.

By weighing up the sensitivity of various players to prices, they shed light on how individual investors may have ended up calling the shots in the world’s biggest equity market.

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New research highlights price insensitivity of big funds and institutions.

The Inelastic Markets Hypothesis.

The research, titled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” isn’t focused specifically on the retail-investing crowd, but the correlation is clear.

Xavier Gabaix and Ralph Koijen’s theory is that institutional managers are largely insensitive to prices because their buying and selling is primarily driven by their mandates. That bestows disproportionately large influence to other investors, like retail funds.

According to their inelastic-markets perspective, the booming day-trading flows of late could have had an impact many times larger than their absolute size.

“The demand by households (including mutual funds and ETFs) is positively correlated with price changes while the demand of the other sectors is strongly negatively correlated with price changes,” Gabaix and Koijen wrote in a September paper. “This is consistent with the inelastic markets hypothesis in which shocks from the household sector” lead to volatile prices, they said.

All that means “investing $1 in the stock market increases the market’s aggregate value by about $5,” the pair wrote.

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Not every kind of investor has a big price impact.

Source: Gabaix and Koijen

The Inelastic Markets Hypothesis.

No one can say for sure how much cash individual investors have poured into the market this year, but the number of accounts on platforms such as Robinhood Financial has ballooned.

E*Trade Financial Corp., TD Ameritrade Holding Corp., and Charles Schwab Corp. each saw record sign-ups in the three months ending in March, with growth continuing thereafter and clients trading more than ever in the second quarter. Robinhood said in May that 3 million new funded accounts were added in 2020, with half of the new customers being first-time investors.

This frenzy of interest fueled stock gains even as company profits plunged and economies ground to a halt in the pandemic. At one point, even bankrupt businesses like Hertz Global Holdings Inc. were surging.

Gabaix and Koijen hope their approach will be a stepping stone to finally understanding just how stocks move — one of the questions that has long defied explanation, despite the best efforts of both Wall Street and academia.

The duo suggest that a better starting point is understanding what’s driving flows. This could include everything from foreign investors withdrawing to new share issuance to insurers selling stocks to raise cash.

“The mystery of apparently random movements of the stock market, hard to link to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows,” the researchers wrote.

— With assistance by Sarah Ponczek

As originally posted here.

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Every Day-Trader Dollar Is Worth Five in a New Theory on Stocks

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