Whether you take financial advice from an influencer or a professional financial advisor, at the moment most of their advice can be bifurcated into two camps: buy hot assets like tech stocks, crypto or NFT’s and make money fast or, invest for the long term in index funds and let the power of compound returns over time take over and make you wealthy.

I myself have struggled with which path to steer people towards when they are inclined to ask me. The allure of quick money is a powerful aphrodisiac that may push some people to invest who wouldn’t have otherwise. In his profile featured in the Wall Street Journal, legendary Redditor Keith Gill aka Roaringkitty, pointed towards his lack of interest in the slow accumulation strategy of adherents of John Bogle, known as bogleheads, the founder of Vanguard and considered one of the fathers of index investing. Rather, the allure of taking a large bet on a turnaround play in a name like GameStop appealed to his appetite for original analysis and risk taking more.

Even billionaires, those who many consider to be the apex of accumulation and advice on getting rich, don’t agree on these matters. Warren Buffet is famous for his long term outlook and often advises laypeople to just invest in index funds while Mark Cuban, although he has said that index funds are a great way to invest, has also said diversification is for idiots, so who to believe?

Although I was traditionally trained in finance, economics and investing I am not against the new batch of influencers that are repackaging and tailoring financial advice for a new audience. I applaud anyone that is able to empower people by using the many tools currently available in the US and other countries to take control of their future. Whether it is through this newer route or through a more traditional route like a financial advisor from a large institution however, just make sure that the person you follow has a passion for new ideas and learning about new ways to make their followers or clients wealthier.

A Unifying Hypothesis

A recent paper by Xavier Gabaix of Harvard and Ralph Koijen of the University of Chicago, propose a new hypothesis that could potentially unify the the disconnect between the fast money and the long term money.

The hypothesis has to do with the elasticity of demand for all stocks. According to theories like the efficient market hypothesis, the stock market reflects all available information to investors at any moment. Any stock that is bid up by investors without any underlying fundamentals driving the behavior, can be quickly shorted and beat back into where it’s valuation should sit according to the market.

Yet this doesn’t explain the long term behavior seen in the market where the P/E ratio of a large index like the S&P 500, which currently sits near an all time cyclical high of 38.6, can vary greatly over long periods of time.

Periods of high equity prices overall will create opportunities for both companies and investors. For companies it will give them an incentive to go public and take advantage of the appetite for equities. For investors, there will be an incentive to short the market in anticipation of mean reversion and make money on the way down. These forces would act in tandem to oversupply equity as well as drive down prices until they reach their equilibrium again. Time and time again however, we have witnessed the boom cycle go on for much longer than many experts have anticipated and continued to make those who bet on it going up a little more wealthy.

Those same experts, and much of the academic community was perplexed by this likely because they held conscious or unconscious assumptions that the equity market was elastic, i.e. that it would act according to those market forces I described above.

Yet if the equity market is inelastic, meaning the supply of equity doesn’t respond one for one to an increase in inflows, then this could drive prices up. The authors theorize this may be true now more than ever due to index funds themselves. They use both mathematical models and assumptions as well as observed data on inflows and aggregate prices to show that an extra dollar invested in the equity market could produce prices anywhere from $3 to $8 higher. To simplify things the authors took the midpoint of this at $5 through much of the paper.

Although the current consensus says that for every buyer there is a seller, the index funds seem to magnify flows from investors as the supply of shares remain relatively inelastic and funds which have a fixed portion dedicated to equity, like an 80/20 equities to bonds fund, can amplify the effects of inflows due to the fact that equity has to stay as a fixed multiple to bonds as per the investment mandate.

The arbitrageur role the hedge funds should occupy in the market aren’t large enough to make a dent. The authors show that even before the crisis, these players only made up 4% of the investor market and they too were bound by the redemptions from investors. Again flow matters.

On a micro level the flow phenomenon has already been observed. For example, selling Ford stock to buy GM stock has been shown to raise the price of the stock being bought, even if there aren’t fundamentals underlying the shift. Similarly, the authors create a model where the two options are a pure bond fund and a mixed bond and equity fund to show the multiplier effect on prices in action.

The Consequences of Being Right

If this hypothesis is true then it could upend a lot of financial theory underlying corporate finance and equity investing. They lay out a few implications for investors, executives and policy makers if their hypothesis holds true mainly:

• That government equity buying, or QE from the Fed could have an outsized price effect on the market. This means that a dollar of QE could raise equity prices by $5 overall. The Fed could then act as a stabilizer of the equity market in bear markets;
• That the Modigliani-Miller corporate finance model doesn’t accurately represent how a company should fund itself. This means that share buybacks could have an academic home in producing higher share values for investors and;
• It could provide a new tool for investor models of equity values and provide a rationale based on inflows as to why markets stay expensive for long periods of time even when they defy fundamentals.

Furthermore, this provides a flow of funds rationale to why some stocks have become meme stocks despite terrible underlying fundamentals. Think AMC and GameStop or even Robinhood to name a few, all of which I have discussed in prior posts.

The authors also provide some ideas as to how to go about future research looking into this hypothesis and they provide a few examples of where these flows could theoretically originate from including:

1. Changes in beliefs about future flows;

2. Liquidity needs, say from insurance companies after a hurricane;

3. Wealth shocks to different groups such as foreign investors;

4. Share buy back actions;

5. Shocks to substitute assets, like equity for bonds when rates go down;

6. Change in advice by institutional investors (think ESG);

7. Coaxing or marketing by government or institutional investors, what they call “road shows”;

8. Mechanical trading via delta hedging, ie share purchases and sales via hedging for option writing.

The last one may be familiar to the Reddit crowd, who caught on to the idea that if they operate as a group and are able to overwhelm the volume of options issuing brokers, those same brokers are then forced to buy the underlying stock to hedge their position, driving up the price and making their call options profitable. A virtuous cycle which still seems to be at play with a batch of meme stocks. In this sense, brokers and retail investors are locked in an aggregate staring contest to see who blinks first before the bottom falls out.

What it Means for You

For the average investor this may sound like something that is just made for classroom academic banter, but it points towards further evidence that a diversity in style and approach to investing is also becoming more important towards seeing consistent returns in the future.

Different indexes may experience flows in different ways. A small cap fund sees inflows differently from a large cap fund. The small cap fund can potentially be easily overwhelmed by a single investor class while the large cap fund may be more anchored to large institutional flows.

It also opens a window for academic backing for momentum and factors model driven investing, be it through individual stocks or a ETF’s that utilize factor models for their strategy.

In the past I have touted the core-satellite model of investing as ideal for many investors, meaning that your savings are anchored with the majority being in an index fund or ETF but a proportion of say 5%-10% being in conviction plays or individual stocks to keep you engaged in the market. The diversity of strategy can be incorporated into the core as well with large cap blend combined with small and mid cap indexes increasing returns over time while reducing volatility. We know that individual stocks are risky in the long run, but so too may be just tracking a single index blindly.

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