What determines stock-market prices? Here’s a new theory – Mint

Their price insensitivity can be understood intuitively by imagining a market in which there are just two investors: If the first wants to buy stocks with cash from outside the market, and the second wants to continue owning equities, prices have to go up a lot to convince the second to sell.

This multiplier effect doesn’t exist when the cash used to buy a stock comes from inside the market—from the proceeds of selling another stock, in other words.

The reigning academic theory of the market up until now, in contrast, has insisted that investors are extremely sensitive to price, very willing to sell when prices go up.

One of the contributions of their new research is to show that flows also play a significant role in explaining the market’s volatility, though they don’t yet have an estimate of just how significant that role is.

So, in contrast to what would be expected if these investors were price-sensitive, they don’t significantly reduce their exposures when new cash comes into the market and drives up prices.

According to my tracking of nearly 100 such timers, they on average were completely out of the market at that bottom, when the Dow Jones Industrial Average was below 19000.

For every buyer there is a seller, after all, and it makes a big difference whether the cash used to purchase a stock comes from the sale of another stock or from outside the stock market altogether.

One fruitful avenue for future research, he adds, would be to investigate whether flows into the market as a whole can be predicted.

This new research identifies a potentially powerful tool that governments could use to stimulate the market: direct purchases of stocks, which could increase the combined value of the stock market upward by five times the dollar amount allocated to such purchases.

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