The Efficient Market Model
For most of the post-war era, the prevailing academic models that seek to explain capital market prices have been based upon the assumption that the market is completely efficient. The traditional economic view is that asset prices adjust to financial data. For every buyer of a share of stock there is a seller, and transaction price is based upon data analysis. If the price of a financial asset is higher than fundamentally justified, sellers will correct the price lower. If the price is too low, buyers will move in to correct it higher. The traditional model relies upon the market efficiently pricing assets based on real aspects of the global economy rather than the number of people lining up to buy or sell shares.
Our approach often reflects mainstream economics methodology. Anyone who has spent significant time learning the intricacies of various economic models wants to put them to use. However, rigid adherence to a particular school of thought can be limiting and often fails to account for real world observations. When you have a hammer, every problem is a nail.
Whenever we quote P/E ratios, earnings growth, interest rates, price to book or any other financial metric, we are perpetuating the argument that markets are completely efficient. It is as if we believe that there is a magic spreadsheet in the sky that automatically adjusts asset prices to match fundamental values. But how can this really be the case if the market has spent most of the past fifteen years massively under/over valued by historic averages and exhibited such extreme volatility?
At the beginning of the year, we made the argument that the S&P 500 would top out at around 4300 based on valuations, specifically the cyclically adjusted P/E ratio or CAPE. As we write this, the S&P 500 is just above 4500, and the CAPE ratio is as high as it has been since the tech bubble. Yet, many major investment banks seem to be falling over themselves to increase their year-end targets to ever greater valuations. It seems clear that traditional analytical models simply cannot account for recent market behavior.
A New Model
There is an interesting academic paper making the rounds in economic circles, In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis. The theory posits that overall capital flows, not traditional valuation metrics, has far greater influence than previously acknowledged.
The largest institutional investors that drive market fund flows are: corporations buying their own shares, pension funds, sovereign wealth funds, mutual funds, ETFs and state and local governments. The new theory argues that these institutional investors are price agnostic at the macro level; they seek a predetermined level of equity exposure regardless of the value of the S&P 500. These highly sophisticated investors are price agnostic because they all have specific mandates requiring them to maintain an equity allocation within their portfolios regardless of underlying fundamentals. Economists refer to this idea as “inelastic”, meaning increases in price do not decrease demand.
If a mutual fund or ETF receives a new dollar into the fund, they must buy a company in their prospectus-defined investment universe. Mutual funds/ETFs, pensions and sovereign wealth funds have strict allocations that must be maintained and are rarely adjusted. It really does not matter if the manager of the ETF/Mutual fund/pension fund feels that the overall market is overvalued, they must follow their investment mandate or look for a new job. Investors that lack such strict mandates and have the capacity to analyze asset prices in search of inefficiencies, such as hedge funds, are generally not large enough to move markets in a noteworthy way. Hedge Funds collectively own 5% of the S&P 500, while US-based pension funds own 15%, for reference.
Stating that capital flows matter is not revolutionary thinking. What is unique is how much the Inelastic Markets Hypothesis suggests that they matter. The authors estimate that demand equal to 1% of the value of the S&P 500 increases the value of the index by 3-8%. The S&P 500 has a market cap of $38 trillion, so in theory, an investment of $380 billion would move the S&P 500 up to 4635-4860, all else remaining constant.
According to the authors, their model explains approximately 60% of market movements over the 1995-2020 timeframe. Traditional valuation methodology explains the remaining 40%. Investor demand for equities seems to be more important in determining the price of capital market assets than the valuation metrics that are the result of so much time and effort.
Relevance to Us, and to You
The Inelastic Markets Theory recommends that investment managers focus on relative valuations of market sectors, rather than absolute valuations of the total index. Determining the relative value of sectors (energy, financials, technology, utilities, etc.) and factors (a group of companies that share a specific financial characteristic) is accomplished via the more classic financial models.
This is because a mutual fund or pension manager that has a new dollar to invest still wants to select the most attractive equity in their benchmark, even if the overall benchmark is overvalued. We’ve made it a point to discuss the market in sector and style terms in our monthly commentary because this aspect has clearly been important to portfolio performance over the past decade.
There are a few things we can learn from investor activity. The first half of 2021 saw the highest rate of new investment dollars into the S&P 500 ever. If the pace of the first half of the year were to continue for the calendar year, 2021 would see the largest annual inflows into the market by a factor of two.
From our fund flow data, we know that $12 billion flowed into equities the week of August 25th. On a more granular level, investment dollars are leaving economically sensitive sectors of the market, such as materials and energy, and moving into more defensive areas such as healthcare and technology. In a further display of cautious optimism, $13 billion flowed into bonds overall, but actual investment dollars moved out of junk bonds and into prudent Treasuries and investment grade corporate bonds. Investors are still buying into the market, but what they’re buying is generally considered defensive in nature.
Another major contributor to equity demand is US corporations buying back their own shares in the open market. Corporate share buybacks or issuance is another source of capital flows analyzed by the model. This aspect of financial engineering became especially popular after the tax code changes in 2017. Due to very strong corporate earnings this year, buybacks are running at $683 billion through June, just shy of the all-time record. New share issuance (IPOs and new offerings) has been around $330 billion in 2021. Remember, it’s the net supply of shares in the overall market that matters most to the model. Corporate America is slowly cutting the supply of equities in the S&P 500; share buybacks have exceeded new share issuance for 15 consecutive years, which the model suggests increases index values regardless of other fundamental metrics.
From the perspective of the Inelastic Markets Hypothesis, caution may be warranted. US households currently have a record amount of their overall net worth in equities. The previous high was the tech bubble. Despite $5 trillion in cash floating around in the financial system, it’s hard to see how households decide to move even more of their savings into the equity market. Further, investor sentiment is something that can shift rapidly, and if the new hypothesis is correct, a relatively small amount of money leaving the markets can have a large impact. Survey data on investor sentiment is currently neutral and beginning to show signs of restraint.
After a reprieve last month from delivering such highly technical information, we are sensitive to the notion that the preceding may not be of general interest. However, it is rare that a new compelling theory backed with relevant data over a twenty-five-year period is produced in the field of financial economics. The Inelastic Markets Hypothesis takes an aspect of the market that traditional economics ignores and quantifies it into a metric for analysis.
While we have always monitored fund flows throughout global capital markets and have always employed sector analysis in our investment management process, we suspect that many market participants will be surprised by the large impact that flows have on index level values. A more complete model of asset pricing is an important step in capital markets forecasting.