I mentioned that I usually use a model with exogenous cash-flows, and this gets at the reason.
When I look at how most people around me manage their money, it does not look like “adjust allocations based on the business cycle”. It looks like “keep savings in fixed-allocation retirement portfolio, or index fund, or just buy and hold for years”. Most people don’t actually trade much in response to market fluctuations; they trade when they have spare cash to invest or need to take out cash in order to pay bills. That doesn’t mean their allocations don’t change—e.g. if equity prices fall, then everyone who’s simply bought-and-held will have a smaller proportion of their wealth in stocks without trading at all.
Of course, there’s a whole industry full of professionals who do adjust more actively, but as a general rule traders on any timescale faster than years make money by forecasting the behavior of people trading larger amounts of money on slower timescales than them. The large-scale cash flows from everyday people are the “ground truth” which others make money by forecasting, whether explicitly or (more often) implicitly.
In short: it’s mainly fund flows that drive overall prices, not vice-versa.
Note that the EMH is still compatible with this: the small fraction of active traders will still eat up any opportunities to beat the market. Those fund flows determine the behavior of the market which those traders are trying to beat—they determine the baseline.
Epistemic status on this: I don’t have conclusive data, except in a few relatively-isolated markets (which are simpler to analyze). I trust the model because its qualitative predictions look much more realistic than a prices-drive-fund-flows model. For instance, one of my original big motivators of using a fund-flows-drive-prices model is that it directly predicts that price motion should usually look Brownian (to first order), whereas the usual models don’t actually predict that—they just predict expectations, without actually saying anything about the shape of the distribution of moves.
I’d love to get evidence on that and it seems important.
Your position doesn’t sound right to me. You don’t need many people changing their allocations moderately to totally swamp a 1% change in inflows.
My guess would be that more than 10% of investors, weighted by total equity holdings, adjust their exposure deliberately, but I’d love to know the real numbers.
Regarding safer assets, when you put your money into a savings account (loan it to the bank), what is the bank to do with it? Presumably it has promised you interest. Or if you buy treasuries—someone must have sold them to you—what do they do now with all the cash? Just because you personally didn’t put your money into stocks does’t mean nobody else downstream from you did.
And because most securities aren’t up for sale at any given time, a small fraction of market participants can have outsized effects on prices. Consider oil back in April: sure the “prices” turned “negative” when a few poor suckers realized they had forgotten to roll their futures to the next month back when everybody else did and could get stuck with a physical delivery, but how many barrels worth of contracts did actually change hands at those prices?
Not sure how this would support the OP’s point specifically, but just wanted to point out that 1%-level things can sometimes have large manifestations in “prices”, just because liquidity is finite.
I mentioned that I usually use a model with exogenous cash-flows, and this gets at the reason.
When I look at how most people around me manage their money, it does not look like “adjust allocations based on the business cycle”. It looks like “keep savings in fixed-allocation retirement portfolio, or index fund, or just buy and hold for years”. Most people don’t actually trade much in response to market fluctuations; they trade when they have spare cash to invest or need to take out cash in order to pay bills. That doesn’t mean their allocations don’t change—e.g. if equity prices fall, then everyone who’s simply bought-and-held will have a smaller proportion of their wealth in stocks without trading at all.
Of course, there’s a whole industry full of professionals who do adjust more actively, but as a general rule traders on any timescale faster than years make money by forecasting the behavior of people trading larger amounts of money on slower timescales than them. The large-scale cash flows from everyday people are the “ground truth” which others make money by forecasting, whether explicitly or (more often) implicitly.
In short: it’s mainly fund flows that drive overall prices, not vice-versa.
Note that the EMH is still compatible with this: the small fraction of active traders will still eat up any opportunities to beat the market. Those fund flows determine the behavior of the market which those traders are trying to beat—they determine the baseline.
Epistemic status on this: I don’t have conclusive data, except in a few relatively-isolated markets (which are simpler to analyze). I trust the model because its qualitative predictions look much more realistic than a prices-drive-fund-flows model. For instance, one of my original big motivators of using a fund-flows-drive-prices model is that it directly predicts that price motion should usually look Brownian (to first order), whereas the usual models don’t actually predict that—they just predict expectations, without actually saying anything about the shape of the distribution of moves.
I’d love to get evidence on that and it seems important.
Your position doesn’t sound right to me. You don’t need many people changing their allocations moderately to totally swamp a 1% change in inflows.
My guess would be that more than 10% of investors, weighted by total equity holdings, adjust their exposure deliberately, but I’d love to know the real numbers.
Regarding safer assets, when you put your money into a savings account (loan it to the bank), what is the bank to do with it? Presumably it has promised you interest. Or if you buy treasuries—someone must have sold them to you—what do they do now with all the cash? Just because you personally didn’t put your money into stocks does’t mean nobody else downstream from you did.
And because most securities aren’t up for sale at any given time, a small fraction of market participants can have outsized effects on prices. Consider oil back in April: sure the “prices” turned “negative” when a few poor suckers realized they had forgotten to roll their futures to the next month back when everybody else did and could get stuck with a physical delivery, but how many barrels worth of contracts did actually change hands at those prices?
Not sure how this would support the OP’s point specifically, but just wanted to point out that 1%-level things can sometimes have large manifestations in “prices”, just because liquidity is finite.