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(wow) Words Of Wonders Level 417 Answers – Dr. Michael Berry, famous for his short-term buying of housing and derivatives in 2008, has been criticizing passive investment vehicles since he spoke about them in 2019. In this article, similar to 2008, Dr. Berry may have discovered another bubble that has been brewing for more than 25 years.
However, this time it is not in the MBS/CDS/CDO market, but in the public equity market. In this regard, it has to do with the formation of passive investment funds, a mischaracterization of the efficient market hypothesis, and the derivatives-laden consequences of products built around these unsound premises.
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If our findings and recent academic research are correct, this could be one of the most important pieces we’ve ever presented, as it has serious implications for financial markets.
Businessmirror October 17, 2022 By Businessmirror
Our journey begins with Dr. Berry cited a very interesting scientific paper written in September 2021 by researchers from Harvard and the University of Chicago.
We briefly discuss the results of the study, but for those interested in broader mathematics, the full study can be found here.
In summary, the researchers have provided a framework for both theoretical and empirical analysis of general stock market fluctuations. Therefore, unlike many other economic models, they used practical data from past theoretical data to support their hypotheses. They identified 4 main problems:
As they point out, families provide capital to institutions that are limited in what they can do because they operate under a strict/strict mandate. They are not very elastic.
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Consider mutual funds, index funds, ETFs, and other passive investment vehicles that typically have restrictions, such as that they must be 100% invested in stocks and offer 0 flexibility because they cannot hold bonds or other securities. Investment vehicles like ETFs are allergic to cash.
Even a mandate to invest, say, 70% in stocks puts limits on funds more than people realize, because they have to try to get close to that 70% without wide deviations.
But it doesn’t really matter that these funds are limited, does it? Because you still have a lot of hedge funds that act as arbitrageurs, giving elasticity to the market and acting as arbitrageurs?
In fact, hedge funds make up only 5% of the market, according to empirical data from several recent studies. In addition, they tend to reduce their allocation to stocks during bad times, thus reducing their size. Sometimes we forget that hedge funds can make big withdrawals in bad times, or that they also have risk limits.
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Therefore, in fact, they have low or even negative elasticity for markets. Unfortunately, hedge fund investors are not immune to recessions/depressions either.
The transfer of capital risk between investment sectors is also very low. Thus, the risk changes very little, for example from stocks to bonds or other assets. If something goes in stocks, it usually stays in stocks. Or stocks will be stocks, bonds will be bonds, so the elasticity between different sectors is very small.
In numbers, the average stock market changes just 0.6 percent of its total value every quarter. This means that the elasticity of demand of most investors is very small. If they don’t agree, we’ll see massive flows in elastic markets, which is pretty incredible.
Also, since the early 1990s, we haven’t seen big outflows when it comes to big mutual funds. A passive balloon can be inflated slowly and steadily. The last time we saw a somewhat significant exit was in late 2002, during a two-year bear market.
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What amazes us is that the efficient market hypothesis is still used as the basis for a large amount of research in modern finance and literature. It is these ideas that led us to the last crisis in 2008. All financial models are based on it, and between 1996 and 2007 the hypothesis was not mentioned once in any FOMC manuscript.
The theory we propose is a hypothesis, but also an efficient market hypothesis. Products from Vanguard, BlackRock, etc. are not based on the theory that markets can be inefficient/elastic. The idea that the theory is still alive in academia after the GameStop (GME) debacle of 2008 and last year is beyond our comprehension. As Michael Berry said in one of his most watched speeches, the 2012 UCLA Economics Address (emphasis added):
It turns out that information is not perfect, volatility does not determine risk, markets are not efficient, and individuals are flexible. But the dark age of finance does not allow such light. Leading economists and financial practitioners, please check your premises. You are facing contradictions.
But back to flexible markets. Their findings, supported by empirical data, show that mainstream economists are probably off by two orders of magnitude (100x) when it comes to elasticity with their models for the efficient market hypothesis. Theorists believe that the macroelasticity is about 20, empirical data shows that it is theoretically less than the microelasticity between stocks, which is equal to 1.
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If the implied macroelasticity is 0.2 instead of 20, the macrofinancial picture looks very different. Especially when everything is built on a system that has been proven wrong. An even more recent study called “How Competitive is the Stock Market” also found it to be close to 0.3, suggesting that markets are far from perfect.
In addition, this implies that the price elasticity of aggregate demand in the stock market is low, and that flows to and from the stock market in particular have a large impact on prices. Their findings conclude: “$1 invested in the stock market increases the total value of the stock market by about $5.”
So this also means that at least 30% of stock market fluctuations are caused by flows. It could also be a big reason for a move in stocks like Ark Invest ( ARKK ) or Tesla ( TSLA ), GameStop ( GME ), Bill Hwang’s Archegos, and others. It also explains stocks flying high and low after the dot-com bubble and other phenomena such as the high concentration of stocks in indexes like the S&P 500 (SPY).
It also means that things like buybacks can have a huge impact on share prices, which was not the case in the past when markets were considered completely elastic.
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In traditional finance, the market value of a share does not change at all with a buyback. In contrast, the research shows that in the uncertain universe, the value of the stock increases, with the initial valuation being about $2 for every dollar of shares bought instead of a $1 dividend.
If $5 of added market value is the result of $1 added to stocks, and 90% of millennials (aka future wealth holders) are in passive market instruments, that 5:1 ratio over time is pretty silly remains. COVID couldn’t stop it. Inflation is possible (no). #epiphany (September 19, 2021).
In the study, one of their examples looked like this: in the simplest version, a consumer can invest in two funds: a pure bond fund (100% bonds) and a mixed fund that invests in stocks and bonds according to a certain mandate – for example, 80% of the fund’s assets should be invested in stocks, 20% in bonds.
They looked at what would happen if a consumer sold $1 of a pure bond fund and put that $1 into a mixed fund. The result: the mutual fund must invest the proceeds in stocks and bonds: this increases the price of stocks in an inelastic market, which makes the mutual fund (with the mandate) want to invest more in stocks, increasing prices, etc. . At equilibrium, they find that the total value of the stock market has increased by $5.
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But that still leaves the question: What actually happens during a recession? The study analyzed one of the most recent recessions, from the second quarter of 2000 to the third quarter of 2002. Unsurprisingly, houses were the best sellers. But the interesting part is that they only sold 0.5% (!) every quarter (not a typo). Therefore, the largest outflows from the sector amounted to slightly more than 2% per year.
Flows mainly affect prices/value depreciation and are positively correlated (/mean inverse). Let’s look at what happened in the next crisis, in 2008.
In 2008, sales were about the same, with households selling slightly more, about 0.6% quarterly, while companies also sold stocks, foreign ETFs and pension funds, and national/domestic continued to buy.
In elastic markets, QE for stocks can become as real as QE for bonds. In retrospect, we saw similar price action in China and Japan, where the government intervened and bought stocks, resulting in a much larger 1:1 effect (closer to 1:5 as observed in the study). The article was originally about financial fluctuations, as it has always been, especially lately
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