Many investors believe the latest news flow can move stock prices up and down. Yes, this is true as material news can influence the direction of stock prices, at least from a near-to-medium term basis. However, a new study shows the amount of money flowing in and out of the stock market can play a crucial role in the fluctuations of stock prices.
The recent study suggests that every $1 that enters the stock market from the outside can lead to prices rising by $5. When a dollar of cash enters the stock market from outside the stock market, that subsequently goes into the purchase of stocks will result in the total market cap of the stock market rising by as much as five dollars, creating a multiplier 5X effect. On the other hand, for every $1 that leaves the stock market, it can result in the opposite multiplier -5X effect.
The concept of the multiplier effect is common in economics. The classic example is the case of an increase in spending leading to an increase in national income and consumption much greater than the initial amount spent. For instance, if a construction company builds residential homes, it will need to employ construction workers. The architects, electricians, plumbers, and carpenters employed can influence the consumption and spending throughout the overall economy in different industries, including building materials, transports, auto, energy, etc., creating a multiplier greater than 1.
Although the multiplier 5X effect impacts the entire stock market, individual stock can go up differently when new cash enters the stock market. As expected, stocks and sectors with higher beta and volatility tend to rise more than lower beta positions.
The study also shows investors are reluctant to sell their stocks when cash comes in from outside the market. Intuitively, investors differ in their buying and selling persuasions. For example, when there are only two investors in the marketplace, the first want to buy stocks with cash from outside the stock market. The second want to continue to own stocks. Under this scenario, the prices must go up exceedingly high to convince the second to sell.
The multiplier effect does not work the same if the cash used to buy a stock comes from inside the stock market, typically from the proceeds of selling another stock. The increase in market cap that comes from a purchase is offset by the decrease in market cap by the sale, canceling each other.
The new research study offers new insights into the share-buyback programs, cash, and fundamentals. The current academic theory of the stock market states that investors are predisposed to pricing or are extremely sensitive to price. Many academics and Wall Street professionals believe flows into the stock market not related to a company fundamental play little or no role in the stock price.
The new study does not dispute the fundamental forces related to earnings, dividends, cash flow, and risk appetite that can influence the price of a stock. The study suggests flows can play a critical role in explaining price volatility, although the degree of impact is uncertain.
There are also two primary reasons investors are price-insensitive. One is the way large institutional investors operate in the stock market. Typically, institutional investors have well-defined investment mandates with specific stock allocation and risk exposure. These investors are often constrained to have constant exposure to stocks in their portfolios. Contrary to widely held belief, if these investors were price-sensitive, they would not cut their stock exposure when new cash comes into the market and drives up prices.
The second reason relates to investment psychology. Most investors are more bullish as prices rise than when they fall. For example, at the pandemic market low in March 2020, the recommended equity exposure levels from stock market timers were well below the historical average, some approaching zero weightings. With the stock market doubled in value, the recommended exposure to stock is over 60%. If the stock market timers were more price-sensitive, you expect equity exposure levels today to be much less than before.
Share repurchase remains a controversial subject among academics and Wall Street professionals. Many investors believe repurchases are typically bullish for the stock market, while others believe there is no price impact. The study shows repurchases also have a multiplier effect on the market cap of the entire stock market, upwards as much as five times the original dollar amount allocated to stock repurchases.
We tend to agree with many of the conclusions of the new study. Our technical studies show evidence to support the correlations between money entering and exiting the stock market on stock prices and stock market indexes.
Money flow studies are popular technical indicators to evaluate stock market trends. The typical Money Flow indicator is based on averaging the high, the low, and closing prices and multiplying the average by the daily volume. Compared to previous periods, traders and investors try to determine whether money flow was positive or negative. Positive money flow implies that prices can rise, while negative money flow suggests prices will fall. Money flow indicators can also serve to signal overbought/oversold conditions and positive and negative divergences.
Enclosed below are some of the popular money flow indicators applied to S&P 500 Index ETF (SPY), including the Money Flow Index (MFI), Chaikin Money Flow Oscillator (CMF), Granville’s On-Balance-Volume (OBV), Accumulation/Distribution Indicator (A/D), among others.