Inelastic Stock Market Response to Capital Flows, Conservation of Money, and the Paradox of Investing

Abstract

We discuss phenomenological models of inelastic stock market response to aggregate money flows, including a model with a semi-permanent price impact. The conservation of money in financial transactions means that the aggregate cash investments go through rather than into the stock market, while not reaching the economics of stock issuers in any significant way but affecting stock prices via forces of supply and demand. Market microstructure embedded in a complex graph of money flow implies that the net flow of funds sets overall stock prices via price impact mechanics rather than economics. We argue that the overall secondary stock market capitalization is the result of limited supply of shares and growing demand by households, primarily via large institutions such as mutual and pension funds, and somewhat technical inelastic effects, rather than reflective of the underlying economic activity or enterprise value of the stock issuers. This observation makes long-term equity investment an economic paradox and raises further questions.

Keywords: Stock market, market elasticity, price impact