When The Economy Weakens, The Index Need Not Follow
- Inelastic Market Hypothesis

By Liam Scotchmer
References below.

Trading on internet speculation and gossip rather than market analysis used to sound like a bad idea, but today it has its own category: meme stocks. Meme stocks like GameStop attract a cult-like fascination. Their social media fan bases pull the strings of millions, and prices swing; not because the company changed, but because the money did.

The efficient-market hypothesis states asset prices perfectly reflect all available information, with proponents arguing it’s pointless to search for undervalued stocks. (Burns, 2024)

A Random Walk

“The price is always right”, except you just watched it be very wrong for months

In an analysis of over a hundred or so years of stock price information by Nobel Prize winner and economist, Robert Shiller, stock prices swung many times over what was justified. (The Economist, 2026) So, if it were news or dividend forecasts alone driving the markets, as the efficient market hypothesis says, they would be fairly calm; prices would shift only as much as the new facts justified.

Why does the stock market exhibit so much volatility?

Economists like Robert Shiller have understood prices aren’t tied to fundamentals, but only until more recently was there an explanation of why. A paper by Xavier Gabaix and Ralph Koijen who, in their paper coined the term “Inelastic Markets Hypothesis” suggesting share prices are not set by the dividends or the earnings investors expect, but rather by the flows of money into and out of the market. (The Economist, 2026) Gabaix and Koijen estimate $1 worth of shares with fresh cash pushes up aggregate stock market value by $3-8. (Gabaix & Koijen, 2022) 

Flows moving price without information is the Inelastic Markets Hypothesis

To understand why, it’s logical if you’re a retirement saver wanting to purchase shares during a bull market. To do so, you’ll buy from three types of investors. (The Economist, 2026)

  1. Buying from a return chaser (retail investors and trend-following hedge funds) is difficult because they don’t want to sell in a bull market, they’d rather buy their own shares right now

  2. A person maintaining a fixed asset allocation: 60% to stocks and 40% to bonds (pension scheme) only sells if prices rise as they need to maintain the 60/40 split

  3. Value investors (like Warren Buffett) also won’t sell you anything until shares get more expensive (and to them, less attractive)

And for the efficient-market fans; the people who do correct mispricing, are “few, and tightly constrained,” says The Economist (2026). So they don’t smooth things out.

Flows swing prices.

This simple model shows how reactive and volatile the stock market machine is. 

Now run it backwards

Suppose prices rise 5% on their own, what happens to demand? If the price of the equity market portfolio goes up by 5%, demand falls by only 1%. (Gabaix & Koijen, 2022) To my mind, that’s a strikingly low number, normally you’d expect people to back off a lot more when something gets a whole 5% pricier. The fact that investors barely flinch is what “inelastic” means: demand doesn’t stretch much when price changes. 

Whilst Gabaix and Koijen find that 1% of the market’s value flowing in pushes the market up 5%, the standard models (the rational and behavioural ones) predict that same inflow should move the market about 100 times less. So roughly 0.05% instead of 5%. Basically nothing. Standard models also predict a much larger price elasticity; 20 (demand reacts a lot) versus Gabaix and Koijen’s figure of 0.2 (demand barely reacts to price) . (Gabaix & Koijen, 2022)

So what for you?

The stock market is becoming less diverse in terms of ownership. (Swedroe, 2025) It has recently shifted into a small set of passive, mandated vehicles that don’t trade on price. Passive funds that don’t rely on a human to actively research, buy and sell stocks overtook human-run active funds for the first time in 2023, per Morningstar. (Sabban, 2025) And target-date funds (TDFs), a similar investment vehicle to passive funds except contributions are auto-enrolled, climbed to $4.8 trillion in 2025. (Roy, 2026) The relevant thing about this, especially with TDFs, is they’re the purest version of the inelastic flow the Inelastic Markets Hypothesis is about: stock prices never got cheaper, but money goes in because a paycheck cleared.

Demand was found to be relatively insensitive to price changes (inelastic). According to ‘How Competitive Is the Stock Market?’ published in the American Economic Review, the rise in passive investing over the last 20 years has made the demand for individual stocks 11% more inelastic. (Haddad et al., 2025) Inelasticity with regular (uninformed) flows to stocks results in inefficient price discovery in the long term whereby asset prices fail to reflect all available information, and they become distorted beyond what’s justified.

As a retirement saver actually putting money in, or any investor, rising stocks should not be associated with only improving company or economic performance. Stock prices mirror underlying value, and crucially flows as well. So when the economy weakens, the index need not follow.

References

Bird, B. (2025). Should You Get In on the Meme Stock Craze? Why You Might Regret It. Investopedia. https://www.investopedia.com/meme-stocks-investing-11781274

Burns, W. (2024). Efficient-market hypothesis (EMH) | EBSCO. EBSCO Information Services, Inc. | Www.ebsco.com. https://www.ebsco.com/research-starters/social-sciences-and-humanities/efficient-market-hypothesis-emh

Downey, L. (2024, October 3). Efficient Market Hypothesis (EMH): Definition and Critique. Investopedia. https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

Gabaix, X., & Koijen, R. S. J. (2022). In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3686935

Haddad, V., Huebner, P., & Loualiche, E. (2025). How Competitive Is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing. American Economic Review, 115(3), 975–1018. https://doi.org/10.1257/aer.20230505

Hussain, A. (2022, August 23). What Does Inelastic Mean? Investopedia. https://www.investopedia.com/terms/e/inelastic.asp

Kagan, J. (2025, March 10). Price sensitivity: What it is, how prices affect buying behavior. Investopedia. https://www.investopedia.com/terms/p/price-sensitivity.asp

Roberts, L. (2021, September 16). What Is The Inelastic Market Hypothesis? Investing.com. https://www.investing.com/analysis/what-is-the-inelastic-market-hypothesis-200602124

Roy, M. (2026, March 11). Target-Date Funds Continue Their Rapid Rise. Morningstar, Inc. https://www.morningstar.com/funds/target-date-funds-continue-their-rapid-rise

Sabban, A. (2024, January 17). It’s Official: Passive Funds Overtake Active Funds. Morningstar, Inc. https://www.morningstar.com/funds/recovery-us-fund-flows-was-weak-2023

Sabban, A. (2025, January 21). US Fund Flows: Picking Up Steam in 2024. Morningstar, Inc. https://www.morningstar.com/funds/us-fund-flows-picking-up-steam-2024

Swedroe, L. (2025, July 25). The Risks of Passive Investing Dominance. Alpha Architect. https://alphaarchitect.com/passive-investing/

The Economist. (2026, June 2). Want to know the future? Don’t trust the stockmarket. The Economist. https://www.economist.com/finance-and-economics/2026/06/02/want-to-know-the-future-dont-trust-the-stockmarket