Want to Know the Future? Do Not Trust Stock Prices

For decades, the ‘efficient market’ theory has been considered the primary foundation of the investment world. This theory assumes that stock prices always accurately reflect all available information and a company’s fundamental condition. However, current market conditions appear to suggest the opposite.

Phenomena such as meme stocks, like GameStop, and the surge in technology stocks like NVIDIA demonstrate that stock prices are now more heavily driven by investor fund flows than by fundamental factors. Price rallies can continue even when valuations have become extremely expensive. If stock prices truly reflected all available information, the market should be one of the best forecasting tools ever created. Yet, reality is not always so.

GameStop, the video game retailer that became a symbol of retail investor frenzy in 2020, remains valued at more than 20 times its pre-euphoria levels. In the same period, its performance has roughly matched Nvidia, one of the biggest winners of the AI boom. The narratives are almost opposites: Nvidia is supported by real business growth, whereas GameStop is largely supported by investor enthusiasm. This contrast raises the question: do stock prices truly reflect fundamental value, or are there other forces at play?

For decades, the most influential answer came from the Efficient Market Hypothesis (EMH), popularised by Nobel laureate economist Eugene Fama. The essence is simple: because millions of investors constantly seek information and react to new news, asset prices are believed to immediately incorporate all available information. In such a condition, stock prices become the best estimate of a company’s value and future prospects. For many economists, the market is not just a place for transactions; it is an information-processing engine.

However, the market often moves far more wildly than theory explains. GameStop is a difficult example to ignore; it is hard to explain why a company with a shrinking core business maintains a valuation far above its pre-meme-stock levels. Robert Shiller raised similar issues decades ago. In research regarding bond markets in 1979 and stock markets in 1981, the economist who later won the Nobel in 2013 found that asset prices moved far more volatilely than the underlying fundamental changes.

This is where newer theories are gaining attention. Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago developed what they call the ‘Inelastic Markets Hypothesis’. Their idea is simple: stock prices are influenced not only by earnings expectations but also by the flow of capital entering and exiting the market. Their findings are striking: every US$1 of new funds entering the stock market is estimated to increase the overall market value by US$3 to US$8. In other words, prices do not always rise because business prospects improve; sometimes, prices rise because more money is chasing the same number of shares.

To explain this mechanism, Gabaix and Koijen divide the market into three groups of investors: momentum hunters, who tend to buy when prices rise; fixed-allocators, such as 60/40 equity-bond portfolios; and value investors, who usually enter only when prices are cheap. When new funds enter the market, few parties are immediately willing to sell. Momentum hunters want to buy more, fixed-allocators sell only after prices rise, and value investors often choose to wait. Consequently, new capital flows can drive prices up even without significant fundamental changes.

Furthermore, many investors buy because they must. Pension funds receive contributions every month, individual investors buy stocks whenever they receive a salary, and many institutions must invest to meet specific target returns or mandates. They are not necessarily buying because they have discovered information that company profits will surge next year; they are buying because they are required to buy. These transactions nonetheless affect prices.

Stock indices are often treated as tools to read the economic future. When the market rises, the economy is deemed to be improving. However, if prices are also influenced by liquidity, capital flows, and market structure, that relationship is not so simple. The market still contains information, but that information is blended with many other factors that are not always related to fundamentals. The stock market remains useful, but like many forecasters, it does not always see the future as clearly as is often imagined.