A new study shows how much the flows of money into and out of the stock market affect stock prices—perhaps more than many investors realize.

Specifically, a dollar of cash from outside the stock market that is invested in equities will cause the combined market cap of all stocks to rise by about $5, while a dollar withdrawn from the market will have the opposite “multiplier effect,” the study says.

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A new study shows how much the flows of money into and out of the stock market affect stock prices—perhaps more than many investors realize.

Specifically, a dollar of cash from outside the stock market that is invested in equities will cause the combined market cap of all stocks to rise by about $5, while a dollar withdrawn from the market will have the opposite “multiplier effect,” the study says.

This doesn’t mean that each individual stock will go up when new cash comes into the market. Some stocks and sectors will rise more than others. But overall, according to the study, investors as a group are reluctant to sell their equities when cash comes in from outside the market. Their price insensitivity can be understood intuitively by imagining a market in which there are just two investors: If the first wants to buy stocks with cash from outside the market, and the second wants to continue owning equities, prices have to go up a lot to convince the second to sell.

This multiplier effect doesn’t exist when the cash used to buy a stock comes from inside the market—from the proceeds of selling another stock, in other words. Any increase in market cap that comes from such a purchase will be offset by the decrease caused by the sale.

The reigning academic theory of the market up until now, in contrast, has insisted that investors are extremely sensitive to price, very willing to sell when prices go up. As a result, flows into the market that have no relevance to a company’s fundamentals should play no role. That is why academic orthodoxy up until now has been that the flow-based multiplier must be zero.

The new study that finds to the contrary, titled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” was written by Xavier Gabaix, a professor of economics and finance at Harvard University, and Ralph Koijen, a finance professor at the University of Chicago’s Booth School of Business.

They aren’t denying that traditional forces related to earnings, dividends, cash flow and risk appetite also play a role, Prof. Gabaix says. One of the contributions of their new research is to show that flows also play a significant role in explaining the market’s volatility, though they don’t yet have an estimate of just how significant that role is.

Another contribution is to show that not only does a flow-based multiplier exist, but that it’s quite large.

Cash and fundamentals

One reason investors collectively are price-insensitive, according to the professors, is that large institutional investors typically operate with mandates specifying their equity-exposure levels. Most are constrained to maintain a more or less constant proportion of their portfolios in equities. So, in contrast to what would be expected if these investors were price-sensitive, they don’t significantly reduce their exposures when new cash comes into the market and drives up prices.

Another reason is investor psychology: We become more bullish as prices rise—not less. An illustration is how much stock market timers’ recommended equity-exposure levels have risen since the March 2020 bottom. According to my tracking of nearly 100 such timers, they on average were completely out of the market at that bottom, when the Dow Jones Industrial Average was below 19000. Today, with the DJIA nearly double where it stood then, the average exposure level is 63%. If these timers were more price-sensitive, you would expect their equity-exposure levels today to be a lot less.

Prior researchers failed to detect the big role played by flows, Prof. Gabaix argues, because it is surprisingly difficult to measure flows into and out of the stock market as a whole. For every buyer there is a seller, after all, and it makes a big difference whether the cash used to purchase a stock comes from the sale of another stock or from outside the stock market altogether. A comprehensive accounting of flows requires netting out those that are intramarket, and much of the professors’ research effort was devoted to developing such an accounting over the period from 1993 through 2018.

Many on Wall Street already pay attention to individual pieces of the flow puzzle. For example, some focus on inflows and outflows at U.S.-equity funds (both mutual funds and exchange-traded funds). But, Prof. Koijen says, mutual-fund flows by themselves can be misleading. Other important sources of flows include foreign investors, insider transactions, dividends and share repurchases, contributions to 401(k)s and pension plans, and so forth. One fruitful avenue for future research, he adds, would be to investigate whether flows into the market as a whole can be predicted.

Explaining phenomena

Meanwhile, this new research provides a new perspective on a number of market phenomena that up until now have been the source of controversy, including:

• Share repurchases. Though many on Wall Street already believe that repurchases are bullish, others insist that they have no price impact. The professors show why repurchases could have a multiplier effect on the combined market cap of all stocks.

• Government stimulus. This new research identifies a potentially powerful tool that governments could use to stimulate the market: direct purchases of stocks, which could increase the combined value of the stock market upward by five times the dollar amount allocated to such purchases. Though the U.S. government hasn’t yet employed such a tool, it wouldn’t be a surprise—especially in light of this new research—that the government is seriously considering it.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at reports@wsj.com.