𝜉 and the Fundamental Drift: Why Large-Cap Prices Have Broken from Economic Reality

by John-Michael Kuczynski

In classical finance theory, prices are thought to reflect fundamentals. Stocks represent ownership claims on real economic activity—on revenue, profits, capital structure, and future cash flows. Valuation, in that framework, is not guesswork; it is the quantitative distillation of corporate performance. But this assumption, though repeated in textbooks and market commentary, is rarely tested directly.

I decided to test it.

To measure the actual degree to which a company’s price behavior tracks its fundamental metrics, I built an application that continuously compares time-series data on fundamentals (e.g., earnings, revenue, margin, debt ratios) with contemporaneous price action. To formalize this comparison, I introduced a proprietary metric, which I call 𝜉 (xi):

𝜉 is the statistical degree to which changes in price are correlated with changes in a company’s fundamentals.

The empirical results are not ambiguous. For large-cap equities—particularly those that dominate the S&P 500 and global indices—𝜉 is effectively zero.

The Collapse of Price-Fundamental Alignment

What does it mean for 𝜉 to be zero? It means that a company’s stock price can rise or fall independently of any measurable change in its core economic reality. It means that even large, sustained improvements in revenue, margin, or earnings per share often have no reliable effect on the firm’s market valuation. And conversely, prices may fluctuate wildly in the absence of any underlying change in the company's condition.

This decoupling of price from value implies a profound epistemic failure. If stock prices do not reflect what companies are, then what do they reflect? One answer—discussed elsewhere—is that in the case of large-cap stocks, prices increasingly reflect order book dynamics, short-term momentum patterns, and the microstructure behaviors of algorithmic traders, rather than any enduring economic substance. Fundamental information, even if available, becomes lagging, background noise in a market dominated by speed, flow, and liquidity arbitrage.

Do Smaller Companies Exhibit Higher 𝜉?

Given this decoupling at the top of the market, the natural follow-up question is whether smaller and mid-sized firms exhibit a higher 𝜉 value—i.e., whether they maintain a stronger correlation between their economic reality and their market price.

Empirical evidence suggests that the answer is yes, but only modestly.

Numerous studies in asset pricing have found that fundamental metrics—such as P/E ratios, profit margins, and earnings growth—have greater predictive power for future returns in small- and mid-cap equities than in large caps. While these correlations are rarely strong in an absolute sense, they are statistically significant and nontrivial, often in the 0.2 to 0.4 range. That is, while large caps exhibit a near-total disconnection (𝜉 ≈ 0), smaller firms display a measurable, though still noisy, sensitivity to fundamentals.

Why Might This Be?

There are several plausible reasons why 𝜉 would be higher in small and mid-cap firms:

Reduced algorithmic saturationLarge-cap equities are prime targets for high-frequency and quant-based trading strategies that focus on technical and flow-based indicators rather than fundamentals. Smaller firms, by contrast, often lack the liquidity required for such strategies and thus may be less distorted by non-fundamental trading.
Greater transparency of fundamentalsIn mid-sized firms—particularly those in industrials, regional banking, or materials—the firm’s financial statements may provide more direct insight into operational performance, with fewer layers of abstraction or speculative narrative.
Lower narrative interferenceLarge companies are disproportionately affected by macro narratives, geopolitical sentiment, and “brand momentum.” Mid-cap firms may fly under the radar and thus allow real performance to move the needle.
Analyst neglect paradoxBecause fewer institutions track or model small and mid-cap firms, the price may more readily respond to real shifts in fundamentals, which are not already fully digested by consensus models.

However, there are limits to this effect:

Small caps are often highly volatile for reasons unrelated to fundamentals—especially in sectors like biotech, clean energy, or junior mining.
Many small companies are pre-revenue, or have economic models that are not yet stable or measurable in conventional accounting terms.
And even in mid-cap territory, speculation, liquidity effects, and hype cycles can distort prices well beyond what fundamentals would justify.

A Tentative Landscape of 𝜉

Market Segment	𝜉 Value	Notes
Large-cap	≈ 0	Price driven by liquidity, flows, algos, and macro narrative
Mid-cap	~0.2–0.4	Fundamentals have modest influence, especially in stable sectors
Small-cap	~0.1–0.3	Mixed: some correlation, but often drowned in speculative noise

Thus, while 𝜉 is higher outside the large-cap domain, it is not high in absolute terms. The partial alignment between price and fundamentals that exists in the mid-cap world should not be romanticized. It merely appears more coherent in contrast to the large-cap segment, which has become epistemically adrift.

The Deeper Implication

That 𝜉 is low across the board—especially in the most visible, liquid, and analyzed corners of the market—has far-reaching implications. It casts doubt not just on the EMH, but on the broader ideology of valuation-based investing. If the price of an asset does not track its economic value, then what is being priced? And how can rational capital allocation be claimed?

The answer, increasingly, is that price reflects second-order beliefs: beliefs about what others believe, rather than about what is true. This reflexivity feeds a feedback loop in which narrative and structure supplant content.

In that context, the act of measuring 𝜉 becomes not just a statistical exercise, but a philosophical act—a way of interrogating whether markets still serve their stated function: to reflect, and allocate according to, real value.