Definitely not how equities are priced.

Well, the efficient market debate tends to devolve into semantics somewhat. You are correct that passive investing is distorting the modern market and feeding on itself. It was originally designed to latch onto the consensus machine that is the market, but when the dominant participants are all passive, distortions occur.

What makes it difficult is that if you are, say, a short fund that is genuinely great at identifying overvalued companies trading far above their intrinsic value, you don't get rewarded from stepping in front of these flows. Every active manager who doesn't join in is fighting against a strong current, loses AUM, and even the active space converges with the passive space. This is a positive reflexive feedback loop, and it also shows up as a long-term megatrend (strong decade+ timeframe trend), which also brings in players like CTA/trend followers, and of course average retail investors, who are very trend sensitive.

In fact the efficient market has gotten increasingly good at boosting these forces in recent years, especially in the single name options space, index options space, and volatility complex spaces. Essentially, the modern market spends most of its time in a state where volatility is suppressed by dealers, and all informed market participants are incentivized to join in. It's a bit of a prisoner's dilemma situation. Then when enough pressure has built under the hood (in the volatility complex), there will be sudden, violent price discovery that overwhelms the passive flows, then everyone reshuffles their books, and the jaws lock down again until the next volatility breathing cycle. Then the financial news media will make a backwards looking narrative of the "cause" when it was in fact just a catalyst. It's an emergent, known cadence, but the specifics of it are unpredictable, because the catalysts that start each phase of the process are often unpredictable real world events.

To the index investor, it doesn't matter to them. Their capital will simply slosh from a trillion dollar TSLA to a trillion dollar NVDA or whatever the next boosted name is. They are not so much investing in the broad market as participating in some sort of strange liquidity simulation.