How This Little-Known Theory Could Bring You Outsized Returns

October 11, 2017

How This Little-Known Theory Could Bring You Outsized Returns

  • Stock prices haven’t been following fundamentals for 5 years now. The theory of reflexivity is the only one that can explain what’s been going on.
  • The main message is that as long as the trend is strong, don’t fight it, but reinforce it.
  • If you want to know when the current bubble will burst, focus on the twilight zone.



Introduction

One of the best traders and investors over the last 50 years has been George Soros. Whether you like him or not, his track record is something to respect and learn from whenever possible.

In today’s article, I’ll describe his reflexivity theory in a, hopefully, much simpler way than Soros has described it in his book, The Alchemy of Finance.

I promise not to mention Popper, Heisenberg, Marx, Keynes, or Hegel, all of which make Soros’ book a very hard read. There’s a lot that every investor and trader can apply from his theory of reflexivity as it gives an explanation of what is going on in financial markets when fundamentals fail to explain.

The Theory Of Reflexivity & Fallibility

One of the biggest issues today is that economists and policy makers focus on equilibrium, certainty, and stability.

Just think of what the FED’s goal is: stable growth and low unemployment. However, that’s something that’s impossible to realize and has historically never been achieved because uncertainty is a constant.

Reflexivity’s key concept is uncertainty, which is the opposite of what economic theory more broadly has been preaching for the last century. Just look at the U.S. unemployment level. It has never been stable, and has always gone up or down.

Figure 1: U.S. unemployment. Source: FRED.

Financial markets are even more unstable with stock prices all over the place. Such volatility is the result of the fact that our thoughts and actions reflect on market price and, consequently, fundamentals in the first place and secondly, because our thought process aren’t perfect, and are thus, fallible.

The theory of reflexivity is based on the fact that situations have thinking participants and that those participants’ view of the world is always partial and distorted, which is the principle of fallibility. The problem is that those distorted views influence the situation to which they relate because false views lead to wrong actions, i.e. the principle of reflexivity.

For example, parents that constantly tell their kid that he is a bad boy will probably end up with a very bad kid because he will really start to believe it. Thus, the distorted thinking eventually affects the fundamentals.

On financial markets, participants can’t base their decisions on knowledge because they have to anticipate the future which is dependent on things that have not happened yet.

As an example, those who believe in and are invested in Tesla (NASDAQ: TSLA) positively influence the stock price and the fundamentals of the company through capital raises at high valuations and takeover activities. Tesla managers to cover all of its liquidity needs with small stock issuances which improve its book value.

Figure 2: Even TSLA’s employees know it’s all about the stock market and not production. Source: LinkedIn.

The image above is the perfect example of reflexivity, where beliefs affect the stock price and later the fundamentals of the company.

The concept of fallibility is strictly related to reflexivity. It says that the world is too complex for us to comprehend. Thus, all of our conclusions are distorted because we constantly resort to various methods of simplification, be it generalization, metaphors, history, etc. We can easily say that our understanding of the world we live in is inherently imperfect.



Reflexivity, Fallibility & Investing

Investing is a process that has thinking participants. The participants’ thinking serves two functions, one is to understand the environment and the other is to act in that environment to the participant’s advantage. Thus, we have a passive, cognitive function and an active, manipulative function.

So the logical thing is that you see the world, gather data, and then act on it. Reflexivity adds a step into it where your thinking and actions also affect the world you are viewing, thus the world is always uncertain, unstable, and your thinking is fallible.

Consider a statement like “It is raining.” It can only be true or false depending on what is actually going on outside. However, a statement like “cryptocurrencies are revolutionary,” is a reflexive statement as whether it is true or not depends on the effect the statement will have on the world.

The easiest way to understand reflexivity is through feedback loops. The participants’ views influence the course of events, and the course of events influences the participants’ views, and round and round it goes.

This influence can be positive, which drives the participants’ views and the events further apart, and negative, which brings the two close together, and thus is self-correcting. A positive feedback creates a self-reinforcing cycle.

The important thing is that the cycle can’t go on forever as the participants views would become so far removed from reality that at some point, the participants would recognize their views as unrealistic and start a self-correcting trend. However, the positive or negative feedback also has an effect on the actual event, thus all is reflected. It all leads toward a dynamic disequilibrium.

The self-reinforcing trends lead to boom-bust processes or bubbles on financial markets. What’s important to understand is that misinterpretations and misconceptions can play a very important role in human affairs. Are we sure that the current FED members are interpreting correctly how the financial system works? Additionally, are we sure that how the FED thinks now and impacts financial markets is the best way?

These questions lead toward uncertainty and is something that we have to live with when investing. As we make decisions based on our imperfect understanding of the world, it’s logical that the results of our actions won’t correspond with our expectations.



Reflexivity & Financial Markets

The basis of the theory of reflexivity is that market prices always distort the underlying fundamentals, where the distortion can be small or significant. Secondly, financial markets can affect the fundamentals they are supposed to reflect. This is where reflexivity goes one step beyond behavioral finance as behavioral finance focuses on the mis-pricing of assets and not on how that mis-pricing may affect the fundamentals.

The most common way market prices impact fundamentals is the use of leverage, be it in debt or equity form. When a stock price of a company rises, then the equity becomes more valuable and a company can take advantage of it by doing acquisitions or borrowing at lower costs. Both situations also improve the fundamentals and make the cycle self-reinforcing. When the stock price is low, creditors think that there is something going on in the company, and aren’t willing to lend to the company any more money and the company’s fundamentals deteriorate even more.

Now, this is all very interesting and a great way to explain what’s going on in current markets. However, you’re probably interested in how to make money on all this and how Soros made money by using this theory.

To make money, you have to invest in a bubble when you spot one and then find the climax or reversal point of a self-reinforcing cycle at which point the cycle becomes self-reinforcing in the opposite direction.

A boom bust process is set in motion when a trend and misconception positively reinforce each other. Now, what we have to do is test the trend with negative feedback. If the trend is strong enough to survive the test, both the trend and the misconception will be further reinforced.

However, at some point it becomes clear that a misconception is involved and a twilight period ensues during which doubts grow and more people lose faith, but the trend is sustained by inertia. The current market is far from the twilight period as the greed factor is at maximum levels.

Figure 3: The current greed index. Source: CNN Money.

The current stock market trend is reinforced by companies improving their earnings per share through buybacks, even if they destroy shareholder value, i.e. book value. As long as that’s still considered normal, stock prices will continue to go up. Additionally, the trend is reinforced by extremely low interest rates which make stocks more attractive.

After the twilight period, which we are still far from, the trend will reverse and the problems will surface. There will be no book value to protect the stock prices and the market will collapse.

Soros also describes bubbles as asymmetric shapes with a long boom that is slow to start, accelerating gradually and reinforced by successful tests, until it flattens during the twilight period. The bust is always short and steep as investors enter panic mode.

The length and strength of each stage is unpredictable, but there is an internal logic to the sequence of stages. So the sequence is predictable, but even that can be terminated by government intervention like quantitative easing.



The best way to explain reflexivity with an example is to use real estate.

Real estate enters into a bubble when credit becomes cheap and easily available, as it is now. Banks look at higher real estate prices and are willing to give more credit. Their fallacy is that they don’t see the connection between credit availability and rising collateral prices. The banks think collateral values are independent from increased credit. Cheap credit leads to higher prices and better credit scores which relax borrowing standards.

If you apply the theory of reflexivity, you’ll rush to buying when you see a bubble forming because the trend is usually self-reinforcing. And you’ll rush toward selling when there is twilight. Many other market participants do this and a bubble usually gets bigger and bigger. Thus, you can’t expect the market to adjust itself based on fundamentals as looking at fundamentals isn’t the way to make money in the short term.

Figure 4: The S&P 500 is the perfect example of the reflexivity theory. Source: Yahoo Finance.

Reflexivity also manifests itself on currencies which tend to move in large multi-year waves.

Conclusion

I believe there are many strategies to making money by investing.

My favorite is the value investing way. However, this doesn’t mean that value investing is the best suited strategy for everyone.

Applying the reflexivity theory can really bring about outsized returns as the theory is relatively unknown because most people don’t like Soros. However, investing isn’t about emotions and likes and dislikes, perhaps people don’t like Soros because he probably has the best track record in modern history. Thus the reflexivity theory is definitely one to closely follow as it can provide exceptional insights to all kinds of investors and traders.