Reflexivity Redux

One of the most important philosophical constructs ever created to explain markets is the Theory of Reflexivity by George Soros. The basic idea behind Reflexivity is that values in the investment markets can create their own fundamentals in the real world. In other words, higher stock prices in a given market or sector can lead to improving fundamentals as executive confidence works its way through the system in the form of increased spending, hiring and expansionary activity. Conversely, weakening bond prices and the corresponding spike in yields can worsen an entire country’s economic fundamentals as lenders pull back and business actors grow cautious, delaying capital spending and laying off employees.

Here’s Soros in January 2001, explaining his theory in the wake of the Dot Com crash:

What should now be clear is that the so-called fundamentals that supposedly determine stock prices are not independently given. Instead, they are contingent on the behavior of financial markets. There are, indeed, myriad ways in which stock prices affect the fortunes of companies: they determine the cost of equity capital; they decide whether a company will be taken over or acquire other companies; stock prices influence a company’s capacity to borrow and its ability to attract and reward management through stock options; stock prices serve as an advertising and marketing tool. In other words, when financial markets believe a company is doing well, its “fundamentals” improve; when markets change their mind, the actual fortunes of the company change with them. Moreover, changes in financial markets also have far reaching macroeconomic consequences.

The truth of this Reflexivity concept can be found in the relationship between market statistics and business section headlines everyday.

Are we seeing any obvious examples of it right now?

In my Bubble Guppies piece the other day – which by the way is the highest trafficked thing I’ve written so far this year – I argue that “bull market behavior” is apparent virtually everywhere one looks; Sold out theater tickets, a new art market explosion, the white-hot Miami real estate market, Bitcoin speculation, instant IPO doubles, etc. I would argue that the majority of this activity, which is unquestionably altering economic fundamentals, is being driven by what’s happened in the investment markets. A sub-3% risk-free rate (10-year Treasury yield) combined with $4 trillion in stock market gains last year are finally having an impact on the real world.

Ben Levisohn noted a study on how markets are currently reacting to M&A news in Barron’s this weekend:

In 2013, public companies that announced acquisitions of more than $1 billion gained 4.1% on the first trading day after the announcement, according to Dealogic, the highest since at least 1995 and only the third time during that period that the response has been positive. And even that strange breed on Wall Street — the arbitrageur — has noticed something strange afoot. Instead of automatically selling the acquirer and buying the target, some are now buying both, Moore says. He chalks up the positive response to borrowing costs, which have never been lower. That has meant deals have added to earnings more quickly. “That gets the investing community excited,” Moore says.

Markets have begun rewarding CEOs for taking risk again and the obsession with Return Of Capital may be morphing into a new celebration of Return On Capital. If this continues, it would only be a matter of time before CapEx becomes Hot and raised buybacks become Not. This would bode well for growth stocks and would probably mean a pause in the clamor for “bond-like equities” and the supposedly low-volatility value stocks that investors had bid up to outrageous multiples over the last few years.

The interesting question now is whether or not this reflexive influence from the equity markets will last long enough for a true, self-sustaining expansion to take root.

Or will the recent enthusiasm for risk and growth in the real world flame out quickly if and when the stock market cools off?


Bubble Guppies (TRB)

When Internet Boom Went Bust (ProjectSyndicate)

M&A as a Growth Strategy (Barron’s)




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