There is no secret that the market fluctuates up and down and having a big-picture model of financial markets gives us more clarity for interpreting current situations. Understanding how it all fits together can help us decide in which areas to pursue investment.
Most economic theories state that there is a steady state of equilibrium between the competing forces of supply and demand. This may sound good in theory but traders and speculator on Wall Street know this to be far from reality. Markets are far more dynamic an unreliable and they often go from one extreme to another extreme pushing price beyond what normal levels of supply and demand would allow.
Many economic theories assume markets are dynamically stable, or self-correcting. For example, when profits become excessive, new competition will drive down prices. Similarly, rational investors are supposed to allocate capital out of overvalued stocks and into the most attractively priced shares causing stock valuations to move closer to levels supported by fundamentals. In theory, supply and demand always moves towards an equilibrium that creates a market clearing price. However, reality does not always follow these over-simplified theories. Traders and investors understand this better than economist. They see firsthand the dynamics and volatility of markets and they rely on tools such as momentum, trend following, charts, and public sentiment rather than an economic model to make buy and sell decision.
A simple big-picture model of markets can aid us as investors to determine where prices are headed in the future and help us to make buy and sell decisions. The legendary investor and self made billionaire George Soros developed a theory about financial markets he called reflexivity.
In his theory of reflexivity he claims that markets are never in equilibrium, they are always in motion, constantly oscillating between two extremes. Markets are inherently unstable and driven by positive and negative feedback loops.
For example consider the relationship between a company and its publicly traded stock under normal business conditions. It is intuitive that when the company fundamentals improve the share price rises. However, does it make sense that a changing share price might, in turn, change the fundamentals? According to Soros theory of reflexivity the answer is yes.
Here is why! A higher share price gives a company the ability to issue shares at higher prices and raise more capital than competition which in turn gives them a competitive advantage. The company then uses its new capital to buy out competitors through merger and acquisitions or to expand existing operations. In another example, a company with a strong credit rating is able to make loans or barrow at attractive rates. However, a downgrade from Moody or another credit rating agency would increase their cost of capital and impact on the amount of collateral the company must pledge to back its obligations.
So not only do fundamentals improve a companyâs stock price but the stock price also improves fundamentals. This phenomenon is referred to as feedback loops and they cause prices to diverge wildly from equilibrium. When destabilizing forces take hold, businesses, industries and financial markets move along a relentless path away from equilibrium, sometimes creating a virtuous spiral of prosperity, and other times a vicious cycle of economic destruction.
Feedback loops cause markets to become unstable in both directions, sometimes to the benefit of investors and sometimes to their detriment. For instance, when the internet was created, a breakthrough technology, thousands of millionaires appeared almost overnight. As people heard of these amazing successes, others wanted to take part, and as result more investment money became available further pushing up prices and improving companyâs revenues. This feedback loop continued until there was more money that the industry could effectively absorb. Prices were bid up to extreme levels, far beyond a level that sustainable profits could generate, and to the point where investors realized that levels had become unsustainable. Thereafter, prices quickly revert and the positive feedback loop was replaced by a negative feedback loop working in opposite.
In summary, a reflexive relationship is characterized by feedback loops that cause dynamic disequilibrium in the interaction between fundamentals and price. Thus prices move to the extreme. Soros credits his investment success to reflexivity, which he uses to identify price extremes. He then bets on a sharp reversal. As a result he has been able to continuously outperform the market betting on reversals of trends that reached an extreme. His hedge fund, the Quantum fund which he managed with Jim Rogers, return 4200% over a 10 year period at a time when the DIJA was flat.
During a virtuous cycle also referred to bull market, a positive feedback loop interacts between the economy and the stock market. A positive feedback cycle causes the stock market to raise making consumers wealthier. The consumers increase their spending making the economy stronger and increases company profits which in turn lead to again higher stock prices which takes us back to the beginning. The stock market and economy create self-support for a positive feedback loop. This positive feedback loop continues until the âeconomic pendulumâ has made a complete turn to one extreme.
The graph below illustrates how the stock market and the economy have worked together over the last 60 years creating either a positive or negative feedback loop.
A vicious cycle takes place when the relationship between the economy and the stock market operates in destructive reinforcing patterns. Vicious cycles are the reverse of virtuous cycle and make the âeconomic pendulumâ swing to the other side. The extreme overvaluations eventually lead to a significant correction in stock prices. This was witnessed in March of 2000 when the .com burst and in November of 2008 when the stock market crashed.
When the market corrects consumer slow down their purchases, especially big ticket items like cars, houses, and with discretional spending like TVâs, computers, etc. When businesses see lower earnings they cut down on capital expenditures and employees. Consumers see a slowing economy and further cut back on spending which in turn cause the economy to slow even more and so a vicious cycle has been created. This vicious cycle continues until it reached the other extreme and reverts.
The market is never in equilibrium, it moves like a pendulum swinging back and forth between one extreme to another extreme. A self reinforcing virtuous cycle is present during a bull market making stock prices raise and making the economy stronger. A vicious cycle is called a bear market and it makes the economy and stocks weaker.
Understanding how the market works can help direct our investments. When markets move to one extreme we can bet on the reversal. Tools like charts and historical data gives us most of the information we need to make sound decisions. According to the theory of reflexivity there are times when to be invested in stocks and there are times when general stocks perform poorly.