How Reflexivity Rules Financial Markets
Mastering the concept popularized by Georges Soros is indispensable to understand what is going on with financial markets
Prediction is very difficult, especially if it’s about the future!
Niels Bohr (Nobel laureate in Physics)
In the realm of quantum physics, observation doesn't just reveal reality; it creates it. In the world we're used to, if you throw a ball, it goes in a straight line, and you can predict where it will land. But in the quantum world, particles (like electrons) don't just travel in a straight line; they explore every possible path at the same time.
The really magical part happens when we decide to check on one of these particles, say by measuring where it is or how fast it's moving. The moment we do that, all the other potential paths or stories collapse into one. The particle 'chooses' one position or one speed, and that's the reality we see. Before we looked, the particle was in a state of 'maybe this, maybe that, maybe everything at once.' But our act of observing forces it to make a decision. The observation itself impacts what is being observed.
Why am I suddenly talking about quantum physics? Because financial markets are like quantum physics. Financial market participants are always observing and trying to guess what the future will be. Will company X be able to grow its profit margin? Will the economy be in a recession next year?
In finance, just as in quantum physics, the actions and observations of participants influence the outcomes they aim to predict. This, in turn, changes their perceptions, creating a self-reinforcing feedback loop. This loop can alter the fundamentals of what's being observed or shift prices away from their true underlying values. In finance, this concept is called reflexivity. It was popularized by George Soros, the billionaire investor and philanthropist.
Reflexivity is one of the most important concepts investors must master to navigate financial markets. Without it, you can’t explain why the US stock market is at an all-time high, why Nvidia is valued at a whopping $1.8 trillion, or why a rising price of Bitcoin increases its likelihood of being successful.
So, in this week's edition of Vincent's Corner, we will try to explain what is happening with financial markets through the lens of reflexivity.
The US Stock Market
On Friday, the S&P 500 closed at a new all-time high. Here is a simplified version of what happened:
At the end of last year, the US Federal Reserve (the Fed) signaled that it was done hiking rates. Until then, the market was still worried that the US might enter into a brutal recession. This would be a hard landing.
With long-term yields falling, the value of stocks started rising. Long-term yields are a critical component in the valuation of stocks since they are used to discount the value of future cash flows back to today. A lower discount rate means that future cash flows are suddenly worth more today.
With the stock market rising, investors started believing that the Fed might actually be able to pull off a soft landing, i.e., a controlled slowdown in economic activity that would tame inflation without causing a recession.
With the stock market rising, investors started pricing in the impact of the “wealth effect,” i.e., the observed phenomenon that, as consumers see their stock portfolios rise, they are more likely to spend more. If consumers continue to spend, there might be no landing after all, i.e., no recession. With the recession out of the way, the stage was set for a market melt-up.
In the US, the stock market influences the economy, not the other way around. The stock market is the economy. In just four months, the market went from being worried about a recession to being euphoric about the growth potential of the economy. But it wasn’t so much exogenous factors that triggered this turnaround. It was the stock market itself. Reflexivity.
But if consumer spending doesn’t slow down, inflation may not go down as the Fed expected, which would have an impact on its monetary policy and lead it to keep interest rates higher for longer. The market will soon start realizing that interest rates may not go down as fast as it thought, and the reflexivity loop will kick back in again.
Tesla
In its formative years, Tesla was more akin to a black hole, swallowing vast sums of capital while struggling to escape the gravitational pull of financial collapse. The road to electrifying the auto industry was littered with skepticism and financial potholes.
Yet, it was the very belief of the market, the investors' unyielding faith in Tesla's mission, that propelled its stock price into the stratosphere before Tesla was even financially viable. This ascension was not merely symbolic; it was a financial lifeline.
The market's belief did more than just inflate a stock ticker; it opened the floodgates of capital. When Tesla's stock began its stratospheric climb, it wasn't just numbers on a screen; it was the rocket fuel Tesla needed. In February and September 2020, Tesla raised $2.3 billion and $5 billion, respectively.
By believing in the company, the market bestowed upon Tesla the means to realize its ambitious vision. It was reflexivity in its purest form: the belief in Tesla's potential catalyzed the financial resources necessary for its actualization. If investors had not believed in Tesla, the stock price wouldn’t have risen beyond reason, and Tesla may not have been able to raise the capital it needed for its development.
Bitcoin
If there's an asset that embodies the essence of reflexivity, it's Bitcoin. Dubbed the most reflexive asset of all, Bitcoin’s journey is a vivid illustration of how price can influence perception, adoption, and success. As Bitcoin's price climbs, so does the belief in its future as a potential reserve asset. This is not a mere observation but a self-fulfilling prophecy where adoption trails the price rather than leading it. When Bitcoin surges, interest spikes, drawing more investors into the fold. Conversely, a price crash often leads to fears of a collapse to zero, cooling off interest and investment.
The end of 2022 presented a formidable test of faith for Bitcoin enthusiasts as prices tumbled to $16,000 in the midst of a broader financial asset sell-off and a series of bankruptcies in the crypto sector. Buying Bitcoin at this point was not for the faint-hearted.
However, the narrative and the market sentiment began to shift once again in 2023. Bitcoin closed above $47,000 this Friday, a resurgence fueled in part by the launch of 11 ETFs in the US a month ago (see my newsletter about it here). These financial products not only facilitated access to Bitcoin but also signaled a growing acceptance and legitimization of Bitcoin as a major financial asset. Just look at how BlackRock is now pitching it to its clients.
This newfound ease of access, coupled with a recovering price, has reignited interest and investment in Bitcoin. The introduction of ETFs has lowered perceived risks and encouraged a wider demographic of investors to gain exposure to Bitcoin, reinforcing the reflexive loop. As more people buy into the rise, the more likely Bitcoin is to cement its place in the financial landscape, showcasing the powerful interplay between perception, price, and success in the reflexive world of financial markets.
Sidenote on the launch of the 11 Bitcoin ETFs just a month ago
It turned out to be the most successful launch in the history of ETF products. The top 5 Bitcoin ETFs already own more than $9 billion worth of Bitcoin.
With a market capitalization already north of $900 billion, the trillion-dollar mark is now in sight for Bitcoin.
Nvidia
Then there is Nvidia. This company is in a league of its own. Its market capitalization is currently $1.8 trillion, making it the 6th most valuable company in the world. Before Covid-19, the company was worth about $100 billion.
Nvidia produces the new oil: the microchips needed to train AI models. Because no other corporation can compete with its microchips (yet), it can charge pretty much whatever it wants. The result: Over the first nine-month period that ended in October 2023, its profit jumped to $17.5 billion, up from $2.9 billion a year earlier.
The company’s market capitalization is equivalent to 94 times its past 12 months’ earnings. In plain English, the company is valued at the equivalent of 94 years of the company’s current profit. This is where reflexivity breaks down.
Reflexivity can spiral into a bubble when investors' collective belief in a company like Nvidia, with its massive market capitalization, pushes its stock price to levels disconnected from its fundamental value.
As Nvidia's stock price climbs, its share within stock indices grows, amplifying its presence in the portfolios of passive investors. ETFs that track these indices are compelled to buy more Nvidia stock to maintain their index-matching strategies. This mechanism forces passive investors to inadvertently fuel the bubble, buying more shares as the stock's price and index weight increase, regardless of the company's underlying earnings or market realities.
This cycle of reflexivity, where the rising stock price feeds into index-based buying, further detaches the stock's valuation from its economic fundamentals. The feedback loop between Nvidia's soaring market value and the mechanics of passive investing exacerbates the bubble. As the stock rises and its share in stock indices swells, passive investors, through their ETFs, buy even more, propelling the cycle forward until the bubble reaches a tipping point, potentially leading to a sharp and painful correction.
If you’re thinking about shorting the stock, remember the famous quote of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent,” or the WallStreetBets version from the GameStop era, “We can stay retarded longer than they can stay solvent.” I prefer this version!
As we wrap up this edition of Vincent's Corner, I hope you've gained valuable insights into the concept of reflexivity and its impact on financial markets. I believe understanding this intricate relationship between perception and market dynamics is crucial for navigating the complexities of investing, so I hope you learned something!
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Vincent