Posted on December 1, 2008 - by DanielXX

Reflexivity revisited

Let’s review the various perspectives about the relationship between stock prices and “business fundamentals” as most people understand it. First, there is the advice given by the Sage of Omaha about Mr Market being manic-depressive and that the prices he/she/it quotes can have a disconnect with underlying fundamentals. Then there is the typical technician’s/efficient market theorist’s view that price reflects underlying fundamentals, even though it might not seem so at the time to the outsider. And then there is George Soros, who advocates that market prices can actually actively influence fundamentals. The last view is known as reflexivity, a term coined by Soros.

Despite Soros’ celebrity fund manager status, reflexivity has never really caught on in popular investment literature, partly because it does not really have mathematical grounding. It is more of a philosophy than anything else, in its recognition of the two-way feedback between price and fundamentals, instead of the traditional view that fundamentals drive prices. But in the aftermath (I hope) of this credit crisis, it deserves serious all-round consideration and recognition now.

First of all, by virtue of the fact that Soros was among the first to recognise the seriousness of this crisis, calling it the greatest financial crisis since the Great Depression, his market ideas and philosophy deserve special elevation. Now everybody knows the current crisis as …. yes, “the greatest financial crisis since the Great Depression”. Talk about parrots. But more importantly, the mechanics and evolution of this financial crisis indeed has the feel of a price-induced death spiral about it.

The most obvious linkage is market confidence. There is nothing that unnerves the self-assured long-term “fundamentals-driven” investor more than to watch the market value (and his net worth) of his investment drop day by day; it has the effect of shaking his conviction to the point of changing his perspective from “Mr Market is wrong” to “Mr Market might know something”. The same applies to the bond investor of course, who will be driven more by credit concerns than earnings concerns (bond investors also tend to believe in market efficiency more).

This is all fine if the stock is trading on the secondary market and the business is self-sustaining without funding concerns, because the business doesn’t really care what price it’s worth according to Mr Market, as long as its suppliers and customers continue doing business with it. Operations-side partners tend to be less market-sensitive; however financial-side partners are hyper market-sensitive, and this is where declining market valuation can feed into faltering confidence. If the company is constantly dependent on financing cashflow (not necessarily from stock market or bond market) to sustain its operations, or if indeed (in the case of banks) market trust is integral to its business model, then the reflexivity effect is particularly influential. Indeed, in Soros’ original illustration of the reflexivity effect, he highlighted the case of REITs, which often funded new property purchases through issue of new units and therefore depended heavily on high market prices of their units to purchase these new properties at above-average yields ….. sort of a Ponzi scheme in my opinion.

Today, REITs face a different market confidence-related concern …. they have trouble rolling over their current debt. Read more…

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