George Soros is known as the “man who broke the Bank of England” in the early 1990s, but his main contribution to the financial world is the theory of reflexivity, which claims the following:
- Prices aren’t objective; they’re based on people’s biased perceptions of the future;
- Biased perceptions define people’s buys and sells, so perceptions will influence prices;
- Prices impact perceptions and fundamentals too; therefore perceptions could impact fundamentals.
Soros’s reflexivity theory is also a common-sense explanation of why trends exist and why price momentum could be an excellent equity selection filter.
What happens when the price of a stock makes a new all-time high?
1) The market is considered a feedback mechanism. When prices go up, people assume that their initial investment thesis is right and their expectations justified. They buy more and are joined by even more people wanting to participate in the trend. The fear of missing out is ruling market’s behavior.
2) Higher stock prices mean happy shareholders. Since the manager of our company has made his investors a lot of money, he receives a lot of good faith and patience for future experiments. This manager could make a lot bolder moves and he is given more time to be right.
We have all seen the incredible faith that Amazon’s shareholders have in Jeff Bezos. 16 years after its IPO, Amazon still losses money on the occasional quarter, because it invests heavily in new projects. Amazon missed Wall Street’s earnings expectations in four of its last five reports. Any other stock would have been killed for missing estimates so many times. Not Amazon. Its stock climbed 50% in the past year and a half.
Management is an important part of the fundamentals of one company. When investors trust and believe management, they are willing to give his/her company a lot higher P/E multiple, and for a good reason. Investors tend to trust managers that make them money.
3) The company could use its appreciated stock as a currency in order to acquire smaller competitors and the best human talent in its respective field, which makes it a lot stronger, functionally and operationally. We see how Google is scooping up many of the best engineers in the world. We see how Salesforce is incredibly active on the acquisition field. Better people, new and better products, less competitors are all factors that actually improve company’s fundamentals and they could be all derived from higher stock prices. The improved fundamentals attract a completely new set of buyers, which props the prices even higher.
And all of this could be started with just a good story about a better future. This is how perceptions become a reality.
Prices change when expectations change and expectations change when prices change. A good story that could capture the imagination could change expectations. The dream of future profits is what excites people, not the reality.
This is how momentum works, but the process does not last forever. People’s expectations about the future don’t always come true. The market constantly tries to discount events that have not happened yet. As a result, it will sometimes discount events that will never happen. The market is forward looking, but in the same time it is constantly looking for a feedback: in short-term perspective from price; in longer-term perspective – from fundamentals.
Sometimes, expectations turn into a self-fulfilling prophecy and end up impacting fundamentals. More often than not, the discounted future is way too optimistic or pessimistic. It is human nature to over-discounts identified risks and opportunities. When the market realizes that it is not right, it just gaps in the other direction and starts the process of correcting its mistake – that process is usually a lot more violent and quicker.
