Opus 17: Reflexivity

Along with Inflation, Nomads, and Franz Gordon


Reflexivity is the most important concept I am guessing you have never heard of. The term is used across philosophy, sociology, anthropology, and many other social sciences. I briefly mentioned reflexivity in Opus 15 after I listened to George Soros’s 2010 lecture series at Central European University regarding his General Theory of Reflexivity. As I continued down this rabbit hole, I discovered Soros’s Alchemy of Finance, arguably his capstone piece of work. Immediately, I was surprised to see that the book only has 355 reviews on Amazon, which, compared to its literary peer group, is shockingly low for an author with such an infamous brand attached to him.

The book is not an enjoyable read. Soros openly admits that his initial career path was that of a philosopher, not an investor, and his love for the academic style can be felt throughout the 350 pages. Arguments are drawn out far beyond their required length and repeated in nearly infinite forms. The Investor’s Podcast summary of the book accurately comments, “this is not an easy book to read.” The mental damage one has to assume when opening up the text is an unfortunate price to pay because the book contains incredibly valuable insights. Thankfully, Soros divides the body of work into a theoretical introduction, a historical view, and a practical test of the theory to help distill his points as much as possible.

In this Opus, we will explore, summarize, and show the power of Soros’s theory from a theoretical and practical perspective. As you will see, it shows itself in many facets of our everyday life, and it is more alive than ever today.

Everything You Know About Economics is Wrong

The axiom of classical economics is that prices follow fundamentals. We all remember our supply and demand charts where the equilibrium price was a function of these two curves - a “passive reflection of the state of affairs,” as Soros describes it. Said another way, our perception is supposed to follow, not affect, the fundamental reality. Soros argues that this is wonderful in theory but, “there is scant evidence of it in practice.”

For active market participants and followers, it is clear we find ourselves in abnormal times these days. Even as one tries to correct for “in the moment” bias, the world today is simply strange. We are experiencing a clashing of data, commentary, and emotions that are completely incongruent with one another. The world is still reeling from Covid, but we have vaccinations moving at warp speed. We just experienced the fastest decline ever in the employment markets, but consumer confidence is skyrocketing. Certain business sectors, and especially the small businesses within them, got decimated, but the equity and credit markets are at all-time highs. Macro growth estimates worldwide have been revised down for the medium and long run, but the last few days of public company earnings have shown growth is alive and well in their specific industries. In my tiny corner of the market, prices are higher than ever, capital is being deployed faster than ever, and growth is moving at a breakneck speed. We reach an impasse.

When the fundamental reality becomes a point of contention, narratives and storytelling run rampant - the best story wins, as Morgan Housel says. But, while some may say these narratives, beliefs, and behaviors are simply reflections of reality, they are actually the alchemists of what is to come.

Reflexivity first assumes that all market participants suffer from fallibility. Soros argues,

In situations that have thinking participants, the participants’ view of the world is always partial and distorted.

Clearly, this is in direct contention with the efficient market hypothesis, where it is assumed that all participants have equal and complete information. Soros immediately disregards this with his ego by referencing his 12 years of outperformance.

It is on the foundation of fallibility that Soros asserts the true reality of the markets. They are not simply reactive agents but rather active participants:

These distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity.

While most commonly found in financial markets, reflexivity shows itself in many places across any situations that involve thinking participants,

For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that government is bad tends to make for bad government.

For the most part (more on that later), natural sciences are somewhat hedged against reflexivity as their participants have little effect on their developments. As an example, the biologist’s does not affect a cell experiment, and if a chemist predicts the interaction of elements it is unlikely anything will change. Soros does point out a fun exemption here being The Heisenberg Uncertainty Principle, where the very observation of quantum particles affects their course. Similarly, many experiments of the natural world must assume some uncertainty of reality because natural beings most likely act differently while being observed. But, I digress.

The focus for this Opus will be reflexivity within the financial markets.

Equity Reflexivity

Returning to financial markets, reflexivity is a, if not the driving force of the market past and present. Markets, specifically equity markets, are simple devices used to quantify participants’ expectations, a perfect “laboratory,” as Soros calls them. He argues,

I do not accept the proposition that stock prices are a passive reflection of underlying values, nor do I accept the proposition that the reflection tends to correspond to the underlying value. I contend that market valuations are always distorted; moreover - and this is the crucial departure from equilibrium theory - the distortions can affect the underlying values. Stock prices are not merely passive reflections; they are active ingredients in a process.

More succinctly,

Markets can, and will, influence the events that they anticipate

Credit Reflexivity

Reflexivity shows itself clearly in credit: lenders’ beliefs dictate the outcomes of borrowers. For example, a noncreditworthy borrower will receive a higher borrowing rate than a creditworthy one. This makes sense in the world of risk vs. reward. But, the decision of the lender to increase the rate for the uncreditworthy borrower directly impacts the likelihood of repayment. On an individual basis, the lender would be best served by offering the same rate to the noncreditworthy borrower as they are offering to the creditworthy.

Clearly, this does not happen in practice as there are numerous lenders competing for multiple borrowers, and the higher rate for noncreditworthy borrowers will create the most efficient lending portfolio.

Reflexivity At Work

Reflexivity can be hard to understand when only talked about in the abstract. It may prove useful to provide a few examples.

Soros gained notoriety for his trade that “broke the Bank of England” back in 1992. He knew that if he pushed the value of the British Pound low enough through his short positions, the BOE would be forced to change the fundamental reality to align with the market. In just a few days, the BOE did concede and exited the exchange rate mechanism (ERM) and the British Pound cratered.

This is a strange causal relationship for most to think about - the market is supposed to react to reality, right? Markets and fundamentals have a bidirectional causal relationship. Most of the time, markets are correcting themselves to represent reality better. We see this on earnings days for stocks, jobs reports, etc., where the market will quickly move to be the best representation of all available information. But this is not always the case, as shown by Soros’s trade. This relationship can be clearly seen at the end of cycles when markets go bust. Markets are not only predictive but also causal in their movement. In the dot com bubble, the market cratered months ahead of the fundamental correction:

Soros provides the following schematic:

Markets ignite the start of a cycle and they are the decision-makers that end cycles too, not the fundamentals.

Soros goes on to explain the conglomerate boom, or “merger mania”, of the 1980s. Companies continued to merge using their stock as currency. As inorganic growth continued, the share prices kept going up and more purchases could be made. The moment the market changes its “prevailing bias” (as Soros labels the general “feeling” of the market), then these companies’ currency craters and the fundamentals quickly follow suit. Once again, the market drove reality, not the other way around.

Looking at today, reflexivity is everywhere. When a stimulated market meets a quickly changing world, reflexivity breeds quickly. Take Tesla for example: the company's shareholders believe it could be the largest EV company in the world. Right now, they fundamentally are not. But, due to the perception held by the market participants, Tesla can now fund its business cheaply through its highly inflated equity. The market will drive the fundamentals. Reflexivity.

The small world of private venture capital is an even better example. Early-stage growth capital has increasingly become reflexive. Historically, businesses have pulled capital to them as they need it for projects, factories, geographic expansion, or specific growth opportunities. Today, as the capital rivers overflow, they start to push capital onto labor. Reflexivity becomes the market standard as capital participants continue to dictate rather than react—more on this in the next Opus Letter.

This kingmaking has become the norm for the cross-over and mega-funds that decide to back entrepreneurs with the grandest vision. These funds’ size and deployment velocity are the perfect ingredients for reflexive capital. Within the companies, the limitless capital allows for cheap hiring through inflated equity issuance and high cash compensation. Externally, the PR buzz created by these mega-rounds scares opponents and discourages upstarts from entering the market. Soros touches on this valuation point:

Money values do not simply mirror the state of affairs in the real world; valuation is a positive act that makes an impact on the course of events. Monetary and real phenonmena are connected in a reflexive relationship; that is, they influence each other mutually.

Reflexivity vs. Feedback Loops

Many may reflect on the above and be quick to compare reflexivity to feedback loops. While they often show up in similar places, the two have a few distinct differences. Feedback loops are self-reinforcing onto themselves; they have nothing to do with the participants of a market. Network effects, marginal cost / benefits of scale, and other positively reinforcing phenomena never interact with the outside market.

On the other hand, reflexivity requires thinking participants. It has no concern for the structural constraints or benefits. But, the “prevailing bias” of the market does have a similar effect compared to feedback loops. Soros explains,

When stock prices reinforce the underlying trend, we shall call the trend self-reinorcing; when they work in the opposite direction, self-correcting.

Third Body Reflexivity

Soros originally described his General Theory of Reflexivity long before the new paradigm of capital entered the market. While the idea of reflexivity became famous after Soros’s run-in with the BOE, he generally put the theory to practice in a market without a highly active monetary body being involved, the “third body,” as Ben Hunt calls it.

Monetary bodies were classically thought to be proactive defense mechanisms. But, since the financial crisis, these groups have formed a reflexive relationship with the market rather than the actual economy that underpins it. A tiered system emerges:

  1. The monetary bodies now influence the markets they aim to anticipate

  2. The markets influence the fundamental economy they aim to anticipate

Soros spends much of the back half of his book contemplating the idea of a global central bank. He turns and criticizes the very mechanism that made him so much money, floating exchange rates, and notes that they have been “a major source of disruption for the world’s economy" His prediction, or arguably plea depending on the interpretation of his text, has clearly still not come true today. The IMF is a far cry from being an international, unilateral controller of policy. And while the big four central banks (Fed, BOE, ECB, and Bank of Japan) have worked in concert, they are still inherently competitive.

Interestingly, Soros predicts that Japan could become the world superpower and notes that the U.S. would need to fall from its pedestal for this arrangement to work. I suppose Soros is still in the red on that trade.

Reflexivity Moving Forward

There is still a lot more to unpack when it comes to reflexivity. The political and societal implications for the phenomenon are seen everywhere but that is a topic for another time.

The most important question to consider today is: where will reflexivity break next? It certainly will as everything is cyclical, and we all have an incomplete and distorted view of the world that is driving this reflexive behavior. The self-reinforcing trends are kind while the self-correcting ones are destructive.

Homework Reading

Common Myths About the Federal Reserve - I learned quite a few things in this run-through of commons myths surrounding the Fed. It is a great prelude to The Jekyll Island book.

The 2x2 Inflation Debate - As always, Byrne Hobart has the most fine-tuned thinking around today’s hot topic.

My Mom, The Nomad - A great accompaniment to the new film, Nomadland.

Why is Everything Liberal?

Democracy does not reflect the will of the citizenry, it reflects the will of an activist class, which is not representative of the general population. Populists, in order to bring institutions more in line with what the majority of the people want, need to rely on a more centralized and heavy-handed government. The strongman is liberation from elites, who aren’t the best citizens, but those with the most desire to control people’s lives, often to enforce their idiosyncratic belief system on the rest of the public, and also a liberation from having to become like elites in order to fight them, so conservatives don’t have to give up on things like hobbies and starting families and devote their lives to activism.

Today’s Music

I recently stumbled across the Swedish composer Franz Gordon. Born in 1971, he is a relatively recent contemporary composer. As you listen, you can hear remnants of Debussy and Chopin.

A few favorites:

The French Library

The Beggar

Song for Johanna