George Soros adopted and adapted Karl Popper's philosophical theory of reflexivity to explain market movements. |
Reflexivity can be understood in engineering terms as a feedback loop, the reinforcement of a trend by its effect on itself. |
In this context, the obvious example is how an initially small rise in prices creates more demand for stocks, thus leading to further price rise. |
In the reverse case, prices may fall drastically because an initially small drop in prices leads to more sales. |
Stripped of nuances, reflexivity suggests that price movements often swing beyond the rational; sometimes way beyond. Reflexivity implies equilibrium is an unusual state "" market prices will usually be above or below fair valuation. |
Soros realised that, if this was true, positions could be safely held beyond the point of rationality. When trends developed they would continue well beyond "fair value". |
The theory of reflexivity flies in the face of conventional market models such as capital asset-pricing models, and other calculations of fair value by discounting returns versus risk-free debt. |
Soros has also made far more money than conventional traders, so his beliefs have to be treated with some respect. |
If true, reflexivity accounts for some of the irrationalities we see, especially bubbles. Soros-Popper provides an interesting explanation of the lost decade of 1992-2002, when long-term returns were negative. |
The reflexivity of the Harshad Mehta boom created a massive bubble, which took a full decade to deflate. |
By some measures, prices stayed above fair value through all but a few months of the decade. We can calculate fair value as the reciprocal of risk-free returns. |
Since the risk-free return is equivalent to earnings divided by price (E/P), the reciprocal, or P/E is approximately fair-value. If rates drop, fair value rises. It also rises if earnings rise. Earnings rose through the decade and rates fell towards the end. |
The risk-free interest rate was 15 per cent during those glory days of 1991-92. So fair equity values were then around P/Es of 7. The Sensex peaked at average P/Es of 55 (4450 points) in April 1992. The following bust saw a 58 per cent dip inside 12 months. |
But even at the decade's lowest prices (1900 Sensex) in April 1993, average P/Es were 25, way above fair-value. |
In the next boom, prices peaked at Sensex 4600 in September 1994, equivalent to P/Es of 45. Dropping rates meant that fair values were then around 8. |
In each subsequent bust, P/E levels declined more since earnings grew steadily. Rates also fell, especially after 1998. In late 1998, average P/Es dropped to around 9-10 at Sensex values of 2700-2800 points. This was close to fair value. |
In September 2001, prices declined to P/E levels of about 13 and nominal Sensex levels of 2600 (the index had been rebalanced causing the anomaly versus 1998). Rates dipped. So, fair-value would then have been 11-12. |
Recently valuations did drop below fair-value at around 2900 Sensex in April 2003, when average P/Es hit 12. The current run up has pulled the Sensex to 14 P/E with risk-free rates down to 7. |
So the market has pulled upto fair-value. Given reflexivity, this bull-run surely has plenty of steam left. |