If you are not familiar with George Soros’ Theory of Reflexivity, something he credits for making him incredibly rich and successful, here are a few good summary articles.
To very quickly summarize, when it comes to the stock market and investing we are always dealing with incomplete and/or imperfect information. At certain times that leads to so called positive or negative feedback loops. Leading various financial instruments or overall markets to diverge significantly from their true value.
For example….
Take a highflying tech stock like Amazon (AMZN) for example. The company has made little in the way of income (in relation to its market cap) for the majority of its existence (over 15 years) but the stock has continued to soar. This is happening because people formed a number of positive beliefs about the stock. These beliefs could be that the company will make tons of money someday because it’s innovative, eating market share, or has a secret profit switch it can flip whenever it wants. Or maybe people continue to buy the stock because it’s gone up for a long time and so they assume it will continue to go up.
Mr. Soros goes on to explain:
Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced.
Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.
Sounds like today’s stock market, doesn’t it?
Over the last couple of days/weeks we have shown a number of scary charts on this site. Most importantly……
- Shiller’s Adjusted P/E is now at 34.35. Which is 4 points above its 1929 peak. Last week we had a chart showing we are at the highest valuation level in the stock market’s history.
- Margin debt has double since 2007 peak.
- Most bullish sentiment readings are either at record highs or getting very close.
That is to say, it is now obvious that a massive positive feedback loop has been established in the stock market. With people arguing all sort of nonsense, from tax cuts not being priced in, to hyper inflationary fears, to this bull market running another 20 years.
Long story short, as Bridgewater’s Ray Dalio pointed out yesterday ‘if you’re holding cash, you’re going to feel pretty stupid’ And god forbid you are short.
However and as Mr. Soros’ theory teaches us, such positive loops eventually end up imploding on themselves. And when they do, the underlying assets typically collapse in a spectacular fashion as well.
If you would like to find out exactly what happens next based on our Timing and Mathematical work, please Click Here.