Understanding Reflexivity with $INTC
George Soros: "Stop trying to make EMH happen, it's not gonna happen"
The very existence of such an emotional “political” component in the determination of stock prices renders the concept of perfectly rational markets (as dictated by EMH) irrelevant. Markets ARE emotional — hence Keynes’ famous saying “markets can stay irrational longer than you can remain solvent”.
Most people would not think to associate George Soros with Value Investing, yet he is undoubtedly one of value investing’s biggest contributors. As a reminder, value investing concerns itself with the gap between price and value, rather than low price multiples (i.e. cigar butts) per se.
Aside from his infamous pound trade on Black Wednesday, Soros is best known for his discovery of a market phenomenon known as “Reflexivity”. Reflexivity is not a very intuitive concept, but it’s easier to understand once you contrast it against the Efficient Market Hypothesis (EMH).
While EMH is typically used to describe the existence of efficient markets, the underlying premise of EMH is that financial markets merely reflect fundamentals/reality. That is to say, they reflect reality but are completely independent from reality. This is just like how a mirror reflects the real world, but the world in the mirror doesn’t actually interact with the real world (or even exist).
Under the efficient market premise of EMH, financial markets (“mirror”) simply reflect fundamentals (“real world”) but do not influence them — in the same way that a mirror only reflects the real world, but does not influence what happens in it. What the notion of Reflexivity is trying to suggest instead is the reverse — that financial markets do influence the real world, i.e. what happens in the mirror actually does influence the real world!
This would be akin to a Mirror Ghost trapped in a mirror reaching out of the reflection and strangling the observer. Truly spooky — yet an undeniably real phenomenon in financial markets!
Reflexivity is crucial to recognize because it has all kinds of implications on market prices. Imagine if financial markets didn’t merely reflect fundamentals, but actively influenced fundamentals as well. Wouldn’t it throw out all your assumptions about how financial models work, since the models themselves aren’t supposed to impact fundamentals??
In a system with Reflexivity, fundamentals wouldn’t be an isolated system — they’d be swung around wildly by extenuating circumstances which affect financial markets themselves. Given the feedback loop nature of such a system, wouldn’t recognizing the existence of Reflexivity be of utmost importance when attempting to value businesses?
Let’s use a present-day example to demonstrate Reflexivity in action — $INTC!
Reflexivity & The INTEL-ligent Investor
Unless you’ve been living under a rock, you’ve probably heard about Intel’s catastrophic share price dive by now. It’s gotten so popular, even the share price trajectory has become a meme!
However, a very interesting phenomenon can be observed in its share price trajectory — Reflexivity. On one hand, the recent slide in INTC’s share price was initially caused by its deteriorating fundamentals. However, as developments in financial markets progressed, we can observe management taking actions in response to the share price decline.
This stands in stark contrast to what EMH would prescribe — which assumes that financial markets are an isolated system from fundamentals, like the reflection in a mirror. Assuming otherwise would necessitate modeling a feedback loop system — where the ghost in the mirror influences the real world, and such influence affects the reflection as well. Obviously, this wouldn’t play nice with financial models that are trying to model static systems.
However in INTC’s case, it’s pretty clear that Reflexivity is in play. Following the initial share price drop after Q2 results, CEO Pat Gelsinger immediately sought to calm financial markets by introducing several new suggestions. One of them was segmenting their internal foundry into its own subsidiary (so that it could raise funds independently from the Group); while another was entertaining acquisition offers from Qualcomm.
Given that neither of these events had happened over the prior three years since Pat had become CEO, it’s unlikely that these options had been considered before their latest Q2 results. And since these developments most certainly did impact Intel’s share price, that would confirm the existence of Reflexivity — i.e. the man in the mirror reaching out of the reflection to influence reality.
As Soros alludes to, it’s incredibly important to recognize the existence of Reflexivity — i.e. how financial markets can influence fundamentals, and not just how fundamentals can influence financial markets.
In Intel’s case, it’s actually pretty easy to understand the source of this Reflexivity — the massive (un)popular tide turning against Intel today can only be described as an “emotional” outpouring. Such irrational processes should have no place in our perfectly rational financial status quo — and yet they unmistakably exist.
If Reflexivity didn’t exist, Intel’s management probably wouldn’t be trying so hard to calm financial markets, since they’re actually cash flow positive. Consequently, they wouldn’t have to worry about the “political” crisis of confidence brewing around their stock, potentially compounding fundamental issues (e.g. causing high employee turnover).
The chart above demonstrates Reflexivity in Action, as it pertains to $INTC. The takeaway here is that if an investor assumed that Reflexivity didn’t exist, he would miss the completely new trajectory that Intel’s share price could’ve taken (blue bubble) — and potentially arrive at a completely wrong target price based on the old trajectory (prior to assuming Reflexivity exists).
If you take some time to think about it, this kind of feedback loop — where share prices impact fundamentals, and such altered fundamentals subsequently inform new share price trajectories — can potentially play out ad infinitum, resulting in the final share price outcome being completely different from the old expected trajectory. With the underlying premise of the DCF model assuming perfectly static external environments, it’s no wonder that the sellside gets share price forecasts wrong so often.
The very existence of such an emotional “political” component to the determination of stock prices renders the concept of perfectly rational markets (as dictated by EMH) irrelevant. Markets ARE emotional — hence Keynes’ famous saying “markets can stay irrational longer than you can remain solvent”.
In this way, we have managed to amply demonstrate what Reflexivity looks like in markets. It may feel relatively insignificant, but it’s clearly extremely present in markets. And not acknowledging its existence can clearly lead to making mistakes in markets.
Reflexivity in Other Stocks
If you thought INTC 0.00%↑ was just a special basket case suffering from this phenomenon, think again. Reflexivity is everywhere — you can’t help but notice it once your eyes are opened to its existence.
Extending the “Man in the Mirror” analogy above, I’ll be using the terms “mirror” and “real life” to more obviously highlight the feedback loop relationship between financial markets and fundamentals with respect to Reflexivity. Here are some examples:
NVDIA announcing a share split at all-time highs in response to its surging share price (“mirror”); hoping to cultivate greater confidence in Sales & Marketing (“real life”) from having a very publicly inflated valuation (“mirror”);
OXY rapidly buying back Berkshire preferreds upon the surging of its stock price in 2022 (“mirror”); which has since dramatically improved its gearing from 210% at its peak to 65% today (“real life”);
GME and AMC issuing shares (“mirror”) following the meme stock craze, which actually improved their balance sheet conditions (“real life”);
SEA Ltd responding to its share price collapse in 2021 (“mirror”) by rapidly cutting costs in various areas (“real life”), in order to rehabilitate shareholder confidence (“mirror”) — thus allowing its business extra breathing room to navigate autonomously, without which they’d be in trouble (“real life”, feedback loop!)
In each of the above examples, new and unexpected developments in financial markets ended up impacting management decisions in real-life — creating entirely new business fundamentals and thus share price trajectories. Notably, none of these outcomes would’ve likely been caught by a standard DCF model valuation, given its assumption of static external influences on fundamental valuations.
The point of all this is to demonstrate the importance of simply recognizing that Reflexivity exists. It’s not so much something about Reflexivity being all-important, moreso that not recognizing it can be deadly.
This also provides ample evidence for how EMH isn’t exactly a perfect descriptor for how markets work. Financial markets are ultimately about human prediction, which involves all kinds of emotional and non-rational behavior — what we call behavioral economics. As I’ve gone to great lengths to describe in other articles about Value Investing on this newsletter (also see links below), this makes risk management the lynchpin of good investing; rather than return management.
One reason why many value investors end up beholden to the School of Graham & Doddsville is because of massive gaps in orthodox statistical valuation theory like this. It’s not so much that we care incrementally about Value Investing, but rather that we can no longer ignore the flaws which exist in the financial status quo — with all their real-life portfolio consequences. To authentic investors in underlying businesses, we have no choice but to identify as value investors.
Which of the stocks below exhibit Reflexivity? Take a gander at our research and find out!
Click one of the links below for more articles about Value Investing!
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I don't think the concept of feedback inside stochastic systems really needs another name/buzzword.
"Reflexivity" is just another concept that has been both borrowed and misunderstood by the investor community. Complex systems have internal feedback loops that around equillibrium. The human body maintaining homeostasis operates by very similar principles.
It doesn't prove or disprove anything about the efficient market hypothesis. Crowd wisdom certainly exists and denying its existence seems like delusion. The OPs argument seems to be some variant of the NAXALT fallacy ("Not all X Are Like That") - not all markets are rational - at least to the observer, is again somewhat self-evident.
However, the implications of these exceptions disproving the rule is that there is a rule to begin with - and that rule is the EMH. What one has observe is that the users of this systems have decreasingly little understanding of systems in general; and tend to conflate the brokenness of markets with personally bad outcomes.
Blaming abstract concepts like the 'market' for being 'broken' is akin to blaming the hypothalamus for not working because you shot its owner in the head. For all the worry about runaway feedback loops, it's fair to say that the vast majority of them function more or less as intended.
There are already existing concepts like hysteresis, wicked problems, stochastic systems that sufficiently describe the phenomenon at play here - "Reflexivity" is just a buzzword that describes a small feature of these systems as it were the keystone to enlightenment.
Reflexivity is so much fun to consider, but it took me a while to get there. It's the same thing as the observation problem in physics, where looking at something changes that system, or creating a sculpture where the clay itself kind of leads the way.