“Reflexivity” is a strange word. For investors, it’s important to know what it means.
This is because markets are reflexive — that is to say, markets show reflexivity — which creates both danger and opportunity at bullish or bearish extremes.
What does it mean to say the market shows reflexivity?
To put it simply, the market observes itself and then responds to itself. This observe-respond dynamic, which endlessly repeats, will sometimes create a feedback loop, like sound waves oscillating at just the right frequency.
At market extremes, this feedback loop can intensify to the point of euphoria and mania (on the bull side) or despair and panic (on the bear side).
A common assumption is that feedback loops are always emotion-driven. Optimism fuels more optimism, which then leads to euphoria and ultimately mania. Pessimism fuels more pessimism, which then leads to despair and ultimately panic.
But this is too narrow a view, because data can be reflexive, too. For example:
- A homebuilder borrows at low interest rates to build houses.
- More people buy houses because of the low interest rates.
- The builder shows his rising profit balance to the bank.
- The bank lends the builder more money.
The cycle described above does not require wild emotion. Everyone in the process can be sober and rational. The builder sees that business is good, so he keeps borrowing and building. Consumers see it’s a good time to buy a home, so they keep signing up for mortgages. The bank sees a profitable and growing homebuilding industry — so they authorize more loans.
It’s a reflexive process even without emotion. Things will naturally keep going until they’ve gone too far. But of course, at the extremes you get emotion thrown in, too.
The builder, flush with profits, doesn’t keep expanding at a normal pace. As confidence rises, he starts to go a little crazy. Home buyers, seeing how fast home prices are appreciating, do the same thing. Banks start tripping over each other to do more loan business, which they see as justified by the numbers.
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Emotion isn’t necessary to kickstart the process. Positive feedback loops can build for completely rational reasons, in part because it is the natural tendency of business to expand; and expansion creates positive data signals, which are interpreted as reason to expand further; and there is no reliable mechanism for putting the brakes on that process.
But then, with markets, even if a trend starts out rationally, emotion can build up toward the end, fueling the extremes that lead to euphoria and mania — or despair and panic. That is where danger and opportunity reside.
This also plays out in terms of reflexive second-order effects.
- A first-order effect is a normal cause-and-effect relationship: “X is causing Y.”
- A second-order effect is a thing that happens because of the first thing that happened: “Because X is causing Y, there is additional result Z.”
Here is another real estate example of reflexive second-order effects.
The Wall Street Journal had a recent article titled: “So Long, California? Goodbye, Texas? Taxpayers Decide Some States Aren’t Worth It.”
The article described how residents of high-tax states are increasingly moving to low-tax states. California is an obvious high-tax state; Texas is included in that group because of property taxes.
This passage in particular described the California-Nevada migration:
California has lost residents to Nevada for years, but that accelerated after the tax law passed. Nevada picked up a net of 28,000 people from California in 2018, according to the U.S. Census Bureau. That is the second-highest year since before the financial crisis.
Nevada home prices rose more than 12% from the end of 2017 to November, roughly double the change in California prices, according to online real- estate company Zillow Group Inc.
Ruchelle Stuart, a real-estate broker in Las Vegas, has tailored her business around people looking to move from California. “The reason people from California don’t mind it so much here is that home is only three and half hours away,” she said.
At first glance, a bullish stance on Nevada real estate is quite reasonable. It is also first-order reasoning: Californians will continue migrating to Nevada, keeping real estate prices strong.
But with a second-order effect, it is not just “X causes Y.” You also get “additional result Z,” which sometimes changes everything.
Consider what could happen, for example, if it becomes received conventional wisdom that migrating Californians will keep Nevada real estate strong:
- Builders, betting on a “can’t lose trend,” start overbuilding Nevada properties.
- Banks, also betting on a can’t lose trend, happily lend to the builders.
- New supply outpaces the California migration — leading to a glut.
This is classic reflexivity. Overconfidence in a trend that “everyone knows” about — Californians migrating to low-tax Nevada — can lead to a situation of oversupply, feeding a glut and eventually a bust.
If another Nevada housing bust like the one in 2007 happens (which remains to be seen), it likely won’t be because optimistic builders were wrong about the California migration trend, but rather that their overconfidence led to a self-fulfilling prophecy in reverse.
That is why the combination of reflexivity and second-order effects can be particularly dangerous at market extremes — when “everybody knows” such-and-such situation is a guaranteed lock.
Those are the conditions where the largest percentage of the crowd is caught wrong — and where the market is most prone to reversing itself.
TradeSmith Research Team