Do you ever feel like you’re coming in midway through a conversation?
Markets and the economy talk to each other all the time. Companies report earnings or losses, investors decide how reputable the managers are, and the share prices adjust. Political leaders alternate between cooperation and confrontation, and the market reacts with hope or concern. But information flows both ways. Share prices rise, giving managers more currency to finance stock-based acquisitions. Or the market falls, leading folks to rein in their ambitious plans. Maybe we’ll just enjoy a “stay-cation” this summer, rather than travel overseas.
Fundamentals affect market prices. Fast-growing companies receive high share prices. But market prices impact fundamentals, as well. High share prices can attract ambitious, talented employees.
Photo: Skeeze. Source: Pixabay.
Reflexivity refers to this circular relationship between cause and effect, where the relationship is bidirectional. The most obvious examples are during a period of financial exuberance, where a booming stock market gives us a sense of euphoria and optimism, and the upbeat sentiment contributes to economic activity. People spend more, save less, and businesses expand. This kind of positive feedback loop can also act in reverse, where falling prices lead to gloom and depression which causes the economy to shrink and prices to fall further. News stories appear pronouncing the “Death of Investing.”
But every trend can only go so far. As we saw in March of 2009 or January of 2002 – the depths of the Financial Crisis and the bottom of the dot-com bust, respectively – there are pools of patient capital waiting to be put to be tapped. Even when there was a broad sense of gloom and despair, the underpinnings of the economy were sound. As one CEO put it, 10% unemployment means 90% of people are still working. And on the flip side, a low unemployment rate means companies have a hard time finding workers to expand. Eventually, expansion goes too far, and folks fill up their time with unproductive tasks. Higher prices lead to higher prices, until they don’t. Eventually, there are no more talented employees to attract or interesting companies to acquire.
Reflexivity works because the trend is your friend, until it ends. They key is knowing when the conversation is about to change.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”